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Authored by Tsvetana Paraskova via Oilprice.com,

The always-volatile oil market is set for even more volatility over the next two years as investors and speculators try to make sense of the conflicting market forces determining the pace of demand growth and global oil supply.

Over the past month, the two key themes have been how much Iranian oil will come off the oil market from U.S. sanctions in November, and how much demand growth could suffer with the trade wars. More recently, another theme is the emerging markets turmoil following Turkey’s crisis. Throw in all the new and much stricter International Maritime Organization (IMO) regulations on sulfur fuel oil requirements from 2020 that are expected to upend the refining and shipping markets, and oil prices are set for wild swings, industry executives and analysts say.

The severe IMO restrictions on fuel oil’s sulfur content – aimed at reducing emissions – will drive increased demand for middle distillates such as diesel and marine gasoil, which in turn will push up demand for crude oil, Morgan Stanley analysts say. This would boost crude oil demand by additional 1.5 million bpd, potentially sending oil prices to $90 a barrel in 2020, according to Morgan Stanley.

But before the 2020 regulation, analysts and investors are closely watching two currently unfolding developments – the sanctions on Iran’s oil and possibly weakening global oil demand growth – the main bullish and bearish factors, respectively, in the market right now.

“With new sanctions coming into play and also the IMO 2020, we see there is more volatility and therefore more opportunities to trade. So, we see our customers taking, slowly but surely, positions for that to happen,” Eelco Hoekstra, chief executive at independent tank storage company Vopak, told CNBC on Friday.

Earlier this month, Tom Kloza, co-founder of the Oil Price Information Service, told CNBCthat prices could swing wildly, with a plunge to $50 and a spike above $100 not completely ruled out.

“If we had an oil [volatility index] it would be incredibly volatile” over the next year and a half, Kloza told CNBC.

The volume of Iran’s oil that sanctions would take out of the market is the biggest ‘known unknown’ on the supply side, with Venezuela’s plunging production and unstable Libyan exports already factored in in analysts’ estimates. But some experts believe that the Iran sanctions are yet to be fully priced in.

Earlier this month, Fitch Solutions said that the market is unprepared for the loss of Iranian oil, and that Iranian exports are “set for a ‘cliff edge exit’ from the market in Q418.” Under its core scenario, Fitch Solutions sees Iranian oil exports dropping by 1.3 million bpd by end-2019 with China expected to keep imports at around current levels; India and Turkey substantially reducing intake to qualify for waivers; and Europe, Japan, and South Korea cutting imports “to low or near-zero levels.”

“We are substantially above-consensus and our forecast implies Brent will average almost USD80.0/bbl over the rest of the year,” Fitch Solutions said.

ING, for its part, sees the global oil market “largely balanced over 4Q”, but this assumes that Iranian losses due to U.S. sanctions don’t exceed 500,000 bpd and Venezuelan production averages 1.2 million bpd in Q4.

However, ING commodities strategist Warren Patterson warned last week that the trade war and the higher risk in emerging markets have weighed on the price of oil, with Brent Crude prices dropping nearly 10 percent since late May.

“It does seem that the synchronised global growth story from earlier this year is losing some momentum,” Patterson said.

“Looking at individual cases suggests the potential impact on demand growth is limited, however when looked at in aggregate, the potential impact does start to look more significant,” the strategist noted.

The higher oil prices are already destroying gasoline demand in Brazil, for example, where motorists have the alternative to switch to ethanol, ING’s Patterson says. In Brazil, more than 50 percent of the light vehicle fleet consists of flex fuel vehicles that can run on gasoline or 100 percent ethanol. When ethanol becomes cheaper than gasoline, drivers switch to ethanol. In the first half of this year, gasoline sales dropped compared to the same period of 2017, while ethanol sales increased, said Patterson, adding that “This alternative option for motorists in Brazil has meant that we are actually seeing oil demand destruction in the country.”

