Interviewed for this Reuters article, I suggest today’s low levels of market volatility could be “the calm before the storm”
Saikat Chatterjee and Vikram Subhedar, AUGUST 11, 2017 / 5:06 PM
LONDON (Reuters) – After this week’s war of words between the United States and North Korea triggered the biggest fall in global stocks since the U.S. presidential election, investors are wondering what other off-radar shocks may be waiting to rock world markets.
Although there is little sign so far that investors are protecting themselves against a major sell-off, some say the current environment masks latent risks.
“Every day, our risk models tell us to take more risk because of falling volatility but with markets being where they are, we have to be very careful in not following them blindly,” said James Kwok, head of currency management at Amundi in London. ”So we try to project scenarios on what can go wrong and where are markets not looking.”
Such has been the extraordinary period of stability in financial markets in recent years that world stocks have hit a series of record highs while gauges of broad market volatility have plunged to record lows. That benign investment environment has been fostered by central banks which have pumped vast sums of cash into economies since the global financial crisis that began a decade ago, lifting asset prices globally.
Flows into most asset classes have already overtaken peaks reached before the financial crisis. For example, inflows into active and passive equity funds have nearly doubled to $10.9 trillion at the end of June 2017 from a September 2007 peak, according to Thomson Reuters Lipper data. Inflows into bonds have meanwhile increased nearly three-fold to $4.1 trillion in that period.
Broad market gauges of risk, such as the CBOE Volatility Index .VIX, better known as the VIX, and its bond market counterpart, the Merrill Lynch Option volatility index .VOL remain pinned near record lows despite a spike this week. But analysts say low market volatility masks the heavy weight of options written on these gauges by investment banks betting that the calm conditions will persist for a long time.
That has been accompanied by the growing popularity of inverse-volatility ETF products, which have doubled in value this year as market volatility has cratered. Morgan Stanley strategists say the volume of bets on volatility remaining low means even a small increase in price swings could force some of these leveraged bets to unwind, triggering shock waves in the financial system and sending stock markets tumbling.
Daily percentage changes are important in the volatility world because a lot of these exchange-listed products and notes are rebalanced daily based on these changes, so that any large change would automatically trigger selling pressure elsewhere.
“This is why lower volatility creates higher risk,” said Christopher Metli, a Morgan Stanley quantitative derivatives strategist in a recent note. He estimates that a 12 point rise in the VIX could send the S&P 500 index down by 3.5 percent. A move of that magnitude was last seen after Britain’s shock Brexit vote in June 2016.
But a spike in volatility is not the only scenario worrying investors.
Other risks markets may be ignoring include the implications of a messy British exit from the European Union and the risks that the Qatar crisis could spiral out of control in the Middle East and hit oil prices. Even the prospect of a newcomer at top of the U.S. Federal Reserve when Janet Yellen steps down in 2018 could prove unnerving.
“Today’s low volatility is the calm before the storm and doesn’t reflect the real world in which companies are operating, or the major uncertainties that are developing,” said Paul Hodges, chairman at International eChem, a consultancy.
Another variable is the expectation that central banks will soon start unwinding their massive post-crisis stimulus measures, with unpredictable results. One of the biggest risks seen lurking is the rise and growing influence on the world’s stock markets of passive funds, which aim to track rather than beat benchmarks and charge lower fees than their more actively-managed peers.
The proportion of stocks on the main U.S. benchmark equity index that are now owned by such passive investors has nearly doubled since the 2008 crisis to 37 percent. But redemption pressures on large passive investors could exacerbate any market selloff.
Apple Inc (AAPL.O), a stock market darling, has a fifth of its outstanding stock held by index funds with Vanguard, BlackRock and State Street making up the top three holders, according to latest Thomson Reuters data. The head of sales of a large British-based bond fund said some of its clients are trying to put together pools of money with which to snap up beaten-down stocks if a large emerging market-focused ETF is faced with sudden redemption pressures.
“We get a lot of queries on what are some of the risks that markets may be overlooking, and that is what keeps us up at night,” he said.
