Grain stocks and planting - Mixed with no large war response in planting expectations

USDA report on grains stocks showed mixed results. Soybeans, sorghum, and soybeans all higher while wheat, oats, and barley lower. Consistent with price action. All grains higher since the beginning of the Ukraine War, but prices off their intra-month highs. Suggests US does not have the supplies to meet demand of Ukraine and Russia re not exporting. Tightness will be strong in wheat.

Estimated corn planting lower while soybeans higher based on relative prices from last year. Wheat unchanged. Farmers cannot react that quickly to Ukraine-Russia export situation. 

 

2-10-year Treasury spread not as predictive of recessions as short-term spreads

The Treasury 2-10-year spread is often used by market participants as a predictor of recessions. The spreads inverted and a recession is coming. Unfortunately, the evidence does not support this view. A better predictor is the short-term spreads; the 18-month to 3-month spread. See (Don't Fear) The Yield Curve, Reprise.

The Fed researchers show there is a great divergence between the 2-10 spread and the short-term spread. The short-term spread has further steepened while the 2-10 has flattened. There may be an expectations component in this longer maturity spread, but it unlikely to be a recession.

 

The abnormal curvature flex in the yield curve

Yield curve movements are usually divided three types of latent factors: level, slope, and curvature. The first is the overall parallel movement in yields. The second is the slope associated with steepening and flattening. The third is curvature or the amount of bowing or butterfly twists in the curve. 

Generally, approximately 85+% of the yield curve changes over the long run have been through adjustments in level. Slope is the next most important and can represent 5-10%. The remainder is associated with curvature. This month, curvature is having a strong impact on yields. This is not normal behavior. 

This curvature expectations are that the Fed will increase rates rapidly, but it will have to stop the increase and reverse some of its actions beyond 2025. Inflation will either be controlled after three years or there will be a recession that will force rates lower. Nevertheless, these are current expectations and just as fast as the increase, the bond market can price a reversal if there is a recession from our current commodity shock.  

Asset class performance - A new commodity super-cycle?

A performance map gives good perspective on returns this year versus the past. What really jumps out is the return of what could be a commodity super-cycle like what we saw at the beginning of the 21st century. We have had a combination of demand shock from monetary and fiscal policy with now a supply shock from sanctions and war. While the demand shock may dissipate as the Fed tightens and there is no further fiscal action, the disruption supply shock may not be solved in the near-term. Sanctions may not be easily reversed, and the war may prove to be a stalemate. Logistics will still be a near-term problem; however, under investment will be the longer-term cycle issue.

A longer-term supply shock will place negative pressure on bonds especially if the Fed raises rates during this shock. Stocks will see margin erode from elevated levels which will place downward pressure on equities when coupled with a higher discount rate. Investor should increase their commodity exposure where backwardation supports index exposure. 

The dynamics of oil is always connected to inventories

 

Low stock levels for 2022 places a floor on any oil price decline. After the large build in 2020, stocks were drawn down to levels below their 5-year average and levels from a year ago. Now we are at levels not seen in the last five years and that was at the beginning of the year. we are at the same levels of ending stocks as a decade ago. 

Under current conditions, hard to see how there will be a build in the short run except if there is a major albeit unlikely change in demand. 

Hard versus soft data - The impact of expectations

Hard data would be the economic announcements from collection of real activity. Soft data is the collection of data on opinion or surveys. For example, hard data will be unemployment and industrial production while soft data would be consumer surveys. Soft data is represented by the University of Michigan consumer survey indices. Hard data usually comes with a longer lag while soft data is more current.

A strong economy will have soft and hard data both being positive. An economy in transition will show divergences between these two groupings. There is a current divergence between hard and soft data. Unemployment data show a robust economy at 3.8% and initial jobless claims have fallen below 200,000, yet soft data is showing increasing signs of worry. The Michigan current economic and consumer expectations both show significant declines that take us back to the Great Financial Crisis. 

