EXPERT VIEW: Metals sell-off - not as bad as it could have been?

The early-February sell-off in London Metal Exchange base metals seems to have run its course for now, but it may have not been as extreme as it could have been, ironically because of the growing influence of computerized trading systems.

At the end of December last year, copper traded as high as $7,291.50 per tonne, and was pretty much maintained at solid levels comfortably above $7,000 for the first month of 2018 – the metals market in general was perhaps in the foothills of a bull market.

But in just over a week, prices have fallen back considerably – the decline since that end-2017 high watermark to a sub-$6,800 close on Friday February 9 was virtually without respite. At a two-month low of $6,733, the market had shed over $550 or nearly 7.70% - most of it in just over a week.

There is a similar tale in aluminium. From $2,290.50 on the last trading day of 2017, the market has dropped close to $170 or nearly 7.5%.

Indeed, this is the picture right across the base metals: Hard-won early-2018 gains wiped out by the knock-on impact of sharp global equity market declines.

Turmoil in stock markets was the catalyst, but the early-2018 stock market pummeling is not entirely due to ashen-faced panic-stricken investors losing their collective nerves. Rather, it incorporates a significant element of high-speed computer-based activity.

And that may not have the same damaging impact on both equities and base metals in the medium-to longer-term.

The reasons for the wash-out in equities – led by US stock markets – are well-documented. The perception that US Federal Reserve policy tightening will happen quicker than had been previously thought is being mirrored by other central banks – the United Kingdom’s Bank of England hinted as much this week.

Factors at play
A decade after the Great Financial Crash, the world is in the throes of synchronized economic growth, while the era of abundant quantitative easing (money printing) is coming to an end. Normality is returning, and inflation, which has not been tamed, will have to be tackled by interest rate increases.

None of this has significantly changed the micro-fundamental outlook for base metals in the longer-term. Those fundamentals are broadly positive – rising demand in China and other key economies, some questions over supply prospects for the likes of copper and increased investment interest.

That is helping the LME - January ADV (average daily volume), when UNA (unallocated) trades were adjusted out, was little changed from a year ago at 622,560 lots, another sign that the trend of falling turnover has been arrested and possibly reversed.

But, as has been the case for decades now, all the world’s financial markets are inter-linked, so commodities cannot remain immune to what happens elsewhere. Inevitably, volatility in wider financials ripples through to the LME complex.

And that is no bad thing. Increased price volatility means wider movements and provides more attractive trading opportunities. Apocryphally, LME brokers say February turnovers have been good so far. For example, last Friday heavyweights copper and aluminium notched up turnovers of over 20,000 contracts on Select. Zinc volume was over 12,000 lots, while nickel was close to 10,000 contracts

It is worth remembering that the current washout in US equities, which is the catalyst for the mirror-image falls in China, Asia, Europe and the UK, is somewhat overdue. For over a year, Wall Street has enjoyed almost uninterrupted advances. So a correction, technical retracement - whatever it is called - has been on the cards for some time.

And although the down-days on the Dow Jones, Nasdaq and S&P 500 have looked dramatic – 4% daily more than once, they are not game-changers, as they were in previous crashes. Meanwhile, the nature of trading, as well as behavior, not only in stocks and shares, but also in commodities, is different from a generation ago.

In October 1987, the Dow Jones saw in excess of 20% wiped off share values in just one day. While not so extreme, there were similar routs in the early 1990s and towards the end of the decade when the dot-com bubble burst.

In all these – October 1987 in particular – the world’s central bankers and finance ministers hastily took to the airwaves and media. The message was that nothing had really changed and there was no need to panic. But panic there was, and it continued for days, exacerbating price falls.

The reason why the likes of US Fed titan Alan Greenspan attempted to calm nerves is basic – markets at the extreme are driven by fear, greed, irrationality and panic. And that is much more in evidence when values are falling precipitously – the herd-mentality of panic-sales leads to price routs.

Emotion vs algorithm
That is not necessarily the case now because humans, for all their foibles, are not as influential. Much of the business in equities for sure, and to some extent on the LME, is computer-driven. The trend-setter when markets start to move swiftly is artificial intelligence, which dictates what, when and how to sell (and buy).

The algorithms very much dictate the flow, and although there are links between different asset-classes programmed in, sentiment swings and mood-changes are not profiled into computerized systems.

Sure – algorithms are designed by human beings, and they are getting cleverer. But the basic raison d’etre is to be as lightning fast as possible in reacting to nanosecond fluctuations.

An algorithm does not feel fear, it is not driven by greed, it does not have the capacity to over-react – it simply does what the program code says. As algorithms do not have a code that says: “Gosh – this looks bad, so carry on selling,” the system stops when it is programmed to do so.

Although the LME has a less-intrusive systems-based trading community, the behavior and the pattern is broadly the same as in the HFT-influenced equity arenas. There will be rapid movements, and wide fluctuations, but once they have run their course, the downswings may not be as exaggerated.

None of this makes life easy for LME dealers and the trade, but the challenge of taking advantage of increased price volatility, as well as increasing the need for industry price protection through hedging, is what the modern metals business should be.

It may be tough at times, but that is better than sideways markets and shallow price movements.

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