Reporting by Saikat Chatterjee and Vikram Subhedar, Graphic by Saikat Chatterjee and Ritvik Carvalho; Editing by Catherine Evans
“A week is a long time in politics” was the insight of former UK premier Harold Wilson. It is tempting to think that the events of the past week – a terrorist massacre in France: an attempted army coup in Turkey: a fatal US sniper attack: the overnight emergence of a new government with new policies in the UK – confirm Wilson’s remark.
But sadly, these were not just isolated, once-off incidents. They are just the latest examples of the increasingly volatile, uncertain, complex and ambiguous world in which we now live. Instead, the comment of Russian revolutionary leader VI Lenin seems more relevant:
“There are decades when nothing happens and there are weeks when decades happen”
One super-critical issue is that for the past 20 years, policymakers have chosen to ignore today’s unprecedented level of demographic change – the fact that a New Old 55+ generation is emerging for the first time in history. Instead they have claimed that the arrival of 1bn people in this cohort between 2000 – 2030 is simply “business as usual”. Similarly, they have greeted the collapse of fertility rates – now well below replacement levels in most major economies – with just a shrug of the shoulders.
They have effectively created a fictional “La-La Land” where central banks believe they can create economic growth simply by printing money and reducing interest rates. But now, this fiction is being exposed for all to see:
- If the economy is going well, social and political issues tend to be downplayed
- People don’t want to risk losing what they have, and hope their lives will improve
- But when the economy starts going badly, then people have less to lose
The core economic issue is that the fundamentals of the global economy have been undermined by debt. The alchemists at the central banks have promised NICE decades stretching out into the future, offering us Non-Inflationary Constant Expansion. But today, it is becoming increasingly obvious that all the debt they have created – already 3x the size of the global economy – can never be repaid.
Trust in our political elites is therefore falling. And more and more people are becoming uncomfortably aware that there will be many more Losers than Winners in the coming years – many pensioners, for example, will find that the promises they were made, will not be fulfilled. And we all hope to live to be pensioners, one day.
A reader wrote to me recently asking the following question, which highlights just one of the many areas of major uncertainty in today’s world – currency volatility:
“I was wondering if you could talk more about what you think the effect will be on different world currencies as central banks continue to print money. Do you think the dollar will strengthen? Will it collapse with the S&P 500? What will happen to the euro and pound as Brexit intensifies? If the dollar collapses, will that change your outlook on the oil price? I’d also love to hear your opinion on gold and whether it is commodity or a currency – and what do you see happening to it as the Great Unwinding occurs?”
This is a key issue, with major implications for governments, companies and ourselves as individuals. The fact that questions like this are now being asked so often, by so many people in so many different parts of the world, tells us something very important is happening.
It confirms we are now living in a VUCA world, where Volatility, Uncertainty, Complexity and Ambiguity dominate – and where politicians’ focus on “soundbite analysis” fails to recognise there are no easy answers to the problems we face.
The issue of currency values is particularly important, as these are supposed to “take the strain” of balancing supply and demand in today’s economy. I will return to it in a future post. And please do let me know at email@example.com about other questions that you have.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 55%
Naphtha Europe, down 55%. “Naphtha market is over-supplied. US gasoline blending demand poor”
Benzene Europe, down 54%. “Healthy derivative demand and balanced regional availability was keeping numbers buoyant into August”
PTA China, down 40%. “PTA ops rate at operational units remain high ahead of G20 shutdowns”
HDPE US export, down 33%. “Chines market players’ confidence was dampened amid continuous weak demand and sparse deals in the market. Thus, prices are expected to soften in the following week as some traders might need to lower their offers in a bid to move more cargoes.”