The Michigan inflation expectations show one year ahead numbers well above 5% and above the 4.3% forecast of the Fed for 2022. The jump has been especially strong for the last month even with the Fed sounded the alarm on inflation and raising rates.

If you have a choice in an uncertain world, go with the more recent soft data. These expectation data may be noisy; however, it will give you a job on the volatile dynamics.

The changing dynamics of risk between stocks and bonds

There is a large divergence between the VIX stock and MOVE bond volatility indices in the last month. The VIX has usually shown more volatility of volatility and larger short-term spikes. The MOVE index is more stable and will not see large spikes. The Ukraine-Russia War forced both indices higher, but the MOVE is now approaching highs while the VIX has fallen to levels seen last year. With higher inflation and more Fed rate increases expected, bonds have now become the risker asset in the short run. 

Sector Rotation and Inflation - A different form of diversification

One way to gain some protection from inflation is to rotate sector exposures away from those sectors that are more inflation sensitive. Recent research work focuses on inflation regimes what should be avoided and what should offer some protection.  See "The Best Strategies for Inflationary Times". For example, historically holding energy and health should do well in inflation regimes. For fixed income, there is less protection except through holding TIPS and short-duration instruments. 

Using the most recent one year period as the higher inflation regime, holding energy and health sectors would have generated respectively 60% and 18.5%. A tilt to commodities and necessary consumer spending will help investors. These were the number one and three top performing sectors with number two being technology at 22%. The TIPS ETF was down 1 for the last year versus down 7% for the AGG ETF.

Will this relative sector performance continue? Under a current environment of a cautious Fed, the answer seems likely.

What I learned from Ned Johnson during my days at Fidelity - Kaizen

 

Ned Johnson, the driving force behind Fidelity, died last week. We mourn the loss of a money management visionary. 

I worked at Fidelity (FMR Co) for several years in the 90's in fixed income division. While not a regular occurrence, I had to make a few presentations to him and worked on several special projects. He was a tough boss. He did not suffer fools gladly and if you were not prepared it was going to be a difficult meeting. You had to get it right the first time. No do overs, yet he was relentless in driving home the Japanese idea of kaizen - incremental improvement. If you were not getting better on the margin something was wrong.

I was not familiar with Kaizen, the combination of kai (improvement) and zen (good), prior to Fidelity. For some, this was a Japanese business fad from the 80's. Not for Ned. He lived it and instilled it in those who worked for him. He was an inquisitive technology person who was always asking for how more can be done for less and how customer experiences could be made better. There was no company rest with Kaizen. Your best could be made better.

This idea has stuck with me, and it will well serve anyone. For the quant investor, there is no finished model. It can always be made better. You can always learn from both successes and failures. A model may start simple, but complexity and improvement can be added to make it better. It is not about overfitting but trying to see if new ideas can make the existing modeling process better. Kaizen is not for everyone, but in a changing dynamic world, it gives you a chance for a marginal edge. 

The "happy age" before WWI and the new globalization "dark ages"

 … any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages. The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. 

He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. 

But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable. The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.

- The Economic Consequences of the Peace Keynes 

This was the age of globalization before WWI. How will writers express the period before 2022 in 10 years time? My guess is that we will express with longing the old era of liberal world order and global trade. It is ending, and we should expect markets to adapt to the new order of closed economies, focused production within borders, and limitation on investments and travel. 

All commodities are not the same in response to the Ukraine-Russia War

The Ukraine-Russia War has been disruptive, but it should be placed in context. Commodity prices were rising last year before any hostilities. Commodity prices were increasing prior to actual shooting a month ago. All commodities are not the same. Those markets where Ukraine and Russia production influences have seen significant increases. Those unrelated to the conflict have seen modest increases. 

Global financial condition dispersion increasing

Financial conditions indicators are usually stable and will not provide many portfolio allocation adjustment signals. However, the current changes show a world in turmoil. The Russian implosion of financial conditions is expected given a war. The same can be said for eastern Europe, but the trends around the world are all headed to tighter conditions. The exception is China, but the financial conditions index may not fully account for the country's real estate problems. 

