The Cathartic Flush
09 MAR 2022
For markets, the conflict in Europe has clearly caused a chain of global risk aversion and a major commodity squeeze. You don’t have to be a specialist in base metals to appreciate that something has gone very wrong in the nickel market (price itself had rallied 250% in the past 48 hours before the LME suspended trading). The episode is probably more likely an outcome of market structure, liquidity and scarcity than underlying real-economy supply and demand.
The event is obviously much broader and has affected a range of energy linked, base metals and agricultural prices. As we noted earlier this week, the other troublesome knock on effect has been in the front-end dollar funding markets, where spreads have widened, liquidity appears to be under some stress and financial conditions have tightened. Although perversely, markets have also started to price an easier trajectory of effective policy. While the current start to 2022 is now the worst equity drawdown since 1900 (let that sink in) some measures of risk are still relatively complacent or not consistent with the sort of cathartic flush typically associated with outright capitulation.
One of the key challenges of the conflict in Europe is that it has exacerbated trends that were already underway in terms of supply-side constraints and inflation. The nickel market is probably the most spectacular manifestation of this trend, however the implications are clearly much broader, including with the banks and trading companies that have been financially exposed.
For the global economy, the risk is if or when the commodity price shock triggers a global recession. As we noted last week, historically when oil has risen above 4% of global consumption (approximately $125) that has been consistent with an oil shock recession (when not driven by demand). Clearly, the breadth of the commodity disruption is much broader than oil and gas. In many ways, it makes the supply disruptions during the pandemic appear deflationary by comparison. The implication for input costs and profit margins is obviously challenging a key reason why equity valuation multiples are being rapidly de-rated. The associated global risk aversion has contributed to a further reflexive or self-reinforcing compression in the equity multiples. On the positive side, the episode has probably reduced policy expectations relative to consensus beliefs (in real terms) prior to the conflict.
Each crisis manifests itself differently. While financial contagion from a Russian default appears to be capped and the global banking system appears to be in a stronger position, there has probably been some material losses related to the commodity squeeze and sanctions. There is also clear evidence of stress in funding markets and financial conditions. Curiously, most of the deterioration in risk perceptions has been in equity, with European implied equity volatility above 48 (+2.9 standard deviations) and European credit spreads and euro currency implied volatility now wider than historical average. However, US credit spreads and financial conditions remain below average (perhaps for good reason). Nonetheless, credit risk premia on global banks (CDS spreads), corporate credit spreads and FRA-OIS funding spreads have widened materially over the two weeks (table below). It is plausible that a liquidity crisis has commenced.
Tactically, the critical question for investors is whether risk perceptions have deteriorated enough to trigger a buy signal on equities? Clearly there is evidence of material de-leveraging and risk reduction. Moreover, measures of investor sentiment such as the AAII survey and demand for protection suggest widespread pessimism. From a pure price perspective, the S&P is also now trading well below the primary trend and there has been material weakness in higher beta sectors of the market. On the negative side, our sense is that a genuine cathartic flush is still absent and risk premia in US credit and equity (the global risk proxy) is still neutral rather than outright attractive. For example, the US equity risk premium is only 3.4% which is close to the historic average.
On the positive side in this region, the outright valuation and equity risk premium is a lot more attractive in Asia Pacific. That is bullish for long term investors. However, participants with a more tactical mandate probably ought to wait for a greater flush in risk before scaling into equity.