Table 1 Global Asset Allocation - nbinvestments.ca€¦ · Tactical asset allocation is never easy,...

Le 1er octobre 2017

May 2020

Highlights

˃ After plunging into bear market territory in record time in March, equities have just recouped over half of their losses in April another record. In other words, in the space of just over two months the stock market has experienced what usually occurs over more than a year. First, there was a "shock" phase (the first chapter), where the accumulation of bad news dragged equities into a bear market. Then, a "policy response" period (the second chapter) followed where the actions of central banks and governments point to an economic recovery and lead equities to bounce from oversold levels.

˃ But no matter how different this time is, markets will still have to go through a period where upbeat economic expectations are confronted with reality (the third chapter). And, that's what we believe is ahead of us over the next few months. We must also not lose sight of the virus, which could cause renewed turbulence should a second wave emerge. Overall, there are grounds for optimism, but the threat cannot be ruled out.

˃ So, what to expect from this point on? In the near term, upside potential for equity markets appears to be more limited. For instance, the rebound in stock prices together with downward earnings revisions have pushed the S&P 500's price-to-earnings ratio to a new high not seen in almost 20 years. While much of this multiple expansion can be explained by the plunge in interest rates orchestrated by central banks, we suspect that further earnings weakness and a slow

range-bound in the coming weeks, or even lead to giving back some of their recent gains. We are therefore maintaining our tactical asset allocation as unchanged for now.

˃ Large-scale asset purchase programs by central banks seemed to revive many investors' concerns about their potential to create a rapid rise in inflation. In the short and medium term, we must emphasize that the economic downturn is likely to exert strong downward pressure on prices, compounded by the sharp drop in energy prices. Nevertheless, TIPS are likely to fare better than traditional government bonds as depressed inflation expectations ultimately recover.

˃ Commodities have always been considered the black sheep of financial markets. But in April this claim was taken to another level, as crude oil prices dropped down to negative $ risk predicting another episode of negative prices, intense selling pressure for the June contract is a possibility as it nears expiry. A scenario where prices are higher and sustainable should only be considered once the market is rebalanced, a painful process that is sure to take several months.

˃ Within equities, U.S. and growth stocks continued to outperform, but small-go unnoticed. Periods of sharp small-cap rallies are to be expected but are likely to be short-lived, given that large caps are better equipped to deal with the substantial challenges posed by the current economic backdrop.

Writing the Third Chapter of COVID-19

Table 1 Global Asset Allocation

Global Classes Weights

Cash

Fixed Income

Equities

Fixed Income

Federal

Investment Grade

High Yield (USD)

Non-Traditional FI

World Equities

S&P/TSX

S&P 500 (USD)

MSCI EAFE (USD)

MSCI EM (USD)

Factors and Alternative Investments

Value vs. Growth

Small vs. Large

Low Vol. vs. High Beta

Canadian Dollar

Commodities

Energy

Base Metals

Gold

Infrastructure

CIO Office Current Allocation

Previous Allocation

MONTHLY ASSET ALLOCATION STRATEGY

2

May 1, 2020

Market Review

Fixed Income ˃ It was green across the board for fixed-income products in

April, as central bank interventions at home and abroad

˃ As a result, the FTSE Canada Overall Universe Index experienced its best monthly performance since 2015 (and second best since 1998!).

˃ Additional liquidity south of the border courtesy of the Federal Reserve was especially helpful in reining in Investment-Grade bond spreads with this asset class outperforming its riskier High-Yield counterpart.

Canadian Equities ˃

by an equally impressive rebound in April (up 10.8%). ˃ A slowing number of new COVID-19 cases, increased testing

capacity, awesome amounts of fiscal and monetary stimulus, and indications that Federal and Provincial governments might soon begin to ease lockdowns provided fuel for the equity rally.

˃ Impressive performances from the Materials, IT, and Consumer Discretionary sectors helped lead the rally.