The dispersion in financial signals can be used as a further indicator on future cross-asset return differences. The trends in financial conditions create added signals on relative country performance. Buy (sell) countries with the strongest (weakest) financial conditions.

We have seen a delinking between the real and financial economy as asset prices moved higher over the last decade; however, the real- financial link may be very different when financial conditions tighten. Of course, financial condition indices are driven by asset prices, credit spreads, and volatility, so any selling-off with higher volatility will translate into a decline in financial conditions. Still, financial price signals still provide a warning signal on what may be store for real growth. 

Global food and commodity fall-out from the Ukraine-Russia War is significant

 

The global commodity and food fall-out from the Ukraine-Russia War is significant. G20 countries will feel the impact with higher energy costs and cost-push inflation, but emerging markets and frontier economies may face a real food shortage. Africa is especially dependent on Russia and Ukraine grain. If that supply is withheld from the market or if grains in the Ukraine are not planted and harvested, the shortfall must be made up from other sources. Yet, those sources may not exist. The last time we had a grain price shock in the Middle East sporadic food riots existed.

The same war disruption problem, albeit to a lesser extent, exists for metals and energies in other countries; however, the gravity of a food shortage dwarfs and shortage in metals or energy.

IMF global growth forecasts are being lowered. At the same time, financial conditions are tightening around the world. There are no easy solutions and investors should be prepared for monetary policy reversals if real growth is truly affected. We are already seeing governments discuss and plan for policies which subsidize the higher gasoline prices.

Any global food shortages will cause a flight to safety and will dampen any risk-on thinking that may try to assert itself in current markets. 

Fertilizer is a critical farm input and important to watch this year

The life of a farmer; crop prices are moving higher but the cost of production may increase even faster. The most important issue is that using less fertilizer will decrease crop yields. For the same acreage planted, there will be less output. A supply shortfall is baked into crops without accounting for weather.

Some basics fertilizer information. Nitrogen is needed every year, but phosphate and potash can be skipped for a year or two based on farmer field practices. Nitrogen is the most important fertilizer because it is used for the formation of plant protein. Nitrogen prices are closely tied to natural gas prices. Phosphorous is linked to a plant's ability to store energy, and potassium supports a plant's resistance to disease and strengthens root systems. See the Fertilizer Institute. 

The fertilizer problem is not going to go away even if the Ukraine war ends soon if there are Russia sanctions. There is a current net imbalance in the market; however, a fertilizer crash did occur in 2009 that matched the last commodity super-cycle. 

Three top fertilizer companies are: Mosaic (MOS) focuses on potash and phosphate, CF Industries (CF) focuses on nitrogen/gas, Nutrien (NTR), a Canadian company, is the top vertically integrated fertilizer producer in the western hemisphere. These firms have been on aggressive stock buyback programs to return earnings to shareholders. The price increases have been a pass-through to investors. 

Ukrainian grains - Stocks are high but current logistics stop movement to consumers

This chart from U1 Argo tells an interesting story on agriculture logistics. Ukrainian grain exists from last year, but with export restrictions and war, consumers will not be able to access in the near-term. Commodities are often about logistics and logistical dislocations are the reason for the large futures backwardation. The investment issue is determining when will these stocks will move, and how strong will be near-term Southern Hemisphere exports and North America harvests. 

Menu costs and inflation

Menus costs impacts firms and mean that inflation can be persistent. During the last true inflation bout, there was significant research on the impact of menu costs on the effectiveness of monetary policy and the reason for why rational expectations could not explain the actual behavior of the economy. Menu costs create price stickiness which impacts firm profits and economic behavior. It was one of the micro foundations for New Keynesian thinking.

Menu cost arguments are simple. There are costs associated with firms changing prices. Hence, prices are often sticky. The presence of sticky prices means that policy surprises will have real effects. Sticky prices impact business profits and the response to policy changes.

