In Risk-Off Markets All Asset Prices Tend To Go Lower And Create Opportunity

  • A volatile week in markets
  • Recessionary pressures- The yield curve, trade, a crisis in Hong Kong, and more
  • In 2008 commodity prices tanked
  • It led to fantastic rallies in some commodities
  • More liquidity=Wild times ahead

We are only about six weeks away from the first anniversary of the very volatile four quarter of 2018. From October through late December last year, the stock market fell dramatically. While the trade dispute between the US and China was one of the reasons, a leading cause was the hawkish approach to monetary policy by the US central bank. During the final three months of 2018, the dollar continued to rise, and some commodities prices moved appreciably lower.

The fourth quarter of 2019 is just around the corner. The risk of a repeat of last year’s market action looks possible. However, the fundamental reasons for a period of risk-off in markets across all asset classes may be different this time.  And, we could be in for even more fireworks over the coming weeks compared to the volatile period in 2018.

A volatile week in markets

It was a volatile week in markets, across all asset classes. At the start of the week, the August World Agricultural Supply and Demand Estimates report sent the prices of the leading grain markets lower. Corn was the leader on the downside as the USDA said that production and stocks are higher than expected. Soybean and wheat followed the corn to the downside. Gold and silver rose to new highs and closed the week at over $1500 and $17 respectively. Crude oil continues to make lower highs, but the price moved marginally higher on a week-on-week basis. Copper finished the week at just below the $2.60 per pound level on the active month September COMEX futures contract. The dollar index was trading around the 98 level at the close of business on Friday.

While there were no dramatic moves, the intraday price ranges for many assets were wide. It has been anything but a quiet August in markets.

Source: CQG

In a sign of the rising price variance in markets, daily historical volatility in the E-Mini S&P 500 futures contract has increased from under 11% at the start of August to over the 33% level. Fall interest rates around the world are pressuring the Fed to follow and cut the Fed Funds rate at the next FOMC meeting. The market is now projecting a 50-basis point cut. However, the Fed is facing a dilemma. Economic data in the US continues to point to robust growth, while Chinese and German data indicates slowdowns in the economies. The US does not exist in a vacuum, and the “crosscurrents” the Fed cited when it cut by 25 basis points on July 31 are only intensifying. Moreover, the escalation of the trade and currency war only occurred in the aftermath of the last Fed meeting.

Recessionary pressures- The yield curve, trade, a crisis in Hong Kong, and more

It seems like the sentiment in the market is now almost wishing for a recession in the US. Meanwhile, the data says otherwise. The inversion of the US yield curve is a troubling sign. To indicate that a recession is on the horizon, it would have to remain inverted for a prolonged period rather than a couple of days.

The trade war with the US is only one of China’s problems. The leadership faces the potential of Tiananmen Square II in Hong Kong as protests are increasing, and Chinese troops have massed on the border. These factors have contributed to the rise of gold and US government debt securities.

The situation in Iran remains a potential flashpoint, as does the deteriorating relations between North and South Korea over military exercises with the US. Kim Jung Un continued to test-fire missiles over the past week. Another deadline for Brexit is a little over two months away. The new British Prime Minister Boris Johnson has pledged that the UK will leave the EU with or without a deal. A hard Brexit could trigger contagion in markets throughout Europe and the world. India and Pakistan are at each other’s throats again over Kashmir, and both nations possess nuclear weapons.

Meanwhile, the US Presidential election is swinging into high gear as the opposition party is moving towards the left in its attempt to unseat the incumbent, President Trump. An election victory by the Democrats would likely lead to a reversal of the tax and regulatory reforms since 2017 and could lead to lower stock prices. This week, one of the many messages from 1600 Pennsylvania Avenue was that the administration is studying the potential to purchase Greenland from Denmark in a Louisiana Purchase type deal. Along with the many other issues facing the world, the potential for a risk-off period in markets has increased, and the stock market is more than jittery these days.

In 2008 commodity prices tanked

Risk-off periods can be devastation for commodities prices. When the global financial crisis hit in 2008, the prices of crude oil, copper, gold, silver, and many other commodities took the elevator shaft to the downside along with the stock market. NYMEX crude oil futures fell from $147.27 in July 2008 to a low at $32.48 per barrel in December of that same year, a drop of 77.95%. Copper plunged from $4.216 in May 2008 to a low at $1.2475 in December, a decline of over 70%. Gold was trading at $1033.90 in March 2008 and fell to $681 by October as the yellow metal lost over 34%, and silver made its way from $21.85 in March to $8.40 seven months later in October, a loss of over 61.5%. There are many other examples of commodities that lost significant value during the risk-off period in 2008 when the prices of all asset sunk.

It led to fantastic rallies in some commodities

As it turned out, the price carnage led to spectacular opportunities in all markets courtesy of the world’s central banks led by US Fed Chairman Ben Bernanke. As the central banks slashed short-term interest rates and instituted programs of quantitative easing to lower rates further out along the yield curve, asset prices came storming back. The stock market embarked on a rally and continued to make new highs, with a few speed bumps along the way. The latest peak came last month. Gold and silver came storming back after the 2008 corrections and rose to highs of over $1920 and $49 per ounce respectively. Copper rose to a new high at $4.6495 per pound in 2011, and crude oil moved back to over $100 per barrel. The surge of liquidity lifted the prices of commodities after the risk-off carnage of 2008.

More liquidity=Wild times ahead

With the potential for a risk-off period in markets across all asset classes rising, now is the time to keep the powder dry to be in a position to take advantage of any fallout. If a period of price carnage occurs because of any one or a combination of the factors that could trigger an event history tells us that the central banks will be right there with healthy doses of stimulus. The monetary authorities and governments of the world have become addicted to both debt and liquidity. There is no reason why they will not act to avoid a global recession and reach further into their accommodative toolboxes if one appears.

One or more of the issues facing the world is likely to trigger risk-off periods in markets. History teaches us that the best time to buy stocks and commodities is when fear reaches a peak. For the coming weeks and months, tight stops and discipline will allow for bargain hunting when others are calling market swoons financial Armageddon. It is not easy to buy when things look the worst. The height of despair in markets has been the time to act in the past. It is likely to be the same in the future.

There is no guaranty that risk-off is on the horizon as it usually comes as a surprise when the market least expects. It could be that there is some political capital to be gained by the opposition party in the US to shift sentiment and trigger a recession in the lead up to the 2020 election. However, too many things can go wrong elsewhere in the world, which is elevating risk these days in markets across all asset classes. Be careful out there in markets.