US$ Index, up 19%
S&P 500 stock market index, up 11%
The good news was that the Eurozone leaders did realise, at the last moment, that Sunday was a “moment of truth” for the currency union and for Europe. They spent 17 hours negotiating through the night as a result. But reports suggest it wasn’t an easy time:
- The BBC carried live reports of arguments between key players and shouting matches
- At one point German Finance Minister , Wolfgang Schäuble apparently shouted “I’m not stupid” at the Governor of the European Central Bank, Mario Draghi
- One participant described the meeting as being like “a kindergarten – the emotions have completely taken over“
And since the meeting, a new IMF report has warned that ”Greece will need debt relief far beyond what euro zone partners have been prepared to consider, due to the devastation of its economy and banks in the last two weeks:
“The dramatic deterioration in debt sustainability points to the need for debt relief on a scale that would need to go well beyond what has been under consideration to date – and what has been proposed by the ESM,” the IMF said, referring to the European Stability Mechanism bailout fund.
“European countries would have to give Greece a 30-year grace period on servicing all its European debt, including new loans, and a very dramatic maturity extension, or else make explicit annual fiscal transfers to the Greek budget or accept “deep upfront haircuts” on their loans to Athens, the report said, adding.
“Greece’s debt can now only be made sustainable through debt relief measures that go far beyond what Europe has been willing to consider so far.”
It thus looks as though this may well be another of those “one step forwards, two steps back moments“.
I fear we will see many more of these moments in the future, as our leaders are finally forced to confront the problems of the real world – and can no longer pretend everything has been solved by printing money. As we wrote in chapter 11 of Boom, Gloom and the New Normal:
“The transition to the New Normal is a sea-change for the global economy. Its full impact will take years, if not decades, to become clear. Meanwhile, the world will face much greater uncertainty, as conflicting views of the world play out on a day-to-day basis. Companies therefore need to plan for a VUCA environment: Volatility, Uncertainty, Complexity and Ambiguity will be the order of the day.”
The Greek crisis thus highlights the insight of Unilever CEO, Paul Polman:
“I use the term VUCA to describe the world – Volatile, Uncertain, Complex and ambiguous. It is very difficult for people to get a total picture.”
- Volatility. Nobody, including the key players, had forecast the twists and turns of the crisis over the past few months. Crisis Eurozone summits followed each other in quick succession, Greece held a referendum on a week’s notice. And we still don’t know if a final deal can be agreed.
- Uncertainty. The focus on the drama now shifts back to Athens. Will the Syriza government gain approval for the package? Will it survive as a government, or be replaced by different leaders? Will there be new elections in the autumn? We simply cannot know the answers to these critical questions
- Complexity. The Greek crisis was supposed to have been settled in 2010, and then in 2012. Each time the bailout figure was higher, and now a 3rd bailout of €86bn ($95bn) is discussed. But nobody really believes this will finally put Greece back on the road to economic sustainability
- Ambiguity. After all this time, there is no agreement within the Eurozone on objectives. Greece wants to “end austerity”, Germany wants Greece to cut spending and increase taxes, other countries (poorer than Greece) don’t understand why they should handover yet more cash to Greece
And Greece is only a very small economy, its GDP was just $238bn last year. What will happen when it becomes clear that one or more G20 countries cannot pay their bills? As I wrote in my 2014 – 2016 Budget Outlook:
“The key is for each company to develop its own VUCA for success:
- “Volatility. Developing a road-map requires Vision
- “Uncertainty. A strategic Understanding of the changes underway is essential
- “Complexity. The planning process requires Clarity over implementation
- “Ambiguity. Unforeseen events will place a premium on Agility
“Nobody said business was meant to be easy. But companies who take on the challenge of today’s VUCA world will be increasingly successful as we move through the 2014 – 2016 budget period.”
Volatility creates uncertainty. And uncertainty can easily lead to paralysis, if a company hasn’t planned ahead for the range of potential scenarios that might develop. This is the risk highlighted in my usual analysis of quarterly results.
A key warning sign is the divide that has developed recently in performance in different regions and industry sectors, as the detailed reports below confirm:
- Several companies use words such as “challenging”, “volatile” and “uncertainty” to describe the outlook
- Middle Eastern companies focused on their lower profits due to the fall in global market prices
- And PPG, industry leader in paint and coatings, mirrored Akzo Nobel in highlighting a more difficult world.
But US petrochemical companies have, on the contrary, been encouraged by the recent rebound in crude oil prices to believe their shale advantage might continue. And China’s majors happily reported further expansions in production, despite confirming weak demand in their domestic market.