U.S. Equities ˃ Not to be outdone by its cousin to the north, the S&P 500

also climbed higher (up 12.8%), as similar monetary and fiscal measures to Canada helped lift investor sentiment, even as the total number of initial jobless claims for the period shattered previous records.

˃

1987 could not be called broad-based however, as the range of year-to-date returns across sectors remains quite wide.

˃ As a result, the index now finds itself 0.9% above its level from 12 months ago.

Commodities ˃ Last month, the COVID-19-induced negative demand

shock contributed to pushed WTI prices to fall into negative territory for the first time in history.

˃ Rapidly dwindling storage capacity in Cushing, Oklahoma, played an important role in the event, as many holders of oil futures were in the awkward position of having to pay buyers to take the oil of their hands.

˃ Prices finally settled near $ ˃ Meanwhile, gold maintained its momentum throughout

April, spurred on by the prospect of lower real rates, with the bullion trading over $1700/oz. by the end of the period.

Foreign Exchange ˃ Following wild swings in March, the U.S. Dollar Index

remained relatively range-bound throughout the month of April.

˃ Surprisingly stable in the face of record high oil price volatility, the Loonie closed out last month having appreciated slightly and now trading near $0.72 US.

Table 2 Market Total Returns

Asset Classes April YTD 12 months

Cash (3-month T-bills ) 0.0% 0.7% 1.8%

Bonds (FTSE CA Ovr. Univ.) 3.8% 5.4% 8.5%

FTSE CA Short term 1.3% 3.2% 4.3%

FTSE CA Mid term 3.3% 6.7% 8.6%

FTSE CA Long term 7.1% 7.2% 13.9%

FTSE CA Government 3.4% 6.7% 9.6%

Federal 1.5% 6.8% 8.3%

Provincial 5.2% 6.6% 10.8%

Municipal 4.6% 5.8% 9.9%

FTSE CA Corporate 4.8% 2.2% 5.8%

AA+ 2.7% 3.1% 4.8%

BBB 5.5% 1.1% 5.0%

BoAML Inv. Grade ($US) 5.3% 1.0% 9.3%

BoAML High-Yield (USD) 3.8% -9.8% -5.3%

Preferred Shares 12.6% -13.1% -11.2%

Canadian Equities (S&P/TSX) 10.8% -12.4% -7.9%

Energy 12.8% -29.1% -27.9%

Industrials 9.0% -7.4% -3.2%

Financials 1.7% -19.7% -16.7%

Materials 33.0% 8.0% 26.4%

Util ities 3.9% -1.6% 15.9%

Cons. Disc 20.3% -19.2% -20.8%

Cons. Staples 7.2% -2.8% -0.2%

Healthcare 7.8% -32.2% -60.3%

IT 29.3% 24.5% 53.1%

Comm. Svc. -0.3% -8.4% -5.1%

REITs 8.0% -22.7% -17.3%

S&P/TSX Small Cap 25.1% -22.6% -18.8%

US Equities (S&P500 USD) 12.8% -9.3% 0.9%

Energy 29.8% -35.7% -38.3%

Industrials 8.7% -20.7% -15.9%

Financials 9.6% -25.4% -16.7%

Materials 15.3% -14.8% -7.2%

Util ities 3.2% -10.7% 0.8%

Cons. Disc 20.5% -2.7% 1.8%

Cons. Staples 6.9% -6.8% 3.6%

Healthcare 12.6% -1.6% 14.5%

IT 13.8% 0.2% 18.1%

Comm. Svc. 13.8% -5.5% 3.3%

REITs 9.5% -11.6% -2.5%

Russell 2000 (USD) 13.7% -21.4% -17.6%

World Eq. (MSCI ACWI) 10.8% -12.8% -4.4%

MSCI EAFE (USD) 6.5% -17.7% -10.9%

MSCI EM (USD) 9.2% -16.6% -11.7%

Commodities (CRB index) -4.6% -12.0% -16.3%

WTI Oil (US$/barrel) -8.0% -69.2% -70.5%

Gold (US$/ounce) 5.8% 12.1% 32.9%

Copper (US$/tonne) 4.5% -16.1% -19.7%

Forex (DXY - US Dollar index) 0.0% 2.7% 1.6%

USD per EUR -0.2% -2.4% -2.3%

CAD per USD -0.8% 7.4% 4.1%

CIO Office (data via Refinitiv) 4/30/2020


3

May 1, 2020

Writing the Third Chapter of COVID-19 After plunging into bear market territory in record time in March, as COVID-19 evolved from a predominantly Chinese epidemic to a global pandemic, the following weeks saw U.S. equities recoup a little over half of their losses (Chart 1), a spectacular rally that is reminiscent of the rebound that marked the end of the financial crisis in March 2009 (Chart 2).

