Market Thinking - a view from the equity market - commentary from Mark Tinker, AXA IM
Thursday March 16th 2017
- The Fed, European elections, Chinese policy meetings, Brexit and an options expiry. This week has a lot of news flow to react to.
- While the fundamentals are important, we should not forget that the March futures and options expiry tends to make markets extremely technical around “the Ides of March”.
- Ironically while bonds are selling off apparently on growth and inflation concerns, a breakdown in oil prices is leading to some distressed selling and an overdue assessment of the consensus trade on ‘reflation’.
In terms of news flow, this week is crowded. The US was looking at the Federal Reserve (Fed) - and the increase in interest rates, Europe has been looking at article 50 in the UK and the Dutch elections and China has been focusing on the National People's Congress (NPC) in Beijing - with discussions about growth, structural reform and particularly limiting capacity in key industrial and commodity sectors such as steel and coal. Meanwhile Korea has just impeached its President so it will be having elections in May at the same time as France.
As discussed last week, broadly speaking, global economic fundamentals appear to be positive and in particular China continues to produce robust data which have in my view been a major factor in the Fed’s increasing hawkishness on rates given that the Fed sets rates for the whole dollar ($) zone these days, not just the US. This has set a tone for a belief in a ‘reflation trade’. However, in the short term the market technicals appear to be undermining this. While much is going on with fundamentals, technical matters are also important as we approach the end of the quarter and the notorious March options expiry and not for the first time I find myself quoting the Soothsayer from Shakespeare’s Julius Caesar “Beware the Ides of March”.
Over the last 30 years or so (!) that I have been writing market commentaries, the third week of March has seen some aggressive moves on a number of occasions, making the Ides (15th) a time of change and volatility. Technically this makes sense as the triple witching on the third Friday is the first big chance to alter the hedging positioning from the beginning of the year. This can take the form of not rolling expensive protection, or the opposite, moving from an unhedged to a hedged position. In equities this now involves buying/selling the Vix, but that is a relatively new instrument, previously it tended to involve market futures and options. In commodities we often see moves between contango and backwardation as the futures contracts roll or expire, while in bond markets we also tend to see a lot of technical activity. Right now, the US long bond is poised at a major Fibonacci retracement, which is arguably more important in the short term than the actions of the Fed or the realities of inflation. Bill Gross was highlighting last week the importance of the 2.6% yield level and you can see the technical set-up he was referring to in Chart 1.
Chart 1: US Treasuries highly technical at the moment
Source: Bloomberg AXA IM March 2017
Generally, I tend to find that currencies are the most responsive to Fibonacci retracements as they are the biggest ‘noise traders’, but fixed income traders also use them heavily. Technically, bond yields have broken higher; the discussion is really about whether they now move into a range with 2.60 as the floor, rather than the ceiling. Ironically, while the sell-off in bonds (spike in yields) at year end was seen as part of a paradigm shift from deflation to reflation, the buy side of the trade – commodities, cyclicals etc. now appears to be meeting some resistance and profit taking.
The most obvious of these this week has of course been oil, where the movement we described last week as aggressively sideways has done what they almost always do – broken out, in this case downwards. If we look at Chart 2 and once again apply our Fibonacci reversal of the rally between February 2016 (China collapsing, all doom and gloom) and February 2017 (everything booming, OPEC controls output) we see on West Texas Crude oil a clear ‘topping’ process, followed by a Fibonacci breakdown to the 23.6% reversal line at $46.5.
Chart 2 – Oil breaks down
Source: Bloomberg AXA IM, March 2017
Also of note among the confusion of lines is that this move broke the long term moving average (the green line). This happened briefly last August (and was reversed) but previous breaks (June 2012, Dec 2013 and most notably June 2014 have produced meaningful technical sell-offs making traders extremely risk averse at the moment. It was the move back above the long term moving average in May last year that stabilised the price above $40 allowing the current momentum trade to build and traders will be looking for this again before re-committing to oil.
Looking beyond the price technical, it is also interesting to consider the fundamentals for oil – although again this involves market positioning, given the hedging strategies employed by producers. If we consider Chart 3, which shows the oil price (in this case Brent, which trades at a premium to West Texas, so is just above $50 (green line)). The black line then shows the extent to which the market is in contango (future trading at premium to spot) or backwardation (the reverse). In commodities generally, backwardation is seen as ‘normal’ on the basis that buying a commodity today and storing it requires a cost, so the future ‘ought’ to trade at a discount to cover cost of storing, including financing. As a result, contango, where we have been since oil prices broke their long term moving average in 2014, is usually seen as indication of a short term glut of the commodity. Of course, it is never as easy as this once traders get involved. For example, the large number of oil based, or oil backed, ETFs means that technical issues arise with ‘rolling’ the futures contract behind the ETF. Thus as the contract expires in a contango environment, the ETF provider finds themselves always paying a bit more for the next contract and not surprisingly we see the current contract they are selling going down in price and the one they want to buy going up in price. This helps to sustain the contango for longer than might otherwise exist. That having been said, we can observe that recently the premium of the future to the spot (the black line) has been falling and thus the move back up towards neutral – and potential backwardation.
Chart 3: Oil contango decreasing, but reserves increasing
Source: Bloomberg, AXA IM
However, we also need to look at the third (orange) line. While the scale of this week’s sell-off (green line) does not look that dramatic in this chart, thanks to the scale of the moves over the last five years, it is interesting to see it in the context of the demand/supply background as illustrated by the Department of Energy Stock levels (orange line, inverted). Here we see that while the contango has been decreasing – apparently reducing short term glut – the stock levels have been increasing and are currently at an all-time high.
