Market Thinking - Market mechanics remain a risk

• The actions in Syria have pushed geopolitics back up the agenda. Bonds and gold rallied briefly then faded. Oil is back to the top of the range and fears over trade wars are subsiding.
• Europe looks cheap, but political risk remains high. Asia meanwhile looks increasingly good value for both bonds and equities.
• Meanwhile market mechanics remain a risk. The inverse VIX is now the 34th heaviest traded equity in the world. It is also being heavily shorted. When derivatives used to hedge become assets used to generate return we need to be extremely wary.

At the end of what was the first in a series of four day weeks for markets in Asia, the missile strike on Syria has just added to the current level of confusion about US policy. In my view there had to have been one eye on North Korea here. Or was this a sudden and deliberate policy change after months of saying the US was going to stay out of Syria? We simply don’t know. Subsequently we have had statements saying that removing Assad is both now a priority and not a priority, there have been accusations of false flags and false reactions. Is all news fake news? Or perhaps not. There are very many ‘known unknowns’ and ‘unknown unknowns’.

The markets weren’t really sure either. The bond market rallied, but failed to break 2.30 on the 10 year and then sold off again to end the week largely unchanged. Gold similarly rallied and then gave it all back. Oil did best, with US west Texas intermediate (which has in any event shown some recent technical strength moving back above its long term moving average) jumping towards the top of its trading range. Also perhaps not surprisingly ITA US, the ETF of US defence and aerospace and defence companies, had a good day.  I have updated the defence stocks versus defensive stocks chart from a week or so ago.

We will have to see what happens next, but obviously escalation is the main concern. One of the more worrying (and intriguing) aspects of it all is the report from December 2015 that Shayrat airport (the airbase that was hit by 59 cruise missiles) was actually a Russian base. Meanwhile the sending of the US Navy and the talk of Chinese troops going to the North Korean border are raising concerns here in Asia.

The fact that there is renewed talk of regime change is worrying to investors, but it is interesting that the full spectrum of Trump critics seem to be now praising his actions. Indeed, there are many observing that this looks like business as usual, we have (retained) Hilary Clinton’s health care policy and now appear to have Hilary Clinton’s foreign policy as well. For good or ill, the Washington establishment seems to have reasserted its grip on policy. This is good news for Saudi and Qatar, who as has been noted in the past are keen for a trans-Syria gas pipeline into Europe, something that requires a different regime in Syria, given Assad’s preference for a rival Iran-Iraq Syria pipeline. But this is unlikely if Putin is still a player in the region. He is known to prefer the Iran-Iraq-Syria pipeline option since this would go through his current zone of influence in Syria and would of course be designed to be less disruptive to the Russian dominance of gas sales into Europe. The pipeline options are as complex and varied as the politics in the region which is perhaps not surprising given how closely they are all linked.

Interesting that for all the talk (and action) over gas, prices have been collapsing everywhere as the US natural gas glut impacts world prices thanks to the arrival of LNG export terminals in the US. We discussed a few weeks back how Australia was exporting natural gas to Japan for less than it sold domestically, well now the rates in Asia are effectively down close to US domestic levels as well. Back in 2010 Cheniere Energy got the licence to export natural gas and watched its share price explode to the upside ($2 to $84). Investors had another chance to get in back in February last year at around $25 (it is now $48). Cheniere will face competition though as new export terminals are coming on board – including from Tellurian, the company now run by Cheniere’s former CEO Charif Souki, who was the first person to import LNG into the US before recognising the significance of the shale gas revolution and switching to export. To date, most of the cargos have gone to Mexico and South America, but one is currently on route to Pakistan, making the market truly global and bringing prices down at the same time. Bloomberg estimate that once all five of the planned terminals are up and running the US will be able to export 10 billion cubic feet of LNG daily – up from only 1 billion in 2016.

