Market Outlook | February 22, 2011

“It must be admitted that there is a degree of instability which is inconsistent with civilization. But, on the whole, the great ages have been unstable ones.” - Alfred North Whitehead (1861-1947)

When observing US based indexes, one would notice the recovery in US markets continues as it recoups losses from 2007-08 crisis while restoring some confidence and reinforcing the power of perception. Perhaps, this provides a sense of fragile confidence, based on large company earnings, perceived value, and favorable reactions by key participants. The synchronized rise in the US stock market is helping the S&P 500 Index approach the 1400 level along with a quiet volatility. Rising markets are known to serve a marketing purpose in which sideline observers are enticed to step in or at least explore. A 30% appreciation in the S&P 500, since August 27, 2010, might dampen the voices of outspoken pundits, who highlight longer-term concerns. However, for those not relying on broader indexes as a barometer of well being, the above discussions of comfort might feel like a mere illusion. The growing disconnect between the market picture and the real economy sparks sensitive reaction as hinted at during the last two US elections. Similarly, odd makers would hardly claim today as a timely entry point to purchase stocks, given this extended market.

If you're a casual global news observer, you might be surprised and/or confused at the rapid widespread of global unrest. The escalating demand for power shift is a trend in itself with plenty of details to grasp as foreign policy experts map out future implications. Libya and Morocco are now added to this growing list of countries that look to reexamine their power structure. Then, it is fitting even for a casual observer to wonder the impact on sentiment, natural resources, and political risks. All factors become instantly relevant in a closely connected world. Clearly, this Monday (Presidents Day) witnessed a sharp rise in Crude and Gold, at least, as a short-term response to these events. Of course, the well-documented rise in agricultural commodities is tied to food riots. Perhaps, this provides a logical explanation to global frustration, which eventually will transform into a political matter. Where is the next turbulence going to come from? That is a natural question, but it is too early to ask without having fully grasped events that transpired.

If you've followed the Eurozone activities, you'll most likely wonder about the future result of German elections and the handling of persistent economic concerns facing southern European nations. It was only last spring that sovereign default worries triggered market sell-offs and ongoing bailout debates. Perhaps, a foreign exchange observer is too plugged in to gauge the Euro’s short-term behavior. Investment managers will have to dissect and scramble to figure out the relatively attractive place in Europe to capture economic growth for the next 5-10 years. In the near-term, stability is the question facing policymakers and investors alike for the weeks ahead.

If you're an emerging market investor, then assessing inflation and managing short-term risk is a lingering, but even more, puzzling question. A decade old theme is intriguing, and those familiar with China and Brazil are seeking the next cycle winner and reconsidering adding to winning positions. Interestingly, FXI (China 25 Fund) and EWZ (MSCI Brazil Fund) are not trading at multi-month highs. This is a noticeable contrast to the US indexes, and inquiring minds are pointing out that emerging market themes are becoming fatigued. Perhaps, inflation is one factor not to underestimate, and previous growth projection might have been too optimistic. Meanwhile, the global landscape remains highly tied to the faith of the US Dollar. This is not only a symbolic but also a practical manner in emerging market trends. Series of events can trigger mood swings in attitude of the US Dollar. At this point, the Dollar is accepted as a dominant currency as emerging economies continue to build a stronger financial infrastructure.

Connecting the Dots

Confluence of events can cause powerful reactions at a faster pace in an interlinked world. Sociopolitical matters have been brewing for a long while, but predicting inflection points in human (or market) behavior is too difficult. Interestingly, the fragility of financial systems in developed nations can trigger doubts for a short period. Yet, those doubts can be quickly forgotten until revisited at the next inflection point. Similarly, global markets have a way of exaggerating or underestimating a nations’ well-being, while painting a misleading perception for an extended period. In short, mean-reversion is necessary to get closer to the truth, but it is a painful process along the way.

Article Quotes

“While there are parallels with the US there are also unique features in Brazil. Risk management infrastructure has largely been missing in Brazil’s credit build up, with a “positive” credit bureau still not yet approved owing to consumer protection issues (a positive credit bureau shares credit history of all customers whereas negative bureau shares information for customers only in default, typically this information comes too late). This has enabled borrowers to build multiple lines of credit without the lenders’ knowledge, especially as most loans are “unsecured” and there is no collateral involved. Brazil is in this spot from a financial standpoint due to inefficiencies in the financial system. The operating expense to assets ratio of the Brazilian banking system is a staggering 4.2 per cent compared with 1.1 per cent and 1.6 per cent for Chinese and Indian banks respectively, and this large expense base keeps the cost of credit abnormally high.” (Financial Times, February 21, 2011)

“Although policymakers in the emerging markets clearly face important challenges, such concerns should be put into perspective. First, these capital flows have been driven by many factors, including expectations of more-rapid growth and thus higher investment returns in the emerging market economies than in the advanced economies. … Second, as I noted earlier, emerging market economies have a strong interest in a continued economic recovery in the advanced economies, which accommodative monetary policies in the advanced economies are intended to promote. Third, policymakers in the emerging markets have a range of powerful–although admittedly imperfect–tools that they can use to manage their economies and prevent overheating, including exchange rate adjustment, monetary and fiscal policies, and macroprudential measures. (Chairman Ben S. Bernanke, February 18, 2011)

Levels

S&P 500 Index [1343.01] – Multi-month highs are in place. The next question is in regards to the index’s ability to reach 1400. That is a level last reached and surpassed in 2000 and 2007. Interestingly, in both cases S&P 500 Index stayed above 1400 for short-lived period and eventually topped. However, the current trends point to the index being extended.

Crude [$86.20] – It has held above $84 and is attempting to breakout from a sideways pattern. The current news flow can provide near-term acceleration.

Gold [$1383.50] – For a few weeks, the commodity has remained in a calmer state in a narrow range of 1350-1400. Next discussion will circulate on Gold’s ability to revisit all-time highs of $1421 reached on November 9, 2010.

DXY – US Dollar Index [77.66] – Once again, the index pattern is not convincing of a strengthening dollar at this point.

US 10 Year Treasury Yields [3.57%] – Mildly pulling back after reaching 3.76%. In the weeks ahead, the magnitude of this decline is noteworthy for those tracking key macro shifts.



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