If we shorten the time horizon to the last six months (Chart 4) we can see more clearly, that in early December the oil price rose (green line) and the contango moved sharply towards backwardation (black line). This reflected a shift in opinion about the ability of OPEC to restrict supply (something we were notably skeptical of at the time). However, if we look at the orange line we see that after only a short sell-off, inventories began to build again rapidly, probably reflecting attempts to take the ‘glut’ off the market. It is thus likely (in my view) that when traders realised that the fall in inventories was not only brief, but rapidly reversed that they recognised that the supply/demand conditions had not in fact been altered to favour higher prices, triggering selling that has produced the current technical set up.
Chart 4: Oil – Supply and demand out of line
Source: Bloomberg, AXA IM , March 2017
To be honest, we really shouldn’t be surprised that the OPEC restrictions have not had much effect – apart from the ‘cheating’, Iraq apparently producing consistently above quota – the US has simply switched production back on. The Baker Hughes Rig count for example has been rising steadily and is currently at 1083, 87% higher than a year ago and the notion that once labour has moved out of the Shale Oil districts it won’t come back has proven to be totally unfounded. As Bloomberg noted, the lodging camps in the Bakken region in Montana are 100% full again, compared to only 65% last July. Also according to a strategist we met recently, the Chinese restocking of oil after Chinese New Year, which were the second highest on record, may well have distorted perceptions of demand and that by not following through in March, the market was caught out.
From a longer term perspective, we should also bear in mind that this reserves series excludes the US Strategic Petroleum Reserve (SPR), which as we noted earlier in the year is arguably twice the size it needs to be given that the US is now one of the world’s major oil producers. This, together with the rapid output response from US shale producers represents a major longer term headwind for higher oil prices and is certainly a headache for Saudi Arabia looking to raise meaningful capital from its forthcoming stake in Saudi Aramco.
In addition to all this I would throw in a further negative demand factor into the mix, following our recent visit to Japan. The best-selling car in Japan last month was no longer the Toyota Prius, but the Nissan E-note. The interesting thing about this model is that it represents a different sort of hybrid. It is a pure electric vehicle in terms of the drive train; it has batteries and an electric motor just like the Tesla or the Nissan Leaf. As such it has the simplicity, lack of gearbox, speed of acceleration and smooth driving characteristics of a pure electric vehicle (EV) with regenerative braking. (It is entirely possible to drive in an urban environment without using the official brake, simply balancing the car on the electric accelerator). What is different about the E-note however is that it has a conventional petrol engine charging the battery, making for a much smaller battery (and hence lighter and cheaper) and no range anxiety. Purists complain that it is not really an EV, but while I haven’t driven it, I can see the attraction. In effect it is the same principle as diesel electric trains or cruise liners and makes for smooth and quiet running and significantly greater fuel efficiency, which should be the key issue for oil producers. The achieved fuel consumption of the E-note is around 37.5km/litre, or 88mpg. Compare that to the average achieved by the US vehicle fleet of 24.8mpg. Clearly some of that is light trucks, but it is difficult to see how miles driven can grow faster than the mpg efficiency of the car fleet, especially as the US environmental protection agency (EPA) has targeted 55mpg by 2025. Moreover, as previously noted, the growth of taxi apps means more focus on mpg than mph as a reason to buy a car.
The fall in oil prices is prompting some profit taking elsewhere and also a re-assessment of the consensus ‘reflation’ trade’ – regardless of the fact that what was arguably the catalyst for the trade, a sell-off in bonds, may not actually be reversing (as discussed earlier.) The obvious follow on trade has been high yield bonds, not least because of the linkage with shale oil companies. Remember that the original sell-off in oil produced a matching weakness in the high yield bond markets. Chart 5 shows how that perceived relationship appears to still be in place.
Chart 5: Profit taking in high yield bonds as oil sells off.
Source: Bloomberg, AXA IM March 2017
More fundamentally, lower oil prices are good for consumer countries, notably Asia and this appears to be helping rotation towards emerging markets once again. Asia is increasingly separating from the US – both economically and market wise, it is marching to its own beat. Right now, it looks cheap and with China looking increasingly stable it will likely attract some Q2 allocation away from the US - which is expensive. The Peoples National Congress in Beijing this week produced the usual discussion over GDP growth rates and the currency, but also some focus on structural reforms (a key driver for commodities last year) and even tax reforms, reminding investors that the policy initiatives affecting Asia and emerging markets are no longer (mainly) coming from Washington. Next week, US Secretary of State Tillerson will be in Asia, meeting in China, Japan and Korea and next month Xi will travel to meet President Trump in Florida, all of which is helping to shift focus onto Asia.
Europe however, continues to make global investors nervous, with news flow around Brexit and the Dutch elections, but also on forthcoming issues such as the French election, a possible election in Italy and a referendum in Turkey next month. This is now one of the few consensus trades from the year end that remains in place. As previously discussed, small/mid cap equities look to be the best risk return for the anti-consensus trade.
To conclude. The approaching end of the quarter/month/fiscal year has thrown up some technical situations across markets that is leading both to profit taking and a rebalancing of positions away from the consensus reflation trades that dominated the beginning of the quarter. Weaker commodity prices, led by oil are rightly being seen as a supply story, rather than a sign of weaker demand which is leading to a reassessment of risk premia in emerging markets and Asia – helped by continued stability in data from China. This is likely to lead to further flows into Asia, where the valuations are attractive compared to the US and where there is less of a perception of political risk, certainly compared to Europe.
Head of AXA IM Framlington Equities Asia
- ENDS -
Notes to Editors
All data sourced by AXA IM as at Thursday 16th March 2017
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