From an Asia perspective, the Middle East tensions may have increased energy prices slightly and the Korean tensions have heightened. Against that, trade war tensions have eased and the longer term energy trends look positive for consumers.  The shift in US policy stance seems to have resulted in a bland meeting with the Chinese leadership this weekend in terms of trade discussions and the prospect of a rapid 100 days project to ‘fix’ things on trade as well as perhaps sending a message to North Korea that the US appears to have returned to a more bellicose approach to protecting what are seen to be US interests around the world.

Last week was the Rugby Sevens week here in Hong Kong (to borrow a phrase, the Sevens is three days of international Rugby and then Fiji wins) and I flew straight in from a trip to the UK to attend a breakfast presentation by Charles Gave, one of the founders of Gavekal to talk about the world but specifically Europe. As ever, Charles’ presentation was a fascinating combination of facts, figures and ideas, especially about his native France to which he has recently returned to live, partly because he sees it as being close to ‘as bad as it can get’. Charles believes that Marine La Pen will win the election and further he stated that the European bond markets should be avoided at all costs since bond markets would have to close immediately on a Len Pen victory – France and Italy because of no bid and Germany because of no offer. When asked if Le Pen would actually call for a vote on the euro, Charles’ view was that it wouldn’t really matter because markets would jump to that conclusion immediately. It also backed his explanation of why people continue to hold German bunds with a negative yield – a two year generic bund yield is currently at negative 82bps. If the euro breaks up, then he believes that the European banking system is bust, especially Germany, which has accumulated a huge capital account deficit with the rest of Europe in recent years – offsetting its current account surplus. In effect Germany has been vendor financing the rest of Europe. The not unreasonable concern according to Charles is that in the wake of examples such as Cyprus, cash balances would be sequestrated. The same would not of course be true of sovereign bonds and if there were to be a reversion to former currencies (apparently the printing presses remain intact in Berlin) then of course the bund would likely get a favourable currency appreciation. In effect cash is return free but it is not risk free. Better to hold bonds and as the spread of holding non German bonds over German bonds does not compensate for the ‘unhedgedable’ currency risk, I think it is better to pay 82bps to keep your money safe.

Charles also highlighted the broader problem that Germany, and much of the European financial system, face in the potential event of a break-up of the euro, their NAVs will collapse if their assets are redenominated into lira, pesetas and even francs. This raises the intriguing prospect of the last minute discussions ahead of a euro break up in the manner of the Federal Reserve (Fed) meetings over Lehman in September 2008 detailed in “Too Big To Fail”. Should Germany simply re-introduce the deutschmark and leave the rest of the members of the euro to hang together? Certainly it is likely that the total assets denominated in the, albeit now devalued, euro would probably be worth more than in their separate parts and in my view in many ways this is probably the least bad option. That does not of course mean that it will happen.

Charles also pointed out that the serial numbers on the actual notes correspond to the country they come from, so probably better to have one starting with an X (Germany) than starting with a Y (Greece). Perhaps this also explains why the share price of bank note printer De la Rue has been so strong lately?

Chart 2 shows the German generic 2 year bund yield (inverted blue, RHS) and the price of currency printer De la Rue. In fact last time we discussed De la Rue in this context was back in 2012 during the ‘Grexit’ crisis when I also suggested that Germany could consider leaving – interestingly this is also something Mervyn King suggests in his recent book “The End of Alchemy”.

A bit more on market mechanics. Apologies for the technicalities, but one of the things I have learned over the years is that economic fundamentals rarely drive markets, while market mechanics often do. While risking getting caught in an endless feedback loop, it was interesting to see my comments from a couple of weeks ago with reference to some of the portfolio insurance behaviours taking place at the moment pop up in Zerohedge. They were highlighting some quotes from the Wall Street Journal on the number of volatility strategies out there, something also picked up by Robin Wigglesworth in FTfm this week, with more detail here. (Apologies both the FT and WSJ are behind firewalls). This is always a concern to me, that market participants start using derivatives designed to reduce risk as tools to generate returns. Thus in 2007/8, credit default swaps moved from being an insurance product to an ‘investment’ in their own right, similarly synthetic collateralised debt obligations (CDOs), while as Robin points out people are now buying products such as XIV US, the exchange traded note that benefits from falling volatility. This week Bloomberg reported that the Velocity Shares Daily inverse VIX short term exchange traded note (ETN) to give XIV its full name, was the world’s 34th most traded equity with a volume of $818m a day.

