Market Outlook | August 26, 2013

“Actions are always more complex and nuanced than they seem. We have to be willing to wrestle with paradox in pursuing understanding.” (Harold Evans, 1928-present)

Twisted puzzle

Not many can claim to understand the cataclysmic US market dynamic that’s torn between an unloved bull market that's heating up (even over-heating) and the growth in the real economy, which is hardly convincing. Sure, cherry-picking some data or comparing today versus the worst point of the crisis would easily point out that stability has been restored in financial services. Yet, the markets have for a long while accepted this stability, as risk-taking has been promoted and rewarded for those who participated. Certainly the guidance and leadership of the Federal Reserve is divided between those who revere the restoration for near financial collapse and others that continuously question the bubble creation driven by low interest rates. Perhaps, judgment will be left to historians in future years than active participants in today’s market.

Influential money managers are forced to sift through and make a choice in doubling down on risk-taking versus reducing exposure in anticipation of a chaotic pattern. