Extreme events? Time for extreme caution in financial markets

At first sight the confluence of major market peaks, extreme but apparently unrelated events followed by subsequent market reversals may seem like just a coincidence. Often though the best contrarian indicators in financial markets are those that are either completely ignored or ridiculed.

Peter Atwater of the research firm Financial Insyghts offers some compelling examples of recent instances where confidence in the markets is at extremes and the timing has been reflected by desperate acts. Atwater believes that when our mood is high, we take bold chances, underestimating risks and discounting all potentially negative consequences.

The first of two recent examples Peter gives are earlier this year when former Russian spy, Sergei Skripal, was nearly assassinated — investigators suggested that his poisoning was the work of the Russian government. This coincided with multi-year highs in the Russian stock-market.

The second example came just days after Brent crude prices also hit a multiyear high. This time Jamal Khashoggi was killed in the Saudi Arabian consulate in Turkey.

Its not just Atwater that believes that broader confidence in the world around us affects behaviour. Back in May 2011, writing for the “The Socionomist, Mark Galasiewski shared:

The assassination of al-Qaeda head Osama bin Laden on May 1, 2011 was a result of the cooperation and success accommodated by the positive social mood trend underlying the global stock market advance since 2009. Bin Laden had been fighting two inverse trends: the increasing commitment of the intelligence analysts pursuing him and the decreasing commitment of his own followers. The increasingly positive social mood behind the stock market advance encouraged those trying to find bin Laden, while the waning negative mood deprived him of many of his traditional sources of support, thereby undermining his security.

These extreme events also relate to the common knowledge game. The basic idea is that there is private, public and common knowledge. Private knowledge as it suggests is what only a small sample of people know about something. Public knowledge is when everyone knows it. Common knowledge is public knowledge with a twist. Common knowledge is when everyone knows that everyone else knows.

This concept is central to game theory but once you understand it you see it in all aspects of our lives from financial markets to celebrity scandals. For knowledge to make the transition from public to common you typically need a mouthpiece (the media for example) or an event that pushes it into the public consciousness so that no one can be in any doubt that everyone else now knows it too.

Why does this relate to the over-confidence brought on by financial markets given in the examples above? Well, emboldened by the notion that “this time is different” the chief protagonists push things too far, make a mistake, talk to the wrong person.

As sentiment becomes stretched sophisticated investors on the other side of the market look for evidence of a shift. The common knowledge game illustrates how that shift can take on a life of its own — everyone now knows that everyone else knows that sentiment is extreme, and markets start to reverse.

For investors these mood connections are critical to understanding the world around us. Extreme events suggest extreme sentiment, cautioning that a major trend reversal is likely.

Also published on Medium

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El Niño looks imminent – here’s what that means for commodity markets

First observed in the 19th century by Peruvian fishermen, the recurring weather phenomenon is known to affect Australasia as well South America. Its climatic effects can reach as far as West Africa triggering downpours or droughts. Previous episodes have had a significant impact on crop yields and the price of agricultural commodities as well as metal and energy prices.

El Niño events tend to develop between April and June and reach their maximum strength during December and February. According to Columbia University conditions usually persist for 9-12 months, but can occasionally last for up to two years.

Two factors, in addition to its severity, will influence the impact that El Niño will have on crop yields and prices. The first is the timing of El Niño event. The impact of which will vary depending on what stage of a crop’s lifecycle (e.g. sowing, growing, harvesting) it occurs at. As the two maps below illustrate the impact of El Niño varies considerably depending on whether it occurs during the summer or winter months (see maps below). The current outlook suggests that if it does occur El Niño will reach its maximum strength towards the end of 2017 – figure 2 below.

The second factor that determines the degree to which commodity prices are affected by El Niño is the degree of geographic production concentration. Some crops, like palm oil, are grown in one specific region whereas others are grown globally. The main commodities to be affected by El Niño are typically those ‘softs’ that are located around the tropical regions.

Coffee – The warm weather that El Niño brings in June to August aids the Arabica coffee harvest as the crop solidifies and warmer weather protects against the spread of the roya fungus (which thrives in wetter conditions). However, drier El Niño weather in December to February may have negative impacts on the next Arabica crop, helping to support coffee prices as the event continues.

Cocoa – Cocoa output has been volatile regardless of El Niño due to the majority of its production occurring in west Africa which has geopolitical, funding and energy issues.

Palm oil / soybeans – This is perhaps the crop with the biggest exposure to El Niño on account of 90% of production occurring in Indonesia and Malaysia. Whilst palm oil plants are fairly resilient during an event, dry weather tends to impact production growth and yield trends in the following 12 months. Though any increase in palm oil prices tends to be capped by increased soybean production, as palm oil is substituted by soy oil.

Sugar – El Niño’s impacts on sugar production are greatest when it brings too much rain to Brazil and drought to India (which, together, produce 38% of the world’s sugar). India’s sugar production is for its domestic market as it has the highest per capita sugar consumption in the world (consuming 15% of the world’s sugar). In Brazil, El Niño means fewer days for crushing and causes lower sugar content in the cane as the wet conditions cause the plant to store less sugar.