Menu costs create asymmetric price changes to input cost changes. Initially there will be a slow response to a producer price increase if businesses view price increases are transitory. Firms may accept lower margins; however, over time, price will ratchet higher by more than the increase in inputs because the cost of menu changes is not trivial. 

Prices may increase by more than a change to just offset input costs. On the other hand, once prices increase, they will be sticky at returning to their old levels even if input costs decrease. Think of the simple example of a restaurant menu. If new prices are printed, it is unlikely that the old price list will be returned even if inputs costs decrease. This may not occur with all markets. For example, the asymmetric price behavior is exactly the opposite for gasoline prices. See "Why don't gasoline prices move one-for-one with oil prices"

CPI will not immediately move in lockstep with producer prices, but if the PPI remains elevated for an extended period and there is the perception that these prices will not be quickly reversed, retail prices will start to ratchet higher to return margins to their old level. Of course, the question is whether consumers will accept these higher prices and whether all businesses will follow. This is the critical reason for focusing on inflationary expectations and the feedback to behavior. Of course, we are in a new world where many prices can be changed quickly through the internet. If inflation expectations change with lower menu costs price dynamics can be more volatile and less sticky.

Inside markets - Look at sector / market relationships

 

“The inside of the stock market, which is the best economist I know and which I've used every cycle when I've invested, is saying there's something not right there,” - Stan Druckenmiller, 12/18/18

“The best forecaster of market action is the action of the market itself” - George Chestnutt

Inside markets are cross market relationships seen in prices and not based on exogenous information. The inside markets are the arena of technical analysis, through broadly measuring all the information embedded in prices. 

Prices are a measure of weighted opinions of market participants, and they provide our best guess of what investor are thinking. They may get it wrong, but the base assumption should be that it is a good average guess on what is going on in an economy. For example: 

• The slope of the yield curve tells us about the opinion of market participants on whether monetary policy is loose or tight and whether there may be a recession. The relative performance between cyclical and defensive stocks tells us something about the likelihood of recession. 
• The difference between low volatility and high volatility stocks tells us something about whether the environment is risk-on or risk-off. 
• The difference between value and growth tells us something about the expectations of more distant future cash flows and overall economic growth. 

While many investors try and anticipate the direction of these relationships, the inside market investors will try and extract meaning from these relationships to guide their behavior. The trend-follower may extract meaning from prices, but only act on the activity seen under the belief that it will continue in the future. 

Using inside market information is core foundation to good investing regardless of how decisions are made. Opinions embedded in prices matter about what was thought in the past, where markets are currently, and where they may be headed. The choice is whether to follow this weighted average opinion or make your own decision against the crowd.

Why don't gasoline prices move one-for-one with oil prices

 

With the significant increases in oil prices, consumers have been more aware of changes to gasoline pump prices. Consumers are sensitive to the fact that gasoline prices seem to rise quickly in response to crude increases and fall slowly when crude oil prices decline.

This asymmetric pass-through pricing appears in many markets and is called the rocket and feathers pricing behavior – up like a rocket and down like a feather. There is nothing new here and there is no recent change in gas station behavior. Gasoline sensitivities may differ by region and type of station, but the asymmetric pricing is found in many markets. 

The behavior can be explained by the Edgeworth price cycle whereby once one firm raises prices all will follow quickly, but a decline will be slow as competitors attempt to slowly undercut to marginal costs. See "Edgeworth Price Cycles". This behavior occurs even in competitive environment and can be viewed as a form of tacit collusion in a market characterized as homogenous where competitors engage in a war of attrition. The changing of prices to consumers are obviously based on demand and supply inputs but also on the behavior of other competitors, the price of inputs, and the margins generated. Retail gasoline prices will closely track crude oil in the longer run; however short-run prices will have this asymmetric behavior.

The LME nickel debacle - What market changes are needed

The LME nickel debacle focuses on a number of aspects associated with derivatives trading on exchanges that need to be addressed. 