Emerging markets currencies have weakened against the U.S. dollar in recent weeks – especially with the Turkish crisis – which could affect oil demand and depress oil prices. But the upcoming sanctions on Iran put an upward pressure on prices, with analysts currently only guesstimating how much oil would be removed from the market. The IMO rules throw in another unknown, so experts see wild swings in oil prices ahead.

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Over the weekend, when discussing the recent bifurcation between the US and emerging markets, we noted that one shouldn’t pay attention to the “significant role played by the sharp decline in the EM tech sector, especially after the recent collapse in Tencent stock and more recently, the sharp drop in JD.com following poor earnings.”

Furthermore, we said that “since the start of June, the EM tech sector has accounted for c.40% of the decline in the value of EM equities, with the Chinese internet names the primary drivers following recent regulatory challenges and poor results. And, as the chart below highlights, this has opened up a record divergence in tech performance between the US and EM. Needless to say, such a divergence is unusual: in the 18 months to the end of June this year, both the US and EM tech sectors rose by 50% in USD terms. Since then, the EM tech sector is down 6%, while its US counterpart up by 5%.”

We concluded that this “record divergence” is bad news for EM bulls, because looking ahead, with the top 5 stocks in EM all tech names, a stabilization in EM tech is a necessary condition of broader EM outperformance

Two days later, none other than JPM’s quant guru, Marko Kolanovic also spotted this bizarre phenomenon, and in a note published earlier today writes that “the recent divergence in the performance of US Equities vs. the rest of the world is unprecedented in history”.

Specifically, Kolanovic looks looks at price momentum which he finds is “positive for US stocks and negative for Europe and Emerging markets across all relevant lookback windows.”

His take on this “unprecedented divergence” is simple: “This has never happened before”, and explains as follows:

Over the past 20 years, even the individual regional indices rarely had such a divergence (for instance, the divergence of US and Europe momentum happened only 2 times). Given that this is such a rare occurrence (has never happened for both Europe and Asia), it suggests to us this is a market condition that will not persist.

In other words, something will give – either the US will fall or EM and Europe equities will catch up and move higher (the historical sample of these events is too small to statistically infer which way this convergence will most likely happen). We believe this market setup has been driven, in part by fundamentals, but also significantly by technical drivers.

The JPM strategist then breaks down the causes for this divergence which he lumps into two constituents categories: fundamentals and technicals.

In fundamentals, he lays out all the usual talking points we have noted in recent weeks that explain why the S&P just hit a new intraday high, oblivious of events in emerging markets: these include “Trump’s tariffs and sanctions causing broad equity risk aversion and a rally in the USD against a backdrop of strong support for US equities from buybacks, tax-related earnings boosts, as well as inflows from systematic strategies since April.“

While buybacks, facilitated by Trump’s tax repatriation, as well as strong earnings thanks to Trump’s $1.5 trillion fiscal stimulus are certainly a key aspect driven US equity outperformance, the other key reason for strong US performance is the Fed pushing the USD higher as other central banks around the world are on hold. Then there is the ongoing trade war:

The trade war is also negatively impacting China equities and CNY, and there are a number of largely idiosyncratic developments from Turkey, Italy, Argentina, Russia, etc. that weigh on equities and currencies outside of the US.

As Kolanovic summarizes, “buybacks are creating a shortage of US stocks, the Fed is creating a shortage of US dollars, and Trump’s trade wars and sanctions are further boosting the USD.”

Kolanovic then falls back on his bread and butter: low liquidity and systematic flows, i.e. the technicals, which further boosted the divergence between the US and the rest of the world.

Low liquidity is magnifying the impact of any fundamental and speculative flows, resulting in large moves and numerous flash crashes (e.g. ZAR, TRY, several prominent stocks, etc.). Systematic equity investors are on one side shorting Europe and EM equities, and on the other side buying US equities. For instance, CTAs and related macro trend-following strategies currently have about average long equity exposure in aggregate (52nd percentile). Given that all trend signals in Europe and Asia are short, and all US signals are long – these investors have large long exposure to US stocks and short exposure in Europe and Emerging market stocks.