The key factor behind this stock market recovery is evidently the massive and coordinated response from government bodies: wartime-like fiscal deficits (Chart 3); the fastest monetary expansion in history (Chart 4); and, most importantly, strict containment measures that have proven to be effective in slowing the spread of the virus thus far (Chart 5). Accordingly, our market sentiment indicator exited extreme pessimism levels on April 9 and is now near the neutral point (Chart 6, next page). In other words, in the space of just over two months the stock market has experienced what usually occurs over more than a year. First, there was a "shock" phase (the first chapter), where the accumulation of bad news (sometimes purely event-driven, sometimes cyclical or structural) dragged equities into a bear market. Then, a "policy response" period (the second chapter) followed, where the actions of central banks and governments point to an economic recovery and lead equities to bounce from oversold levels (Chart 7, next page).

This disconnection from historical precedents is an obvious consequence of the highly unusual nature of the current (self-imposed) economic downturn. But, no matter how different this time is, markets will still have to go through a period where upbeat economic expectations are confronted with reality (the third chapter). And, that's what we believe is ahead of us over the next few months.

1

CIO Office (data via Refinitiv).

-40%

-30%

-20%

-10%

0%

-40%

-30%

-20%

-10%

0%

2015 2016 2017 2018 2019 2020 2021

S&P 500 drawdowns (rolling 2-year window)

Correction territory(>10%)

Bear market territory(>20%)

-34%

+30%

2


-30%

-20%

-10%

0%

10%

20%

30%

-30%

-20%

-10%

0%

10%

20%

30%

1960 1970 1980 1990 2000 2010 2020

S&P 500 price return (rolling 15-day period)

Black Monday(1987) GFC

Dot-com bubble

Flash Crash

(1962)

COVID-19

March 26, 2009April 13, 2020

3

CIO Office (data via Fred, Congressional Budget Office).

thanks to war-

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

1940 1950 1960 1970 1980 1990 2000 2010 2020 2030

U.S. Federal Deficit - Percentage of GDP

CBO projections

April 30 revisions

4


15.1%

$2.4

-0.5 tn $

0.5 tn $

1.5 tn $

2.5 tn $

3.5 tn $

4.5 tn $

5.5 tn $

6.5 tn $

-12%

-8%

-4%

0%

4%

8%

12%

16%

1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 2022

Monetary injections - U.S.

Federal Reserve Assets (YoY $ change)

M2 money (YoY % change)

5


-19 cases

100

1,000

10,000

100,000

1,000 10,000 100,000 1,000,000

Differential COVID-19 Case Tracking

Nu

mb

er

of

ne

w c

ase

s (3

-da

y a

ve

rag

e)

Total number of cases

U.S.

Euro Zone

Rest of world

China


4

May 1, 2020

As such, one indicator keep on the radar screen is the Global Economic Surprise Index, whose specific function measures the comparison between economic data versus consensus. For now, the market has seemingly ignored its precipitous plunge, but the trend will eventually need to reverse for equities to keep pace as it did back in 2009 (Chart 8).

Besides, we should not expect an imminent return to healthy economic figures. For instance, the release of a 4.8% annualized contraction for the U.S. GDP in Q1 (-0.2% YoY) only portends what will likely be a much larger drop in the current quarter, as indicated by the Federal Reserve's new Weekly Economic Index (Chart 9).