Nobody can be sure what the rest of Q2, and H2 will bring. We can all hope that it will finally bring the sustained recovery promised by policymakers for the past 6 years. Stability in feedstock prices would be very welcome too.
But what happens if, as I suspect is more likely, Phase 2 of the Great Unwinding gathers momentum – causing interest rates to rise, and stock markets to weaken?
We have already seen some remarkable increases in Western interest rates. And the increase in stock market volatility would normally be a warning sign that a change in trend was underway.
Knowing that we don’t know the answer, and planning ahead for a range of potential scenarios, is likely to be the best strategy for survival.
Air Liquide. “Growth in the next few years will be supported by the recent major new contract signings”
Air Products. ““Despite economic uncertainty, we remain laser focused on the things we can control and are maintaining our full-year guidance”
Akzo Nobel. “Overall market conditions remain challenging”
Arkema. “Positive foreign exchange will remain a key determinant”
Axiall. “Lower PVC prices and lower ECU values for the combined value of the caustic soda and chlorine”
BASF. “In a volatile and challenging environment, BASF aims to perform well and slightly increase sales in 2015″
BP. Resetting and rebalancing BP to meet the challenges of a possible period of sustained lower prices”
Bayer. “Raising its group sales forecast to between €48bn-49bn from €46bn previously, largely on account of positive exchange rate development”
Braskem. “Restocking trend in the plastics processors chain and strong demand from the domestic consumer goods and agribusiness sectors”
Brenntag. “Macroeconomic environment characterized by moderate recovery”
CP Chem. Margins fell because of lower polyethylene prices, as well as planned turnarounds”
Celanese. “Lower expenses and taxes led profit upwards”
Clariant. “Growth in Europe is expected to remain weak due to the appreciation of the Swiss franc with the weakening of the euro”
DSM. “Impairment charge following announced partnership with CVC and restructuring and related expenses”
Dow. “Looking ahead, we expect geopolitical and economic uncertainty throughout 2015″
Dow Corning. “Despite the headwinds caused by the strengthening US dollar we saw significant growth in our most profitable product lines”
DuPont. “Income fell by 28% year on year as negative currency effects and portfolio changes impacted sales”
Eastman. “We face increasing challenges including global economic uncertainty, the strengthening US dollar, and the impact of volatile oil prices”
Evonik. “Positive business trend in Q1″
ExxonMobil. “We remain focused on business fundamentals and competitive advantages that create long-term shareholder value”
Honeywell. “We will continue to plan conservatively as the global economic environment continues to evolve”
Huntsman. “We have taken aggressive self-help measures to deliver $175m of expected incremental synergies and restructuring savings by the middle of 2016″
Indorama. “Predicted inventory gains for Q2 on the back of stronger pricing for PTA and MEG
LG Chem. “Profit fell by 14% amid a double-digit decline in sales”
Lanxess. “Costs and exceptional charges caused by the ongoing restructuring of the business”
LyondellBasell. “Planned and unplanned industry downtime has continued to support polyolefins pricing”
MOL. “A much better petrochemicals contribution due to the smooth operation of Slovnaft’s units”
Olin. “Income fell by 56% on chlorine and caustic soda sales and costs related to a planned acquisition”
Oxychem. “Margin improvement across most of OxyChem’s product lines”
PKN Orlen. “Constraints on suppliers in western Europe having opened up market opportunities”
PPG. “A weak overall global economy and unfavourable currency effects”
PTT. “Prices of petrochemical products slumped in tandem with crude oil”
Perstorp. “A combination of positive currency effects, positive effects from improved margins and increased volumes”
PetroChina. “Production of ethylene grew by 8% and that of synthetic resins was up by 12%
PetroRabigh. Lower profit margin on petrochemicals, despite the relatively stable operations”
Polyone. “The sharp drop in prices for raw materials caused customers to destock their inventories”
Praxair. “Growth headwinds persist from the strength of the U.S. dollar and the impact of lower commodity prices on our customer base”Reliance. “Profit fell 7%, while sales at the division declined 18%”
SABIC. “Decrease in net income is attributable to lower average sales prices despite the reduction in cost of sales”
Saudi Kayan. “Swung to a net loss due to a drop in prices, production and sales”
