Choc Shock

Here are some of the biggest stories from last week:

• US small caps have suffered their worst run against larger stocks in over two decades.
• The IEA anticipates the global oil market to face a supply deficit throughout 2024.
• Cocoa futures prices soared above $10,000 a ton for the first time ever.
• But the move is arguably more influenced by financial factors than by fundamentals.
• Short sellers are betting billions that the rally in crypto-related stocks will eventually end.

Dig deeper into these stories in this week’s review.

Stocks

Compared to their large-cap counterparts, small-cap stocks typically promise higher returns to investors who can stomach the higher volatility. After all, these stocks are often less scrutinized by the market, presenting more mispricing opportunities that savvy investors can exploit. What’s more, because of their smaller size, they have a lot more growth potential compared to larger, more established behemoths.

But as is often the case, what sounds good on paper doesn’t always work out in reality. In 2023, US small-cap stocks trailed their large-cap peers for the fourth year in a row, marking their worst run of underperformance in over two decades. To quantify this a bit, consider this: the Russell 2000 Index (which includes 2,000 of the smallest US stocks) has risen just 24% since the beginning of 2020 – far short of the more than 60% gain for the S&P 500 (which includes 500 of the biggest stocks).

A big part of this underperformance comes down to investors chasing mega-cap tech stocks – especially those seen as benefiting from AI. But there’s another factor at play: small-cap companies have weaker balance sheets and less pricing power compared to larger companies. This disadvantage has been particularly painful over the past few years, which have been marked by high inflation and a steep rise in borrowing costs. Roughly 40% of debt on Russell 2000 balance sheets is short-term or floating rate, compared with about 9% for S&P companies.

However, barring a recession, small-cap profits are expected to improve as interest rates start to come down. Analysts on average expect 14% earnings growth for Russell 2000 companies this year – above the 10% forecasted for S&P 500 firms. This promising profit outlook, combined with the fact that small-cap stocks are trading at near-record valuation discounts to their large-cap peers, might entice investors back to the little guys, which could help reverse four years of underperformance.

Commodities

In updated forecasts, the International Energy Agency anticipates the global oil market to face a supply deficit throughout 2024, instead of the surplus previously expected. Key to this forecast is the assumption that OPEC+ continues its production cuts, due to expire at the end of June, in the second half of the year. Assuming an extension of the curbs before it’s officially confirmed is an unusual move by the IEA, which typically waits for policies to be announced before factoring them into its forecasts. But the decision is based on repeated previous extensions by the alliance, the agency said.

The IEA raised its forecast for global oil demand growth in 2024 by 110,000 barrels to 1.3 million barrels a day. This was mainly due to a stronger US economic outlook and the increased need for ship fuel, as vessels take longer routes to avoid attacks in the Red Sea. Despite this increase, the updated figure marks a significant slowdown from last year’s global oil demand growth of 2.3 million barrels a day. This deceleration reflects the dwindling momentum of the post-pandemic recovery and the accelerating shift away from fossil fuels. What’s more, rising oil consumption this year is expected to be largely offset by swelling supplies from the Americas, which would leave world markets in surplus were it not for the OPEC+ cutbacks.

Switching gears to another commodity, we need to talk about cocoa again, where supply shortfalls and funding challenges in Ghana have sent the price of the beans to a new record high this week. More specifically, cocoa futures prices soared above $10,000 a ton on Tuesday, leaving the commodity more expensive than bellwether industrial metal copper. The latest spike follows news of funding headaches in Ghana, the world's second-biggest cocoa producer. The country's about to miss out on an important loan as bad weather and disease hit its crops hard, leaving it without enough beans to secure the funding needed to support its cocoa farmers for the next harvest.

Decades of underinvestment mean cocoa production has failed to keep pace with demand, which has doubled in the past 30 years. The most recent wave of tree planting in West Africa took place in the early 2000s. But those trees are now approaching 25 years of age, which is well past their prime. Old cocoa trees don’t yield as much fruit and they’re more vulnerable to poor conditions. That’s been a huge factor behind the recent surge in prices, with drought and disease ravaging crops in the key growing region of West Africa to create the biggest supply shortfall the cocoa market has seen in more than six decades.

Facing a massive shortfall, the market responded by sending cocoa prices high enough to curb consumption and restore the supply-and-demand equilibrium. However, the recent streak of daily record highs is arguably more influenced by financial factors than by fundamentals, and comes down to hedging by cocoa traders.

See, cocoa traders who own physical stocks of cocoa beans or semi-processed products usually offset this by taking opposite positions in the financial market – that is, shorting cocoa futures. This hedging should work well when prices are rising, with losses on the short positions covered by gains on the value of the physical holdings. However, as traders wait for the financial contracts to mature, which can take months, they need cash to meet margin calls stemming from losses on their futures positions.

Typically, trading firms use their cash reserves or borrow to cover these calls. But in a prolonged market upswing, like the current one for cocoa, margin calls can exceed financially healthy companies’ ability to pay, forcing them to unwind their hedges to avoid running out of cash. In that scenario, the only option is to close out the short positions at whatever price the market demands. This leads to a self-sustaining problem: as cocoa prices climb, margin calls increase, which forces traders to close their positions by buying back futures. This pushes prices up further, creating the same problem for others.

Crypto

There’s arguably little doubt that we’re in a crypto bull market, but not everyone is convinced. Short sellers are betting billions of dollars that the rally in crypto-related stocks fueled by a surge in bitcoin will eventually end. Total short interest, or the amount that contrarian traders have bet against crypto stocks, has increased to nearly $11 billion this year, according to S3 Partners. More than 80% of total short interest in the sector are bets against MicroStrategy and Coinbase. Short interest in MicroStrategy, which owns 214,246 bitcoins valued at around $15 billion, now sits at more than 20% of its total shares outstanding. That makes the company one of the most-shorted stocks on Wall Street, stacking up against much bigger companies such as Nvidia, Microsoft, and Apple.

Next week

• Monday: China manufacturing PMI (March), US manufacturing PMI (March).
• Tuesday: US job openings and labor turnover survey (February), UK mortgage approvals and lending (February).
• Wednesday: China services PMI (March), US services PMI (March), eurozone inflation (March), eurozone unemployment rate (February), OPEC meeting.
• Thursday: Minutes of the ECB’s latest meeting, eurozone producer price index (February), US trade balance (February).
• Friday: Japan household spending (February), UK house price index (March), eurozone retail sales (February), US labor market report (March).