… since April, various volatility targeting strategies have added up to $100bn in equity exposure, mainly in US equity indices – another tailwind predominantly for US stocks.

This rotation of a few hundred billion dollars of equities into the US purely on technical factors, “was further reinforced by the significant ‘same way’ flows in currencies, commodities and rates. Significant outflows from EM FX, EUR, etc. and into USD are making long USD a crowded position.”

Meanwhile, as we noted over the weekend, and as Jeff Gundlach notably highlighted last Friday, investors are also shorting bonds (as non-commercial shorts all-time highs), while going long US equities via index futures and short volatility positions.

To Kolanovic, this type of crowding is very similar to early 2016, which led to a subsequent rally of Value and EM assets and USD selloff.

Assuming that Kolanovic is correct (he is) and this divergence is unsustainable, what happens next, and how does the convergence play out? In one of two possibles ways:

“Risk on, USD down” outcome with EM and value assets staging a rally and USD selling off, while US stocks continue going higher (but lagging).

Alternatively, we could see a “Risk off, USD up” convergence, with US markets selling off and catching up with the poor performance of Europe and EM assets, e.g. driven by a continuation of the trade war and further USD strength (for now we will ignore a spectrum of ‘in-between’ outcomes).

Maintaining his optimistic outlook which he has laid out every month this year, Kolanovic remains upbeat and writes that “the more likely outcome is a ‘risk on’ convergence, given decent global growth, cheaper valuations outside of the US, a continuation of buybacks in the US, intensified criticism of rate hikes and strong USD by US administration, new stimulative measures in China, and ongoing negotiations to resolve trade war with China. A ‘risk on’ convergence could be further fueled by poor liquidity and a short squeeze in currencies (EUR and EM FX), metals (precious and industrial), broad EM equities and China stocks.”

That said, Kolanovic cautions that “one should not dismiss a scenario in which the trade war with China is not resolved and the US market experiences a sharp correction. This could be further fueled by concentrated US market leadership, a decline in the high levels of equity HF exposure (e.g. HFRXEH beta in 95th percentile), and selling from systematic investors (e.g. Vol targeting funds are currently in their 66th percentile of equity exposure).”

What could catalyze this “Risk off” convergence?

An obvious potential catalyst for this scenario would be a breakdown in China trade negotiations, and continuation of the USD rally.

There is one additional footnote to the downside case: any “risk off” outcome would hit the US far harder than it does the rest of the world, to wit:

escalating the trade war could cause a disproportionally negative impact on the US economy and equity markets at this stage. The disproportionally higher damage to US markets was described above in the context of the divergence of positioning and valuations.

It gets worse: should the status quo divergence persist, it would imply that contrary to the President’s simplistic interpretation of the market, the “trade war in its current form” will likely be lost by the US given the strong dollar, which made US goods more expensive across the world, with the delayed effect on the economy likely to manifest itself shortly. Kolanovic explains: 

The USD rally effectively introduced ‘tariffs’ against US products sold globally. At the same time, the weaker CNY, EUR, etc. make their products more attractive across the world, including in the US. Given that China represents less than 20% of US total trade, the damage of tariff policies (and strong USD) on US trade could be several times larger (e.g. even up to 5 times) than any intended gain. The simple math is also likely a reason for recent nervous comments from the US administration about the Fed, rates, Chairman Powell, CNY and USD. It is a realization that the trade war in its current form is likely already lost given the strong USD.

All of this, of course, trickles down to Trump, and his belligerent trade war rhetoric. And if Kolanovic is correct, the loss of the trade war couldh it at the worst possible time: just as companies report Q3 earnings… which is scheduled to take place just days before the midterm elections which Trump and the republicans – for fears of impeachment – can not afford to lose in a landslide.

This is why Kolanovic concludes that “an escalation will likely be averted and that a trade resolution and weaker USD will lead to a ‘risk on’ convergence.” That conclusion however, is contingent on one big assumption: that Trump will observe events playing out around the globe rationally, ignore the record stock market, and engage China with the intention of ending the trade war even though – in his mind – Trump is still winning the war.