Shell. “Chemicals earnings were buoyed by improved conditions in the intermediates industry which were more than offset by the impact of unit shutdowns at the Moerdijk chemical site in the Netherlands and weaker base chemicals industry conditions”
Sherwin Williams. Sales increased 3.5%n due primarily to higher paint sales volume in the groups Paint Stores and Consumer Groups, but unfavourable currency translation rate changes decreased consolidated net sales 3.1%”
Sinopec. “Ethylene production during the quarter rose 7% year on year while synthetic resin production expanded by 7.6%”
Sipchem. “Increased production volumes and sales”
Solvay. “Better margins and favourable foreign exchange development”
Slovnaft. “Demand was supported by lower product prices”
Synthomer. “Asian nitrile business continued to be the strongest performer as margins firmed and demand increased throughout the quarter”
Tasnee. “Decline in product prices outweighed the increase in the quantities produced and sold”
TOTAL. “Structural overcapacity in Europe is expected to weigh on margins in the medium term”
Trinseo. ““We are pleased to report break-even results for the first quarter, driven by our restructuring efforts”
Unipetrol. “very high market demand for polymers due to favourable GDP dynamics, limited imports to and higher exports from Europe (a weaker euro against the US dollar and a lower crude oil price were factors here) and force majeures at several European players”
Wacker. “Higher sales volumes, especially for solar silicon and semiconductor wafers, and the weaker euro helped boost sales”
Westlake. “Sales prices were negatively impacted by the significant decline in crude oil prices”
There seems almost no need to publish a forecast for 2014. Policymakers have toured the TV studios to confirm that this is finally the year of recovery. They admit it may have taken nearly 5 years longer than first expected, and that there have been numerous ‘false dawns’ on the way. But now, they are certain that the US, Europe, China and the global economy are all moving forward in a powerful synchronised recovery.
Investors certainly believe them, as the blog notes in its annual New Year Outlook for ICIS Chemical Business. And of course this Recovery Scenario may indeed finally come true in 2014. But the blog was clearly right to be cautious back in its 2009 Outlook, when policymakers and the mainstream media were similarly confident. It suggested then that CEO’s, whilst “keeping faith in the future” needed to ask themselves:
“One key question. ‘Is your business robust enough to survive an extended period of low volumes and margins, against a background of tight credit markets, and continuing volatility in oil and currency markets?”’
As we enter 2014, the blog worries that we are in fact approaching a T-junction, as described by PIMCO, who manage $2tn of assets and who cannot be simply dismissed as a lunatic fringe:
“Where markets realise that the policy Kings/Queens have no clothes… and that monetary and fiscal policies cannot produce the real growth that markets are priced for”. This concern leads PIMCO to the sombre conclusion that “global economies and their artificially priced markets are increasingly at risk”.
The Demographic Scenario seems to make much more sense. It is clearly hard to imagine an economy without people. And the Scenario also explains the economic developments of the past 50 years in a simple and common-sense fashion. It does not require us to believe that central bankers have somehow become ‘Masters of the Universe’, able to change people’s entire behaviour via the simple manipulation of monetary policy.
The auto industry provides a vivid example of the challenges posed for company Boards under the Demographic Scenario. What happens if people’s need for mobility is no longer focused on car ownership and, for example:
- The rising numbers of New Old 55 year-olds decide not to bother owning a car, given they will use it even less than the general average of just one hour per day?
- The percentage of young Western men taking the driving test continues to steadily reduce due to their lack of interest in car ownership?
- Car-sharing and the concept of ‘pay to use’ continue to grow exponentially, as seems likely with the support of companies such as Mercedes and BMW?
- The ‘design to cost’ model for suppliers, pioneered by Renault’s Dacia range, proves equally successful in Nissan’s launch of its $3,000 Datsun range?
Boards may naturally want to believe that this time the Recovery Scenario will deliver on its promise. But today’s VUCA world may well continue to upset conventional wisdom. Those who have prepared in advance for the Demographic Scenario will then prove to be the winners.