1. What should be the level of reporting by members and users to exchanges? 

There was a clear problem with reporting to the exchange. Regardless if the hedger is a large miner, this information on sizes of risk is necessary for both what is traded on exchanges and with banks OTC. Unfortunately, reporting on exchange trades is not enough if there is a significant amount of OTC positions that are not tracked. A question exists on who should have access to this information and how should it be used. 

2. Should there be position limits with these markets? 

When there is often physical delivery, there is the potential for corners and squeezes. Positions sizes must be linked to the amount of metals in warehouses that can be delivered. There is also an issue of speculative versus hedge limits and determining whether there should be hedge exemptions. This leads to the issue of whether position limits should be adjusted as contracts move close to expiration. LME faces unique issues relative to contracts on the CME.

3. Should there be daily price limits with these markets? 

The use of daily price limits is tied closely with margining. Price limits allow for some cooling off period that allows firms to gather margin money as well as assess market conditions. daily limits in nickel would have limited the nickel extremes in any given 24-hour period. 

4. What should be the relationship between exchange traded and OTC markets?

This is one of the critical issues for all futures and derivative trading especially when there are OTC products that are priced against a futures close. It is not just what is trading on the exchange but what is traded OTC but uses exchange pricing. 

All of the above are important questions. Some have already been answered by the LME like daily limits, but other structural issues need to be addressed. Market price extremes uncover problem with any market structure which now requires innovation.

"Margin Calls and Trade Financing Hell" for commodity trading firms

Higher volatility is usually a good environment for commodity trading firms, but that has not been the case for firms that are involved with industrial metals and oil trading in a sanctioned commodity world. Given the size of Russian commodity interests, firms have been shocked with margin shortfalls, shortages of short-term trade financing and letters of credit, basis disruptions, and logistical nightmares from sanctions. Funding becomes a problem when commodity prices spike because the cost of any cargo is higher. Similarly, commodity cash prices that spike and are hedged against futures face the classic problem of being long physicals but having to meet margin calls in cash. Cash shortfalls must be financed, yet a cash futures mismatch reduces the leverage available for these firms.

The bonds for large commodity oil and metals trading firms that have sizable Russian business have fallen significantly given questions on whether firms can meet their margin requirements in a volatility environment coupled with high prices. Trafigura 5-year bonds down 20%; Gunvor bonds 4-year down 30% as of the end of last week. 

Bunge, ADM, Wilmar international, Olam International as public agricultural firms are all showing positive equity returns for year, but they have not been subject to the same sanction issues and have in many cases more diversified businesses outside of metals and oil.

There have been whispers that some firms may need bailouts or at least capital infusions. The events of the last month focus on the problems of leverage, financing shortfalls, and the simple issue that centralized exchange trading and clearing are not a solution to large price shocks.

Reputation, cancel business, and sanctions

Even before sanctions, firms have been exiting their businesses in Russia. Importers have self-sanctioned and reduced exposures. Banks have stopped financing Russian trade. Some of these actions were under the expectation of sanction, but it also has been an attempt to maintain reputation. Especially in a cancel culture environment, it makes perfect sense to act first before shareholders and customers question or protest you lack of response. 

Reputations has real effect on stock prices and risk premia. A declining reputation will cause investor exits and thus needs to be managed. Reputation can come in several forms:

• Marketing - Branding - Better perceived products will command premium pricing. 
• Regulatory - fines, penalties, and lawsuits - A more reputation from regulatory issues will be costly.
• Quality - Poor quality and service will destroy firm value. 

Notice that choosing who to source for firm inputs and have as customers is not usually thought of as foundational to branding, yet it is now critical. In the case of Russia, this type of branding has been front and center in the news. The size of Russia's raw material exports coupled with their active aggression on another country makes this reputation issue too hard to ignore. 

Below we show a simple framework for categorizing at reputational risk. It can take the form of a reputation-reality gap, changing beliefs, and poor internal coordination. A loss of reputation is hard to regain and can have lasting damage. Reputation cannot be seen in the accounting numbers; however, a decline in reputation capital is measurable with share prices as investors cancel those perceived as engaging in questionable practices.  