That is a big assumption.

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Chaos broke out Monday night as a group of around 300 demonstrators gathered at the base of Silent Sam, a Confederate memorial statue on the University of North Carolina Campus. 

After covering it in gray banners to turn it into an “alternative monument” which read, in part “For a world without white supremacy,” Silent Sam was pulled down just after 9:15 p.m.

Protesters were apparently working behind the covering with ropes to bring the statue down, which happened more than two hours into a rally. It fell with a loud clanging sound, and the crowd erupted in cheers.

After Silent Sam tumbled to the ground, people darted in and out of the crowd through a haze from smoke bombs. Atop the statue someone placed a black cap that said, “Do It Like Durham,” an apparent reference to the toppling of a Confederate statue there a year ago. –News Observer

After the statue had fallen, protesters rushed to the remains to take selfies and stomp on the 105-year-old monument which was erected with donations from the United Daughters of the Confederacy. 

Silent Sam had been the focus of protests and vandalism for decades – much more so in recent years, however. UNC had installed surveillance cameras as part of a $390,000 outlay for security around the statue last year. 

Stephanie Chang, 21, a recent UNC graduate, said she followed the crowd to campus after word spread on Franklin Street. By the time she got there, she saw Silent Sam’s head on the ground. Soon, police were covering the statue with a tarp.

“It’s like, Silent Sam has been tucked in, put to bed,” Chang said.

Andrew Skinner, 23, who graduated from UNC earlier this year, said he was glad the statue fell in an illegal act.

“It shows that we have the power to be on the right side of history,” Skinner said. “We are part of a long tradition of civil rights in this country…..We as a country have a lot of change and a lot of healing to do, and we are not going to get there putting racism on a pedestal.” –News Observer

The Monday protest started on downtown Franklin Street as a demonstration in support of a student who threw red ink and blood on the Confederate statue in April – leading to criminal and honor court charges. 

After someone threw a smoke bomb, a skirmish erupted leading to police chasing one man and arresting another for resisting, delaying and obstructing an officer. 

Several bystanders donning Confederate flags on their clothing watched the protest. 

Clint Procell, 31, wore a Trump hat. A self-described conservative, Procell said he wanted to see for himself how intolerant the people protesting Silent Sam were, and the experience didn’t disappoint. He said he was pushed and his hat was temporarily stolen.

“The main reason for me to come was to see the people fighting against Trump,” he said. He described some of the protesters’ language as hateful against police and conservatives, but said he also had several conversations that were remarkably open. –News Observer

National efforts to rid the country of Confederate monuments like Silent Sam began around three years ago, after white supremacist Dylann Roof murdered African-Americans at a Charleston, South Carolina church – a shooting rampage which resulted in the removal of a Confederate flag from the Columbia statehouse. 

Since then, over 110 Confederate symbols have been removed across the country, while over 1,700 remain according to the SPLC. 

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Earlier today the S&P500 hit a new intraday all time high of 2,373.23 before fading some of the gains, on the day that matches the longest bull run in S&P history. And absent a “force majeure” event and a 20% drop in the S&P in the next few hours, the length of time that has passed without a 20% drop in the S&P500 will set a record with tomorrow’s opening bell.

Below we show some charts that put the longest, if most artificial, bull market in its proper historical context.

On August 22, the current bull market is poised to become the longest on record…

… however it still has room to run in terms of percentage appreciation: from its March 2009 low, the current level of the S&P is 321% higher; it will need to gain another 4% to surpass the Great Depression bull market of June 1932 – March 1937 which saw a 325% rebound. To become the greatest bull market ever in percentage terms, the S&P will need to gain nearly another 100% from here, to surpass the 417% increase posted in the October 1990 – March 2000 market, which culminated with the dot com bubble.

Breaking down the bull market by sector shows that huge gains for companies such as Amazon and Apple helped propel the outperformance of the consumer discretionary and technology sectors.