We must also not lose sight of the virus, which could cause renewed turbulence should a second wave emerge. Overall, there are grounds for optimism considering (1) China has demonstrated that it is possible to reopen an economy while maintaining COVID-19 cases at a minimum, (2) the vast majority of the population must now be familiar with best practices to limit contagion, and (3) countries are significantly scaling up their testing capacity, notably in the U.S. (Chart 10). Nevertheless, the threat cannot be ruled out, as the Executive Director for the World Health OrganizationEmergencies Programme, Dr. Michael J. Ryan, highlighted on April 27:

o early, you may be back in a situation where lockdowns have to be re-imposed,

6


Market sentiment is picking up

020406080100120140160180200220240260280300320340360380400420440460480500

1800

2000

2200

2400

2600

2800

3000

3200

3400

2017 2018 2019 2020

NBI Market Sentiment Indicator (MSI) vs. S&P 500

Extreme Pessimism Extreme Optimism S&P 500 Market Sentiment

45

Extreme Pessimism

Extreme Optimism

7

CIO Office (data via Refinitiv). *Event-driven = 1959, 1961, 1966, 1987. Cyclical/structural = 1968, 1980, 2000, 2007

A bear market like no other

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

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-35%

-30%

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-15%

-10%

-5%

0%

5%

0 50 100 150 200 250 300 350 400 450 500

business days since market peak

S&P 500 bear markets (20% drawdown) since 1956*

Average bear market

COVID-19(Feb 2020 - ...)

Average event-driven bear market

Average cyclical/structural

bear market

8


Will reality match expectations?

-130

-110

-90

-70

-50

-30

-10

10

30

50

70

-130

-110

-90

-70

-50

-30

-10

10

30

50

70

2007 2009 2011 2013 2015 2017 2019 2021

Citi economic surprise index (developed countries, G10)

9


-11.6%

-0.2%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

2008 2011 2014 2017 2020

U.S. GDP vs Weekly Economic Index

US real GDP (YoY)

Fed Weekly Economic Index

10


Testing capacity is increasing in the United States

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

Mar. 10 Mar. 15 Mar. 20 Mar. 25Mar. 30 Apr. 04 Apr. 09 Apr. 14 Apr. 19 Apr. 24 Apr. 29

Daily Administered Tests New Positive Results Positive-to-Tested Ratio (right)

COVID-19 Testing in the U.S.


5

May 1, 2020

So, what to expect from markets from this point on? Over a longer-term horizon (> 12 months), we continue to believe the outlook for equities compares favourably to safer bonds. This is what we argued on March 18 when we concluded the current situation represented more of an opportunity than a threat. Since we have moved away from more dire scenarios, this is now all the more true. In the near term, however, upside potential for equity markets appears to be more limited. For instance, the rebound in stock prices together with downward earnings revisions have pushed the S&P 500's price-to-earnings ratio to a new high not seen in nearly 20 years (Chart 11). While much of this multiple expansion can be explained by the plunge in interest rates orchestrated by central banks, we suspect that further earnings weakness (Chart 12) and a will confine markets to be range-bound in the coming weeks, or even lead to giving back some of their recent gains.

A new episode in the geopolitical saga pitting the United States against China could also deflate stock prices. Sooner rather than later, the current U.S. administration will look to spin this crisis in their favour in the run-up to the November elections. This is likely to involve tougher policies toward the rival country where the virus first appeared.

Under these circumstances, we are maintaining our tactical asset allocation (neutral in equities, underweight in fixed income, and overweight cash) unchanged for now, and we stand ready to make changes as the situation evolves.

Fixed Income: Real Opportunities? After experiencing a shockwave in March, the massive injection of liquidity by central banks allowed fixed-income assets to improve their performance last month. Deeply oversold preferred shares rebounded most strongly (+12.6% in April), followed by U.S. investment grade credit (+5.2%) and U.S. high yield (+3.5%) (Chart 13).