From HBS article "Reputation and Its Risks"

The miracle in current Fed forecasting - Raising rates but no real impact on GDP and unemployment

Tighter monetary policy means that negative real rates should be a thing of the past. Not so with current Fed thinking. The real rate of interest will be at least -2.4 based on their own forecasts.  The real rat should be at zero in 2023 and perhaps slightly positive in 2024. Of course, the current real Fed funds rate is twice what is expected for 2022. The negative real rate will support a GDP above long-term trend for this year and unemployment below the long-term level. 

This is the miracle forecast of tightening Fed policy but continued negative real rates which will allow for low unemployment, above trend growth and inflation that will fall later this year and continue to decline for the next two years. 

It is a beautiful economic world. No fall-out from the Ukraine Russia War, higher oil and commodity prices, supply congestion, or inflation. The political Fed does want to even suggest that higher rates to stop inflation may restrict aggregate demand. 

Who is doing Fed forecasts? These are divorced from reality

What are the best economic minds at the Fed thinking? We might get a decline in real GDP of less than one percent by 2024, and we will get no change in the range of unemployment between now and 2024. This will occur with Fed funds being at 2.8 by the end of 2023. We will see no change in unemployment for 2022 and 2023, the same as December projections which had Fed fund median rates for the dot plot 100 bps lower.  

Few investors make important decisions based on Fed projections of unemployment and GDP, but it suggests that the Fed is divorced from reality. They expect 2022 inflation to come in at 4.3 which means that nominal GDP will be above 7 percent. The Fed is saying that even with a slowdown from 2.8 to 2 in GDP, PCE inflation from 4.3 to 2.3, and rates from current levels to 2.8 by end of 2023, there will only be an increase in unemployment of .1%. No pain for employment regardless of 9 hikes between now and end of 2023. Can you see markets believing this story?

Dot plot dispersion - Policy uncertainty is high

The important take-away from the Fed dot plots and policy announcement is not just the increase in the median since December, but the dispersion in opinions within the Fed and the skew to the upside. This is not consensus. Every dot for March is above the high from the last reading. 7 of 16 dots have rates above 2% by the end of the year. Every dot is above 2% for 2023. 

The wide dispersion is that interest rate uncertain is high and the opportunity for strong returns by playing the wings of the distribution is also high.

 

Stock-bond correlation - Bouncing between safety and inflation stories

 

The stock-bond correlation is critical for asset diversification. No other relationship has been as important to investors, yet it has been switching from negative to positive and back again to negative. The rolling 60-day chart tells story facing investors. 

Where will it move to next? The chart from D E Shaw discussing the four scenarios that will drive the relationship between positive and negative. Shifts in inflation expectations and the monetary policy reaction function will lead to a positive relationship while shifts in growth and risk appetite will lead to negative correlation.

We are facing a fight between the positive and negative relationships. The flight to quality with the Ukraine War and the threat of recession are forcing the relationship to be negative. These two have dominated inflation and monetary policy in the short run; however, inflation and monetary policy may reassert itself based on Fed policy hesitancy and further inflation increases.

Commodity trading - The strange dynamics of the fundamentals and technicals around the Ukraine War

 

The fundamentals suggest shortages and logistical disruptions. Russian sanctions, oil and refined product shortfalls, restrictions on grain exports, fertilizer problems, and planting disruptions. All pointed to higher prices, but price behavior through time is more complex. 

Using the Bloomberg commodity index as a proxy for commodities, we now see the index at levels below the 20, 40, and 80-unit 4-hour moving average to get short-term indicator. If you did not get in when the bullets first flew (February 24, 2022), you might be getting close to a limited upside trade. If you follow the technicals on a long/short moving average model, you would be short the commodity market index on a fast model. 

Margins have been rising from brokers. Volatility increases makes holding commodities riskier. The LME nickel debacle may have scared some speculators. The price action, however, is not consistent with a change in news for the better. You have all of the fundamental news at your finger-tips but the market technicals are saying something different. The trends and fundamentals diverge. Currently, following the price action will be the more prudent trade.

The New Globalization "Dark Ages"

 

We have entered the new "Globalization Dark Ages". Global trade is not done, but the golden age of globe trade is no more. It may have end pre-COVID. It was on the ropes during COVID. The globalization end has come through global sanctions and not COVID restrictions. 

We should see a reversal in trade growth because the foundations of globalization have been destroyed. Sanctions of goods and finance are now a serious global tool of economic warfare that affects all countries, producers and consumers, exporters and importers. In a sanctions world, there is no free trade just allowed and not allowed trade. Free trade is now determined by government policy.

Cancel and isolation are the new means of global warfare. Trade war has been taken to a new level. We are not saying that these actions are unjustified, but the implications are profound and will not be reversed with a flip of a switch. Can we really expect trade and direct investment will return soon if the war in Ukraine ends tomorrow?

Multilateral trade driven by the rules and norms of WTO is no more. Companies are pulling back from global aspirations even without being told by governments to stop dealing with some bad actor countries. Trade is moving from multilateralism to bilateralism as sides are chosen. 

Global financing of trade and foreign direct investment is not just in peril but has swiftly ended. There are no safe assets given a world of electronic money transfer isolation. 

We are moving from low mercantilism to strategic country production as a protection against trade autarky and isolationism. National interests are served by isolation. There is a new Iron Curtain based on a wall of trade and finance limitations. Instead of keeping labor in, the curtain is keeping goods and capital out. Trade shunning.

The triumph of a multinational corporate model has ended and is reverting to a model of corporations serving the interest of states. There is no reason for multinationals to be everywhere if the threat of sanctions are real. The political threats are not just from the host country restricting behavior but the home country stopping corporate action.

Supply chain logistics focused on global cost efficiency will be replaced with supply chains based on national threats and the avoidance of sanction risks. Alternative sourcing is now a critical strategy. 

The source of fungible commodities is now relevant. Oil is not oil. It is biased by being Russian oil. Wheat is not wheat but Russian wheat. Sanctions against commodities coming in and export restrictions on goods coming out of a country.

Every country will be an island or at best part of archipelago of countries not based on a region but on politics. Empires and commonwealths of similar interest will replace free trade. There will be a new equity risk premium associated with sanction risks. Investors will need a premium for multi-national firms. 

The grain commodity situation and fertilizer problems

  

Global grain prices are moving higher which is an inflation problem, but it may be solved through having farmers in non-sanctioned countries increase production. These farmers should make a windfall. 

Unfortunately, the production that will not be available for international trade cannot be easily replaced even if farmers have yet to plant. Fields have to be prepared, and seeds bought and the there is another problem - fertilizer. Guess who is a large provider of vital crop nutrients? Russia. The top fertilizer importer is Brazil, a large soybean and corn producer, and Russia is their key provider. Fertilizer also affects commodities beyond corn, wheat, and soybeans. Commodity and energy prices are higher and that includes all fertilizers.

The Green Markets Weekly North America Fertilizer Price Index is constructed using the fertilizer benchmark prices of US Gulf Coast Urea, US Cornbelt Potash, and NOLA Barge DAP. The index is value weighted based on the annual global demand of each nutrient. The index is at its highest level since inception. 

The three largest US fertilizer companies, CF Industries, Mosaic, Nutrien have all shown significant gains of at least 70 percent in the last year.  

The high fertilizer prices squeeze margins for farmers and make it more difficult to switch planting plans. The commodity shock is multi-faceted and is unlikely to go away soon. Is there money to be made with these companies? Volatility is high and the chance of a reversal is high, but production cannot be adjusted if there is a long-term disruption.  