This is perhaps not surprising given that this note has returned over 1000% since 2012, but there is likely to be a lot of momentum trade in there now. In effect, people chasing the note are creating demand for a product that sells portfolio insurance, but they are simply likely chasing a trending ‘stock’. Like synthetic CDOs, they are buying a product without much thought as to what it actually does. In doing so they are creating an excess supply of what this equity does produce; portfolio insurance. Meanwhile they themselves are unlikely to be considering the complexities of the ‘Greeks’ we discussed a few weeks back and are likely to be relatively passive suppliers of said insurance. We thus have players with different motives. They will not be thinking that they own a product which is short gamma and as such will be unlikely to be actively hedging their positions in the underlying markets. The banks who are trading the VIX however are on the other side of the trade and are long gamma, but they do hedge actively. Thus when prices rise the banks sell the underlying and when they fall they buy it, but the short gamma side does not do the opposite. As a result the one sided hedging collapses volatility and the trade continues to pay off. So more insurance is created and so it continues.

So what could go wrong? Well presumably a sudden rush to hedge by the short gamma side, which then stops the volatility suppression, leading to a spike in VIX and a sharp fall in the price of XIV, the inverse note. This would presumably lead to sellers of the note and a sudden lack of sellers of insurance. The feedback loop would then move sharply in the opposite direction.

Why might this occur? Well obviously any sort of Black Swan event would be magnified by these positions, but it could also be something relatively low key such as a shift from contango to backwardation within the markets. These are expressions from commodities markets and the key is that commodities-like behaviour is infecting equity markets. Part of the 1000% return for the IVX has come from the fall in volatility over the last 5 years, but much of it has come from the internal structure of the market, in particular ‘roll’, since the contract itself has a heavy contango. If we think what these products actually are – a future on a basket of put options for the market – then it makes sense that the longer you are providing insurance for, the more you would charge. Thus the curve is seen as usually upward sloping (in contango). When it comes to the inverse ETN therefore, traders can sell the more expensive second month contract and buy the cheaper near month contract and collect the spread. However, this is not guaranteed. As with most of these commodity market like strategies, the contango can (and does) sometimes flip into backwardation such that the second month becomes cheaper than the front month. This is what we described the other week as close to happening in the oil markets and similarly reflects a near term ‘glut’ of oil or in this case volatility insurance turning to a shortage. The investors in IVX and other such strategies are probably just chasing returns, but are effectively saying, “I want to provide insurance against rising volatility”. The problem occurs when and if the volatility spikes and they decide to buy rather than sell. This could reflect one or two funds getting caught or even be triggered by short sellers – something we know has grown significantly recently.

So to conclude. Risks are rising at the moment. US Political uncertainty on the one hand appears to be lower – we seem to be going back to US business as usual – but this is still uncertain. Meanwhile European political risk is high right now and markets may take things into their own hands should Marine Le Pen win the French election, or even take a much higher share of the first round vote in a little under two weeks. Against this backdrop it appears cheap to buy portfolio insurance, the only concern being that many of those selling that insurance may not fully realise what they are doing. For those that can buy VIX, rather like those happy to own a 2 year bund and pay 82bps for the privilege, this may turn out to be a very sensible idea.

Finally I was intrigued to see this article that airlines make more money selling miles than seats pointing out that the airline branded credit cards are a highly profitable part of the airlines’ business. I guess that the United Airlines loyalty cards may be coming under a bit of scrutiny today though!