How about valuation? As shown in the first chart below, stocks recently were the most expensive on record relative to their long term average of 15.1 on a forward basis and 17.2 on a trailing basis. However, the recent Trump tax-cut inspired burst in corporate profits helped pulled valuations back towards the norm. The question, of course, is whether the current global trade war (or any other black swan event) will make a mockery of projections. One possible such “unexpected event” is a spike in yields: as the second chart below shows, stocks have been supported throughout the run by Fed policy which kept interest rates low, permitting corporations to engage in a record amount of buybacks. The recent modest rise in yields, coupled with a spike in market volatility , helped to cause a recent market correction.

Source: Reuters

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While the market is distracted by record stock highs, a week-long vacation in Turkey, and a mysterious pre-talks bid in the offshore yuan, the truth is that this Emerging Market crisis has been a long time in the making, and based on the Brazilian Real’s collapsed above 4/USD, it has a long way to go.

*  *  *

As a reminder, the first break in the “strong Emerging Market” narrative emerged in late April when as a result of rising US interest rates the dollar surge began in earnest (facilitated by China’s first easing announcement on April 17), which in turn sent the both EM currencies, and EM debt reeling…

… to be followed shortly by the plunge in the biggest EM currency of all: the Chinese Yuan.

And as we highlighted in early May, BofA’s Chief Investment Officer Michael Hartnett observed that higher US rates finally caused a higher US dollar (courtesy of the PBOC), at which point “EM started to crack.” But while many had pointed at the collapse in the Turkish Lira, the Argentine Peso, and the Indonesia Rupiah, as cracks in the EM narrative, the truth is that many of these are idiosyncratic stories.

So how could one decide if the Emerging Market turmoil – whether started by Turkey, Argentina, Russia, China, or any other EM country – was set about to sweep across the entire sector, and result in DM contagion? According to Bank of America the answer was simple. This is what Hartnett said in early May:

“EM FX never lies and a plunge in Brazilian real toward 4 versus US dollar is likely to cause deleveraging and contagion across credit portfolios.”

In other words, to Bank of America, the best indicator of imminent emerging market turmoil is shown in the chart below dated circa three months ago: and as BRL crosses 4.00, it may be a good time to panic as contagion is about to go global.

Fast forward to today, when in light of the latest emerging market turmoil, the Brazilian real, which plunged beyond the key 4.00 level vs the dollar…

…after the Brazilian FinMin said he saw “no need to intervene in FX markets” and fading further as Lula’s Working Party (Leftists) dominated presidential election polls this week –  virtually guaranteeing contagion.

And just in case, Hartnett also laid out a secondary “fail safe” EM-stress indicator:

Tremors in the periphery: 3% + rally in US$ has caused EM tremors (ARS, INR) at a time of peak EM debt/equity inflows ($371bn)…EMB <107.50 contagious

This means that once EMB, the JPM Emerging Market Bond ETF, drops to 107.50 – the level it hit right after the Trump election – it will be time to get out of Emerging Dodge.

Where is the EMB today? It remains below the key 107.50, validating the negative signal about launched by the BRL.

And not helped by the soaring volatility expectations being priced into markets…

So while everyone is hypnotized by the Turkish lira (flat) and offshore yuan (stronger), keep a closer eye on the Brazilian Real: having crossed, it is time for the fireworks to begin.

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Via GoldCore.com,

• Russia buys 839,000 ozs of gold in July as it diversifies reserves from USD

• 25-ton addition brings Russia’s Central Bank holdings to 1,969 tons; the world’s 5th largest gold reserves

• Central bank buying Russian gold on Moscow Exchange for now

• Russia sees gold’s role as independent currency and safe haven as is a “100% guarantee from legal and political risks”

• Russia now has total gold reserves worth  just $76 billion; Dumped $90 billion of US Treasuries in April and May

Russia under Putin continues to add to its gold reserves and added another 839,000 ounces or 25 metric tonnes in June. Many analysts believe this buying will continue in the coming months given the very serious geopolitical tensions between Russia and the U.S.