LME Nickel, Tsingshan Holdings, and the old Metallgesellschaft problem

Tsingshan Holding, the large Chinese nickel firm, is at the center of the LME nickel market failure through its large short positions in nickel futures. We don’t have all the information on the size of its short portions, but it has been reported to be at least 100,000 tonnes going into Tuesday’s market. Some say Tsingshan’s loses last week may be close to $8 billion dollars. 

Tsingshan shows revenue of over $42 billion and profits of $1.1 billion for its last fiscal year ending 8/2/21. It has assets of $13 billion and total stockholders’ equity of $4.5 billion and is the largest Chinese private steelmakers. 

The loses, if true, could wipe out the firm and will exceed the LME clearinghouse emergency capital funds. It is no wonder trades were canceled by the LME and trading has not resumed. The Shanghai Futures Exchange has also halted nickel trading on Thursday.

We cannot say that it was a hedging position against cash nickel holding or a speculative bet on falling prices. We do know that sanctions on Russia which produces about 17% of high-purity nickel production is a disruptive shock that led to a large price increase like the increases in many other commodities. This has placed pressure on all short hedgers in nickel. 

A large short futures position requires increases in margin to be posted at the clearinghouse as part of the usual market to market process. Under the normal clearing arrangement, the clearing brokers are required to post the margin and then get the money from their customers. The hedger is on the hook to the clearing brokers who are on the hook to the clearinghouse. The clearinghouse operates under a “loser pays/no credit” model. Margin is required, no exceptions, and no credit from the clearinghouse. Required funds are adjusted every day.

Brokers and banks may extend financing to the customer who may be short cash and long collateral, in this case nickel. However, if the margin exceeds the bank lines already in place, the hedger must either cover their short positions or find more cash from other sources. 

Tsingshan is in a classic short squeeze position. With rising prices and inability to cover margin or enough nickel to make delivery, it must buy in a rising market when all the other players know you are in a difficult situation. There is a non-linear increase in price which only makes the margin problem worse. Tsingshan specializes in nickel pig iron as low-grade alternative which is not deliverable to LME warehouses. 

Is this short squeeze a true oddity in the marketplace? The answer is no. The hedging problem is also well-known. All we have to do is go back to the collapse in 1993 of Metallgesellschaft from hedging loses from using short futures to offset longer-dated positions as the poster child of this type of problem. Again, the dust still has to settle, but hedging with futures that require daily mark to market with cash against physical cash positions that cannot be immediately turned into liquid cash is a dangerous position if there is a large price shock. 

The position is all the riskier if the short-dated futures are decoupled from long-dated nickel prices. The value of the collateral will not rise enough to offset the short position risk. This positioning becomes more difficult if bank lending requires a large haircut on cash physical positions. Generally, the futures clearinghouse model of immediacy is at odds with bank credit lines which may require some time for execution. 

The cancelling of trades and closing the LME market is a means of giving the market to stabilize and allow Tsinghan to find the bank financing necessary to meet even abridged margin. It is reported that JP Morgan along with a set of other banks will provide the margin financing. Of course, if the market price falls, Tsinghan’s short positions will increase in value and allow for further relief.   

The rationale for momentum trading - It is underreaction

Momentum, as a significant and measurable risk factor, still perplexes many researchers. Why does it exist? The argument is that it is behavioral bias does not exactly illuminate. Of course, there is something about investor behavior that creates an overreaction or slowness in price reaction which creates momentum.

There are several competing theories: overconfidence, slow diffusion of information, limited attention, anchoring bias, and real options. More recent evidence focuses on a frog-in-the-pan (FIP) hypothesis which suggests that due to limited attention, investors under-react to information that slowly adjusts. Trends in information lead to trends in prices because of limited attention. 

A new paper "What Explains Momentum? A Perspective From International Data" looks at all these alternatives and concludes that the frog-in-the-pan (FIP) hypothesis effectively fits the data through testing across international stocks out-of-sample. This is a complex paper because it tests a wide set of hypotheses, but it provides insight on all the thinking on momentum. 

Market underreact to slow adjustments in information. Investors have a lack of attention on small changes in underlying information. This same thinking can be applied to trend-following.