Market Outlook | June 24, 2013

“Truth, like a torch, the more it's shook it shines.”(William Hamilton 1788-1856)

Shaken

The status quo of central bank stimulus (aka QE) succeeded in inflating asset prices, primarily in stocks and real estate. Yet, the stimulus efforts have not proven to be highly effective in re-energizing the real US economy. This is a disconnect that's been much talked about, but cracks in this foundation began to appear in financial markets. Markets globally got a dose of sharp drops last week, setting up turbulent weeks ahead. The catalysts have been building up, and turning a blind eye was not an option at this point of the four-year cycle. Thus, tough questions and inevitable knee-jerk reactions materialized.

So the questions remain: Did the Fed finally realized the ‘disconnect’ is not solved by further easing? Or did the believers in QE realize that, outside of Fed easing, there are not many reasons to own assets? Reality checks on cycles and newly formed bubbles are now playing out in a frantic way as the multi-month smooth sailing market woke up to sharp selling. Certainly, the credit markets were reheating along with stocks to mirror a pre-crisis feel.
Lose-lose options

The overly decorated and at times over-glorified Federal Reserve faced a lose-lose situation last week, ahead of their public announcement:

1. Observers were skeptical of the age-old concept that more easing would lead to growth. There is increasing doubt in that easing strategy today versus two years ago, and rightfully so. The Fed has recognized that as well.

2. Lack of further QE was going to severely impact risk-takers who loaded up on assets with hopes of prolonged QE. Perhaps, overdependence has its own natural risk and at some point this reality must be confronted, as the disconnect was wearing off.

Simply put, both options are not pleasant, but a step toward facing the truth. As the saying goes, ‘If you live by the knife you die by the knife,’ and risk-takers experienced that last week. It’s safe to say that volatility has awakened, and calming participants is not that easy and quick when shifting gears. The macro drivers suggest more turbulence ahead, especially ahead of earnings – which will reveal more. Ultimately, the Fed chatter is not that soothing, and the inevitable correction is here after an explosive first half.

“The Fed has been at the forefront of central banks seeking to stimulate economic recoveries through creating trillions of dollars to buy bonds and wrestle down global interest rates. Much of the new money has spilled into the developing world as investors have desperately sought better returns in new markets. This helped countries from Honduras to Rwanda gain access to international capital for the first time, and buoyed the bigger developing markets.” (Financial Times, June 23, 2013)

Beyond the Fed

Hints of a slowdown have persisted for months, and the signals had been mounting way before the Federal Reserve meeting. A slowing emerging market economy was no secret, especially with the cooling of BRIC nations led by weakness in Chinese growth. In fact, the GDP story of China is unresolved and causes further concerns. This developing nation slowdown is highlighted in the decline in Brazil and Turkey, where investors are discovering the previous growth is not sustainable. Since January 2, 2013 the emerging market fund (EEM) has declined nearly 20%, painting a not so attractive picture.

Similarly, a 12-year bullish run in gold had to come to a pause. This is not a story of gold only, but within the context of the commodity super-cycle that needed a breather. Importantly, over a decade, the commodity boom mirrors plenty of the emerging market explosions and now both are correcting rapidly. Gold is down nearly 28% since October 2012 highs, emphasizing the hype as a safe haven, which has failed despite aficionados’ resilience.
Another critical hint is in interest rates, which bottomed out in early May. The US 10 Year Treasury was already rising heading into the Federal Reserve announcement. Now with 10-year yields reaching two-year highs, analysts are revisiting their targets and bond traders reshuffle their thoughts. Thus, emerging markets, commodities and fixed income all whispered of changes before roaring and shaking the markets.

Bracing for fallout

Linked into developed and emerging economies is the recent shakeup in currency markets. Overall, a three-decade theme of a weak dollar and low interest rates was bound to reverse as well. Even a slight rise in the US dollar led to a domino effect on other currencies, sparking volatility. Thus, the prevailing status quo was defined, as low rates and rising assets must rewrite their path in terms of currency behaviors as well. Surely, the global markets are interconnected and so are asset classes, which are highly correlated. Thus, a sudden spook led to a sell-off in bonds, commodities and fixed income. This only brings up a common theme of: Where does one invest? It’s well known that there are limited options all around, which will force many to look ahead and, like usual, suspect a quick bounce-back. Yet, turbulence has its own pace to sort out and previous misconceptions need to be flushed out of the system.

Article quotes:

“To put it into context, in the four-year period between late 2008 and late 2012, China’s stock of credit, excluding the financial sector, rose 57% of GDP. The US took seven years between 2002 and 2009 to increase the ratio by the same amount, with the UK debt-to-GDP ratio increasing by 80% in the same seven-year period. The speed of China’s growth is not quite unprecedented, but the precedent is not a happy one. ‘These extreme rises of debt-to-GDP have been a very good predictor of financial crises,’ says Coulton. ‘A lot of financial crises have followed this kind of credit expansion.’ There is no sign of any rise in non-performing loans (NPL) as yet, though many suspect Chinese banks are seriously under-reporting deterioration in asset quality. According to the China Banking Regulatory Commission, the NPL ratio of Chinese commercial banks stood at 0.96% in Q1 2013, a nudge up from 0.95% in the fourth quarter of last year – the sixth straight quarter of rises since the fourth quarter of 2011. If there is a bubble in China, it is not a typical one, with government interventions serving to distort the usual indicators – a fact that makes famed China bear Michael Pettis claim the Chinese banking sector is de facto insolvent without state subsidy of interest rates and political cover for asset quality deterioration.” (Euromoney, June 2013).

“From Turkey to Brazil to Iran the global middle class is awakening politically. The size, focus and scope of protests vary, but this is not unfolding chaos – it is nascent democracy. Citizens are demanding basic political rights, accountable governments and a fairer share of resources. The movements may lose their way. The demonstrations will have a limited long-term impact if they fail to become organized political movements. And the violence and criminality that erupted during some protests in Brazil have prompted a popular backlash. … In Turkey, the protests are not the equivalent of the Arab Spring demonstrations that toppled governments across the Middle East. Nor are they simply a pitched battle between religious conservatives and secular liberals. Instead, they are deeply Turkish – and hugely important. After decades of the Turkish state reigning supreme, young Turks are demanding pluralism and basic individual rights. The Turkish state should be accountable to the people, they argue, instead of the people being accountable to the state. … Brazil presents a different dynamic. The ruling Workers' Party is left-leaning and its economic reforms have helped the poor and middle class. But now a souring economy, corruption scandals and $12 billion in government spending on 2014 World Cup stadiums has sparked one million people to take to the streets.” (The Atlantic, June 23, 2013).

Levels: (Prices as of close June 21, 2013)

S&P 500 Index [1592.43] – Since May 22 intra-day highs, the index has fallen nearly six percent. Pausing and poised for further correction.

Crude (Spot) [$93.69] – Once again, oil failed to hold above $100. This is a theme that has repeated again and again in recent months. The ability to hold above the 200-day moving average ($92.30) will set a key tone.

Gold [$1292.50] – Additional deceleration from a multi-month decline. Down more than 25% since peaking on October 4, 2012. Further confirmation of weakness as a break below $1300 sent sharp daily selling.

DXY – US Dollar Index [82.31] – After an up-and-down May, the dollar is stabilizing and appearing to re-strengthen.

US 10 Year Treasury Yields [2.53%] – An explosive run in the last few weeks, from 1.55% to more than 2.50%.




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