Russia’s total gold reserves now amount to 63.3 million ounces or around 1,969 metric tonnes, with a current value of just $76 billion (based on gold at $1,200/0z).

Foreign exchange diversification intensified in April this year and their gold accumulation is averaging over 20 tonnes per month. It is interesting to note that Russia dumped some $90 billion of US Treasuries in April and May – which is significantly more than the value of the entire Russian gold reserves, now worth $76 billion.

Russia’s total foreign exchange reserves are $458 billion and their gold allocation has risen to 17% of their total reserves – even at these depressed gold prices.

This ranks Russia in fifth place globally in terms of gold reserves behind the U.S., Germany, Italy, France, and China.

Russia is also ranked fifth now in terms of gold held as a percentage of total fx reserves. However, the share of gold in Russian foreign exchange reserves is much lower than in many other countries such as the U.S., Italy, and France.

Source: Wikipedia via WGC

The U.S. is believed to have over 8,400 metric tonnes of gold and no foreign exchange reserves. The U.S. gold reserves have not been audited since the 1950s.

In 2014, Russia bought more gold in than in any other year since the break-up of the Soviet Union.  The country acquired over 173 metric tonnes according to World Gold Council figures. Russia has bought 130 tons of gold so far in 2018.

Much of the gold bought may have come from Russian gold production which is currently at about 25 metric tonnes per month.

In 2017, Russia was the third largest gold miner in the world at 266.2 tonnes, just six tonnes short of Australia in second place and China in first place.

Thus, the Russian central bank is generally consuming all of Russian gold production and sometimes having to import gold. Therefore, they currently account for all domestic demand for gold.

Russia is an increasingly wealthy nation with a growing middle class, thousands of millionaires and over a hundred billionaires including multi-billionaire oligarchs.

The Russian central bank, senior politicians and policy makers are all on record regarding the importance of gold as a form of financial protection. They believe gold  provides invaluable insurance against external factors. Dmitry Tulin, manager of monetary policy at the central bank said of gold:

“The price of it swings, but on the other hand it is a  “100% guarantee from legal and political risks”.

Russian gold buying looks set to continue or increase given the heightened financial and geopolitical risks and due to Russia’s belief in gold as a form of safe haven money.

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Amid the chaos and uncertainty of our ever-changing world of tweets, threats, and actions, seeking the safe-haven of so-called “low-vol” or “all-weather” portfolios makes sense right? Wrong!

While levering up long bets on the most-levered and worst-balance-sheet companies has paid off dramatically, Bloomberg’s Dani Burger reports that risk-parity funds – designed to be diversifiers of risk based on volatility changes – are among the worst-performing strategies in 2018 tracked by JPMorgan.

Burger  notes that the commodity train wreck, emerging-market turmoil and shifts in government bonds have created a wave of turbulence in quant strategies this year…

As long-term correlations break-down and resume as if they were penny stocks themselves.

From the trade clash to extreme moves in developing assets,  Burger points out  that portfolios have struggled to find shelter so far this year, with turmoil in metals the latest in a list of stresses.

No one’s saying risk parity is broken. Proponents say the strategy can sustain bouts of underperformance — by design, it captures the average return across assets, so it can outperform in the long run.

“Everyone’s performance has been soft this year relative to U.S. stocks,” Roberto Croce, director of quantitative research at Salient Partners LP.

“Risk parity is trying to be in the middle, trying to get diversification. It’s never going to be the top-performing thing, but it won’t be the bottom either.”

But for now, it means that because the funds have modest allocations to some of the riskier markets, they haven’t harvested the best returns on offer this year, generated by U.S. stocks. Maneesh Shanbhag, who co-founded Greenline Partners LLC after almost five years at Bridgewater Associates LP, concurs.

“Equities came off low valuations to deliver higher returns,” he said. “Now, risk parity looks relatively dull but has delivered what it was supposed to.”

The only managers to fare worse that Risk-Parity funds this year are trend-chasing commodity trade advisers, or CTAs.

Read more here…

Finally, Burger sums it all up in four simple words: “no quant is safe.”

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