Perhaps surprisingly though the commodity that has typically seen the biggest impact on price during the 20 year period to 2015 has been nickel. This has been because dry weather in Indonesia lowered the water levels in canals, preventing the metal from being exported.

Other metals may also be impacted by the arrival of adverse weather. In Peru for example heavy rains have flooded zinc mines in the past triggering price spikes. Gold demand may also be hit if a weak monsoon results in a poor harvest. Indian farmers are large buyers of gold and so any fall in their incomes could hit purchases of the precious metal.

Globalisation of markets and trade should, all else being equal, diminish the impact of any region-specific decline in output. For this reason grains such as wheat and corn tend not to see a significant weather related impact on yields from El Niño. That being said, regional weather conditions may still result in prices responding violently to a perceived or actual threat to output.

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Coffee prices: The top 10 most important drivers

1) Concentrated production

There are two main commercially grown types of coffee beans: Arabica, which accounts for 70% of the world’s coffee, and the Robusta bean which is far cheaper and easier to grow. The largest producer of coffee is Brazil accounting for about one-third of global production and about half of the worlds arabica output. The second major producer is Vietnam, accounting for just under 19% of global output and around half of robusta production. This concentrated output means that supply disruptions in one or both of these countries can have a significant impact on the price of coffee.

2) Substitution to cheaper beans

The robusta bean is far cheaper and easier to grow than arabica, but it has a bitter taste compared with the more expensive bean. This usually means that the price of robusta is much lower than the higher quality arabica bean. However, whenever the price spread between the two beans becomes very large then coffee manufacturing companies may start to substitute more of the cheaper bean into their blend. The incentive to do this is greatest when consumer demand is at its weakest.

3) The price of substitute products

Although many of us would say that caffeine is an essential first thing in the morning, if not all through the day there is more than one way to get it. Until recently the only substitute products was tea but now caffeine rich energy drinks are competing with coffee for attention.

4) The weather

Coffee is a tropical commodity. This makes it more susceptible to tropical weather events like El Niño. The timing of El Niño can have a big impact on whether the impact is positive or negative to supply. The warm weather that El Niño brings in June to August aids the arabica coffee harvest as the crop solidifies and warmer weather protects against the spread of the roya fungus (which thrives in wetter conditions). However, drier El Niño weather in December to February may have negative impacts on the next arabica crop, helping to support coffee prices as the event continues.

5) Disease

La Roya, or leaf rust is a deadly fungal disease rust has plagued farmers for more than a century. When a tree gets infected by it, its leaves produce a brown, thin powder when scratched, pretty much like iron rust. The disease decolours the bush’s leaves from a bright green to a brownish yellow. In the end, the tree loses all its leaves, as well as its ability to produce beans.

If left unattended, the disease can have dramatic consequences. In the late 19th Century, Sri Lanka, the Philippines, and other countries in Southeast Asia were the major exporters of coffee in the world. In a matter of decades, the disease meant they practically stopped growing it.

6) Flowering cycle

Brazilian coffee growing has traditionally followed a cycle of huge biennial swings, with an “on” year of large production followed by an “off” year of low output for arabica. However, these fluctuations have diminshed over time.

The expansion of coffee plantations in the northern areas of Brazil, which are less prone to frosts, has mitigated damage from cold weather. Meanwhile increased use of irrigation has minimised crop losses due to droughts while also helped coffee trees to recover faster from the stress of bearing a large crop. Finally, better fertilisation has also helped plants recover after bean production while plant breeding has led to more drought resistant trees.

7) Currency movements

Given Brazil’s position as the dominant producer of arabica coffee its exchange rate can have a significant impact on the price of coffee. A decline in the value of the Brazilian currency, the real increases the incentive for Brazilian farmers to increase output for export while at the same time reducing their production costs.

8) Stocks

As with all commodities, low levels of stocks indicate strong demand, weak supply or a combination of the two. In addition, low stocks provide very little in the way of a buffer in case of disruption to future harvests.

The split of inventories between exporting and importing nations is viewed as an indicator of coffee price potential. It indicates the level of urgency, and willingness to pay up by importers.

9) Emerging market demand

Growing demand in emerging nations as per capita incomes rise – consumption of coffee in China has doubled in the last five years. Even in countries like Vietnam that are net exporters of coffee but have traditionally been tea drinkers there is a switch towards more coffee consumption.

10) Speculation

Coffee like many other commodities is traded on futures exchanges. Although futures markets serve a valuable function by transferring risk from those who do not want it onto those that are able and willing to take it one there is a risk that at least for short periods of time the price doesn’t reflect the underlying fundamentals.

Previous episodes

Gold prices: The top 10 most important drivers

Silver prices: The top 10 most important drivers

Natural gas prices: The top 10 most important drivers

Copper prices: The top 10 most important drivers

Livestock prices: The top 10 most important drivers

Sugar prices: The top 10 most important drivers

Cocoa prices: The top 10 most important drivers

Palladium prices: The top 10 most important drivers

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