FREE DOWNLOAD OPTIONS FOR THE NEW YEAR OUTLOOK
Click here to download the 2 page Outlook.
Click here to view the 5 minute interview with Will Beacham
Knowing that we don’t know something makes us uncertain and cautious. If, for example, we come to a dangerous corner in the road when driving, we see the sign and slow down. Its when we are driving on a bright winter morning and don’t look for the ice under the trees that we end up in the ditch.
In other words, its what we don’t know that we don’t know, that is the real problem.
As we approach the end of the year, the blog would like to present 4 critical issues where we think we know the answer, but probably don’t:
HOW LARGE WILL THE WORLD POPULATION BE BY 2050?
Everyone thinks they know the answer to this question. We all believe that the population is rising fast. Conferences are often held with the titles such as ’9 Billion People by 2050′.
But the real answer is that we don’t know. The chart above gives the official forecasts from the UN Population Division 5-yearly report in 2010:
- The black line shows the period since 1950, where the global population nearly trebled from 2.5bn to 7.2bn due to the the post-War BabyBoom and increasing life expectancy
- The red line shows the population rising in a straight line to reach 10.6bn by 2050 in the UN’s High Scenario
- The orange line is the rise to the very popular 9.3bn number in the Medium Scenario
- The green line shows growth ending within a decade at 8.1bn in the Low Scenario
But look at the purple line for a moment. That shows the steady decline since 1960 in the number of children being born per woman. It is now close to the population replacement level of 2.1 children. And recent data shows no overall sign of this decline slowing.
Heroically, however, as the UN makes clear in its methodology, all 3 of its Scenarios assume that this trend will now reverse – either immediately or more gradually. And, of course, it may well be right. But even its own estimates under this methodology give very different results. A difference of 2bn people within the space of the period from now to 2050 is a fairly wide margin of error!
And what happens if today’s trend for lower fertility continues? It has been falling at an annual rates of 1.2% since 1950. Could it continue to fall at this rate?
In Africa, for example, the UN assumes that today’s 4.9 level will fall to at least 3.4 in its High Scenario, and to 2.3 in its Low Scenario. They base this on the assumption that African women are following trends already seen everywhere else in the world.
But this assumption then forces us to make another assumption, if we want to believe that the global population will continue to rise – namely that enough women somewhere else will start having more babies to compensate.
Maybe they will, maybe they won’t, the blog hears you saying. But what if they instead follow the lead of Asian women, particularly those in North East Asia, where rates fell in a straight line from 5.28 in 1970 to 1.11 today? They didn’t stop at the magic 2.1 replacement level.
If this became the norm, then the global population could instead be in steep decline by 2050. What would this then do to demand forecasts?
The simple fact is that we don’t know. After all, even if we correctly forecast fertility rates, we still have to guess right on life expectancy. Or to put it another way – did anyone back in 1950 forecast that global fertility rates would halve to 2.5 children per woman today, or that life expectancy would rise 50% to around 70 years?
Knowing that we don’t know something of course leads to uncertainty. And human beings don’t like uncertainty. But uncertainty can also be a good thing if it leads us to watch for the patch of ice ahead that will take us into the ditch.
This is the New Normal in action, where we need to become prepared for whatever outcome develops by challenging accepted thinking as hard as we can.
Tomorrow’s post will look at another critical area of business, where we all think the answer is obvious.
The weekly look at benchmark price movements since January 2013 is below with ICIS pricing comments:
PTA China, down 15%. “Price increases were limited, curtailed by softer downstream polyester sales in China during the week”
Benzene Europe, down 9%. ”Domestic sentiment buoyed by ongoing production outages limiting feedstock availability”
Brent crude oil, down 2% . “Asian naphtha market is keen to purchase as much European product as possible because of fears over shipment delays on other routes”
Naphtha Europe, up 1%
HDPE USA export, up 11%. “Not yet seen any evidence of the typical slowdown in advance of the Chinese Lunar New Year holiday”
US$: yen, up 17%
S&P 500 stock market index, up 21%