Contagion hits financial markets as Great Unwinding continues

GU 22Aug15Crude oil prices continued to fall towards $30/bbl last week.  Markets are finally starting to recognise, as the BBC reported last year, that ‘China fooled the world‘ with its stimulus programme. It had not suddenly become middle-class by Western standards in 2009.  Instead, aided by developed country stimulus policies, its own stimulus had helped create a commodity super-bubble to rival the dot-com bubble in 2000 and the subprime bubble in 2008.

Unwinding2aNow financial markets around the world are being hit by the contagion from the unwinding of this bubble.  China’s Shanghai index is down 38% today from its June highs.  London down 8% from its August peak; Frankfurt down 13%; and the US S&P 500 was down 6% in the week.

The problem is that much of the buying of oil and other commodities has been done on margin.  This risks creating a vicious circle, as buying on margin with borrowed money can be a very dangerous game .  The reason is the way that margin works to magnify gains, or losses, from your trades:

  • On the upside, you can invest $1m in oil futures for just $100k, if you use the standard 90% margin.  If prices then go up $1/bbl, you have made a lot of money with your $100k
  • But if prices go down $1/bbl, you now have to either close your position and hand over the $900k you have lost, or put in more margin

This is what has been happening in recent days.  As oil and other commodity prices have continued to fall, so the speculators have either had to sell their positions at a loss, or provide extra margin.  In turn, this often meant they had to sell something else to raise the necessary funds.  And all of this has to be done in a hurry, as margin calls have to be paid in full each night as the market closes.

This would be bad enough.  But in addition, much of the buying of stocks has also been done on margin. This is exactly the contagion risk that concerned me a year ago, when I worried that developments in China could lead to a downturn in global financial markets:

  • “The prices for those metals and other commodities caught up in the trade would be hit first
  • Mining company shares would also be hit, as people worried their vast capacity expansions were wishful thinking
  • Investors may put 2 and 2 together and worry, as the BBC described in February, that “China Fooled the World

“Next to be hit could be other financial markets.  Complacency and low interest rates have encouraged investors to borrow heavily.  Each night, therefore, they might start to receive margin calls as prices for their commodity-related investments decline:

  • Some investors might decide to sell out, pushing prices further down
  • Other investors might need to raise funds by selling non-commodity related investments
  • At the same time, buyers might then immediately disappear for anything that appears to be high-risk

“A third phase of the downturn could then develop in our globally-linked electronic world:

  • These forced sellers might have to sell in more liquid markets to secure the cash they need
  • This would mean selling blue-chip shares and high-quality government bonds
  • In turn, investors who have borrowed heavily to invest in these markets would then start to receive margin calls

“The risk is therefore that major declines could then take place quite suddenly in a number of major financial markets, just as Hyman Minsky would have forecast:

“His insight was that a long period of stability eventually leads to major instability

  • This is because investors forget that higher reward equals higher risk
  • Instead, they believe that a new paradigm has developed
  • They therefore take on high levels of debt, in order to finance ever more speculative investments

“As in 2008, another ‘Minsky moment’ could thus occur as ‘distress sales’ start to take place.

As the chart shows, the contagion has also been impacting the major chemical markets.  They have been signalling for some time that all is not well with real demand, with operating rates well below pre-Crisis levels.  Now we are seeing prices fall across the board, and revisit January’s lows, as buyers retreat.

Of course, markets may stabilise in September as people return from holiday.  But the risk is that the recent head-fake rally in crude oil has left companies with high inventories, as they bought ahead of rising prices.

With demand in China and other emerging markets now weakening very fast, these inventories may take time to run down.  In addition, last week’s report that Jurong Aromatics is in talks over debt restructuring, highlights the potential for wider disruption of supply chains if companies cannot wind down their inventories profitably.


My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments: 
Brent crude oil, down 55%
Naphtha Europe, down 56%. “Gasoline demand soft amid high Nigerian output”
Benzene Europe, down 55%. “the downturn in Asia appears to be driven by sentiment and some panic among market players.”
PTA China, down 43%. “prices continued to fall amid a weaker upstream energy structure and bearish sentiments in the downstream polyester market.”
HDPE US export, down 27%. “Competitively priced cargoes from North America dampened the market’s confidence. However, traders were unwilling to accept those deep-sea cargoes due to the uncertainty of the Chinese yuan exchange rate”
¥:$, down 20%
S&P 500 stock market index, up 1%

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