Large-scale asset purchase programs by central banks seemed to revive many investors' concerns about their potential to create a rapid rise in inflation. In the short and medium term, we must emphasize that the economic downturn is likely to exert strong downward pressure on prices (Chart 14), compounded by the sharp drop in energy prices. Monetary policy seeks only to prevent these forces from pushing the economy into a deflationary spiral.

Looking further ahead, a case can certainly be made for higher inflation, notably because high indebtedness will likely force central banks to remain accommodative well beyond this economic downturn. So, should investors shift their asset

11


Near term upside potential is limited...

20.1

7x

9x

11x

13x

15x

17x

19x

21x

23x

25x

7x

9x

11x

13x

15x

17x

19x

21x

23x

25x

1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019

S&P 500 12 month forward P/E Ratio

30-yr avg. +/- 1 std. dev. PE Ratio (fwd)

12

CIO Office (data via Refinitiv). *net positive revisions divided by total revisions

... by the weight of downward earnings revisions

-80%

-60%

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0%

20%

40%

60%

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0%

20%

40%

60%

80%

2002 2005 2008 2011 2014 2017 2020

MSCI ACWI (US$) total return and earnings revisions

YoY total return (left)

Net earnings revisions* (right)

13


Better days for fixed income assets in April

14.7%

5.4%

-10.1%

2.8%1.0%

10.4%

-13.1%

-40%

-30%

-20%

-10%

0%

10%

20%

-40%

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0%

10%

20%

Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20

Fixed Income Benchmarks Total Returns - YTD

FTSE Canada Corp

Canada 10-year

Invest. Grade US

High Yield US

FTSE Canada Universe

US 10-year

S&P/TSX preferred shares

14


0.0

0.5

1.0

1.5

2.0

2.5

3.0

32

37

42

47

52

57

62

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

YoY %Index United States

Global PMI (left, 2-year lead) Core inflation (right)


6

May 1, 2020

allocations toward fixed-come assets that are better shielded against inflation, such as U.S. TIPS (Treasury Inflation-Protected Securities)? Relative to traditional government bonds, yes, TIPS are likely to perform better as inflation expectations recover. Currently, the 10-year breakeven inflation rate is only 1.07%, i.e. TIPS will outperform U.S. Treasury notes if inflation averages more than 1.07% over the next decade. The odds of this happening are good. That said, total return expectations for TIPS remain low over the long term as their real rate is currently negative. Hence, we stress that they are a good substitute for traditional government debt, but less so for riskier securities (Chart 15).

Speaking of riskier securities, in April, high-yield and investment-grade credit spreads both narrowed, although they remain in the upper end of their historical range (Chart 16).

For now, we continue to recommend investment grade over high yield, as many lower grade issuers are likely to struggle with payments in the coming months. However, notwithstanding downside risk in the short term, we must recognize that at current valuation levels, high-yield return prospects over a one-year horizon are skewed to the upside (Chart 17).

Similarly, Canadian preferred shares have reached attractive valuation levels in recent weeks relative to government bonds. Historically, such conditions have preceded turnarounds particularly beneficial to the asset class, and would seem more and more probable should market conditions continue to improve over the next few months (Chart 18).

Equities: Sizing Leadership Global equity markets rebounded at full speed in April, this rally even taking the S&P 500 just shy of positive territory year-to-date when measured in Canadian dollars who would have thought (Chart 19, next page)? In terms of leadership, U.S. and growth stocks continued to outperform in the rebound. However, small-cap stocks staged a sharp and sudden comeback against their larger peers late in April (Chart 20, next page). Is this the beginning of a sustained rotation in their favour? If one stands back to look at the ratio between small and large caps over the last three decades, one can see that some mean reversion was imminent given the extent of large cap outperformance in recent months (Chart 21, next page).

