Prices, Probabilities and Predictions
July 18, 2022
The rally in the 10 year bond and the selloff in Commodity prices have been taken by many pundits as ‘Predictions’ of future economic activity, i.e a collapse in demand, a recession and a reduction in the threat of inflation. Maybe. But often not.
As we noted in our recent AFR article, there is the usual talk of ‘Dr Copper, the metal with a PhD in Economics and the (tedious) refrain that equity markets are full of economic naïfs, while bond markets are full of wise old economists. Except of course, markets don’t actually work like that and, while the market is usually a much better indicator of the real world than any of the models employed by experts, we need to understand what it is telling us at any given time. It may be telling us that insiders in the commodity markets are anticipating weaker demand, or, as we suspect is happening at the moment, it may be telling us that a lot of speculators are trying to get out, while others, especially the CTA macro traders, are aggressively selling short to further a narrative. Certainly we have an interesting situation in Oil markets, where the spot month – people actually trying to get physical oil – is at a near record premium to the future months. By contrast two years ago the Oil price went negative at one point as speculators (allegedly many Korean Retail investors) found themselves ‘long’ oil contracts they had no way of accepting delivery on. Distressed markets make for big price moves. Importantly, commodity markets have to settle and clear and, being leveraged, are much more about position squaring than other markets such as equities.
For comparison, think of betting markets and as an illustration the current situation with the betting for the next UK Prime Minister. In a recent article (What Cricket can teach the Tories) we noted that Penny Mordant was, at that time around 7:1 and, full disclosure, put on a modest wager in the manner of an equity manager buying a ‘value stock’. We believed that the price did not reflect the probability of PM becoming PM, not least because of the nature of the final vote (grassroots Tory party members) and that the initial ‘noise trading’ reflected a narrow caste of political bubble insiders, who were reflecting what they wanted to happen, rather than what was most likely to happen. Subsequently of course, the odds on Penny Mordant came in sharply, not because the probability of her winning had changed, but because the weight of money going on forced the market makers (bookies) to adjust the price. They are not predicting she will win, rather they are trying to match a book so that they do not lose if she does. There is a small amount of what George Soros calls reflexivity here, the fact that the odds came in made more people notice her as a candidate such that Penny Mordant went, in equity terms, from a value stock to a ‘meme stock’. Lots of people outside of the political bubble began to bet on what they ‘wanted’ to happen. Indeed, at one point she moved to Odds-On favourite, allowing us to exit our bet with a greater return than if we had held on until September and she had actually won! In a similar manner we closed a bet on Kemi Badenoch at 28:1 out at 10:1, the probability of winning hadn’t changed – in our view – but the risk reward had done. As such we were not predicting anything different.
But this is not about our modest side bets on Politics, rather to make the point that the same phenomenon occurs in markets, sometimes information is revealed by ‘insiders’ and smart traders either follow them or front run them, and sometimes prices reveal the need to ‘balance the book’. In both currencies and commodities it is interesting to observe the general lack of success by traders without access to ‘the flow’ from the underlying investor, not least because the actual profitability, like the bookie, is based on the ‘jobbers turn’, the ability to manage the spread between buy and sell (backing or laying). Also, like bookies, commodities have an ‘end event’, the futures expiry, and while equities and Bonds also have futures, they are not so dominant, not least because (usually) they do not have the sort of leverage traded in ‘noise markets’ like commodities and FX.
So are there any lessons right now? We would suggest that the CTAs are currently the equivalent of the Political Bubble and are promoting a global recession narrative, ‘playing with house money’ having had a very successful run this year, especially on the short bond side. Closing out that ‘bet’ is helping drive the narrative for an ongoing commodity short. The value trade therefore, in our view, has to be the industrial metals and commodity side as well as energy, for while there may well be a balance sheet recession for many western consumers – especially those in countries with floating rate mortgage debt – the actual supply/demand characteristics for energy/commodities remain favourable, especially in Asia.
Finally, there is some interesting activity in the Oil Markets that may well be leading to some ‘mis-information’ for those looking at historic indicators. For all the focus on Brent Oil prices, dropping from $120+ in mid June to $95 last week, the price of Urals Crude from Russia has been between steady between $85 and $90. In other words, the premium for Brent/discount for Urals has collapsed because of arbitrage. The Middle East states have been buying Russian Crude for their domestic consumption and exporting more of their own, sanction free, crude at the higher prices. Similarly, China and India have been importing Urals Crude and refining it to export, sanction free, to the West at record ‘crack spreads’ (the refining margin over crude) even against Brent, let alone Urals. Thus, simple supply and demand has meant less demand from India and China for Brent to refine at $120+, instead substituting Urals and more supply from the Middle East as they substitute domestic consumption with Urals. This is thus telling us nothing about demand and by extension recession. If anything, the key message is that refining margins are incredibly attractive due to, extremely foolish, policies associated with the Green Leap Forward and that western sanctions are not harming Russia, but rather punishing Western consumers of energy to the benefit of OPEC, India and China. No wonder you have to make an appointment to get into Hermes these days.
Meanwhile, we are watching with interest for signs that buy on dip value investors are returning to the energy and commodity related equities.