15


-0.43%

0.64%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2006 2008 2010 2012 2014 2016 2018 2020 2022

U.S. 10-year Treasury Yields

10-year Treasury (nominal yield)

10-year Treasury Inflation-Protected Securities (real yield)

10-year breakeven inflation rate

1.07%

16


Credit spreads have come down from their highs

231

784

0 bp

200 bp

400 bp

600 bp

800 bp

1000 bp

1200 bp

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1600 bp

0 bp

200 bp

400 bp

600 bp

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1000 bp

1200 bp

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1600 bp

1990 1994 1998 2002 2006 2010 2014 2018 2022

US Corporate Debt Spread to US Treasuries

U.S. Recessions Investment Grade High Yield

17


-40%

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0%

20%

40%

60%

80%

200 bp 500 bp 800 bp 1100 bp 1400 bp 1700 bp 2000 bp 2300 bp

To

tal

retu

rn o

ve

r su

bse

qu

en

t ye

ar

Starting High Yield Spread

High Yield: starting spread vs total return over the next year (1986-2020)

W e are here

18

-100%

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0%

20%

40%

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20%

40%

60%

80%

100%

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Performance spread - 10-year Canadian Treasury bonds vs. preferred shares

12-month

3-month


Value opportunity in Canadian preferred shares?

!

!


7

May 1, 2020

Now, what would it take for this reversal to carry forward? One of the key characteristics of companies in the U.S. Russell 2000 Index is that their balance sheets tend to be riskier more leveraged than their S&P 500 peers, which is why the ratio between the two tends to follow the direction of high-yield vs. investment-grade credit spreads (Chart 22).

Thus, although we are likely to see other periods of sharp small-cap rallies when the performance spread reaches extreme levels, those are likely to be short-lived as only a substantial and rapid improvement in economic fundamentals could lead to sustained small-cap leadership. Consequently, we expect the trend to remain favourable for large caps over the coming months as they are better equipped to deal with the substantial challenges posed by the current economic backdrop. Moreover, good examples of companies arguably better positioned to weather the current crisis are the five largest companies in the S&P 500, the well-known FAAMGs, which together represent about 20% of the index. Their just-published quarterly earnings results have evidenced their financial resilience, and that s an advantage that makes and should continue to make all the difference for the U.S. stock market (Chart 23).

Commodities: Negative Energy Commodities have always been considered the black sheep of financial markets, as they are prone to extreme bouts of volatility. However, this claim was taken to another level in April (Chart 24, next page), as crude oil prices dropped down to negative $37 (Chart 25, next page). How is that even possible?

19


S&P 500 nearly positive in 2020 (in C$) !?

-2.8%

-10.6%

-11.8%-12.4%

-35%

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Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20

Major global equity total return indices in C$

S&P 500 (C$) MSCI EM (C$) MSCI EAFE (C$) S&P/TSX (C$)

20


-14.1%

-26.1%

-14.2%

-9.3%

-30%

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0%

5%

10%

15%

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15%

Jan-19 Apr-19 Jul-19 Oct-19 Jan-20 Apr-20 Jul-20

Factor, sector and geographical leadership* (normalized at 0% on Dec 31 2019)

Cyclical vs Defensive Value vs Growth Small vs Large ACWI ex-US vs US

Cyclical / Value / Small Cap / World ex-USOutperforming

Defensive / Growth / Large Cap / USOutperforming

21


70

80

90

100

110

120

130

140

150

160

70

80

90

100

110

120

130

140

150

160

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 2020

Large vs Small caps (S&P 500 / Russell 2000)

Large Caps outperforming

Small Caps outperforming

22


-

100 bp

300 bp

500 bp

700 bp

900 bp

1100 bp

1300 bp

1500 bp

70

80

90

100

110

120

130

140

150

160

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 2020

Large vs Small caps (S&P 500 / Russell 2000) and HY spreads to IG

Large Caps outperformingHY credit spreads widening

Small Caps outperforming / HY credit spreads tightening

23

CIO Office (data via Refinitiv). *FAAMG = Facebook, Amazon, Apple, Microsoft, Google (Alphabet)

-13.5%

-9.3%

-12.4%

-16.6%-17.7%

10.3%

-20%

-15%

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-5%

0%

5%

10%

15%

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-15%

-10%

-5%

0%

5%

10%

15%

S&P 500 S&P/TSX MSCI EM (US$) MSCI EAFE (US$)

Year-to-date total return

FAA

MG

*

EX-F

AA

MG

S&P

500


8

May 1, 2020

The answer lies in a mix of (1) contract specifications, (2) supply and demand fundamentals, and (3) market positioning:

1. Contract Specifications: One major aspect often overlooked when dealing with commodity futures contracts is that these financial instruments are fundamentally tied to their underlying physical market. In other words, when you buy a WTI futures contract, you have the obligation to take physical delivery of crude oil barrels at expiry of said contract in Cushing, Oklahoma. Despite those specifications, only a minimal number of contracts result in physical delivery as most participants close out their futures exposure before the expiry date, and this usually results in much less volume and liquidity in the last days of the contract (Chart 26).

2. Supply and demand picture: The Covid-19-related production surplus generated by a general closing of the economy created a glut which created some operational constraints regarding storage capacity (Chart 27). Transport is another issue, as having available o bring crude oil to it. Under normal circumstances, the system works well. However, the speed and amplitude of

production surpluses created a lot of stress in the system which made it vulnerable to a systemic failure.

3. Market positioning: As the May WTI contract was nearing expiry most of the positions were either closed out or rolled into the June WTI contract. However, some retail investors, notably in China, were still invested in the May one via an ETF even as underlying liquidity was quickly drying up.

4. Tying it all together: Under normal circumstances, a seller close to expiry will find a bid for the right price. But this time, the combination of storage and transport constraints plus near-nonexistent liquidity resulted in negative prices as no one wanted to deal with those barrels. Basically, sellers had to pay to have someone take crude oil off their hands as they had no physical capacity to hold barrels themselves.

In a way, the -$37 bottom reflects more a panic-induced move by financial actors than a clear reflection of market fundamentals. The Covid-cause the negative prices, but rather set about an environment where such an event could be possible. All that was needed was a spark, which in this case came from retail investors who were left holding the hot potato without any oven mitts.

24


Oil redefined the term "extreme volatility" in April...

10

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2008 2010 2012 2014 2016 2018 2020

Commodity volatility: CBOE Crude oil volatility index

25


-40

-30

-20

-10

0

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2016 2017 2018 2019 2020

US$ / bblUS$ / bbl

Crude Oil (WTI) 200-Day MA 100-Day MA

26


Liquidity dries up as contracts near expiry

0

200,000

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1,000,000

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3/23/2020 3/30/2020 4/6/2020 4/13/2020 4/20/2020

Number of Futures Contracts

Number of Futures Contracts

Crude Oil WTI(May 2020 Contract)

Open Interest Volume

The number of Open Positions

was really low going into the selloff

27


Space is running out and the trend is worrying

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Q1 Q2 Q3 Q4

Million BarrelsMillion Barrels Cushing Inventories

Years 2007-2016 2019 2020 Cushing Inventory Capacity


9

May 1, 2020

how unbalanced and under stress energy markets currently are. We expect prices to remain low and extremely volatile on the near-

episode of negative prices, intense selling pressure for the June contract as it nears expiry is a possibility, if operational constraints are present. A scenario where prices are higher and sustainable should only be considered once the market is rebalanced. On the supply side, this presumes that the energy sector will have undergone a rationalization process via shut-ins, while the demand side recovers as the global economy rebounds a painful process that is sure to take several months.


10

May 1, 2020

CIO Office [email protected]

Martin Lefebvre CIO and Strategist [email protected]

Simon-Carl Dunberry Chief Analyst [email protected]

Louis Lajoie Principal Analyst [email protected]

Nicolas Charlton Analyst [email protected]

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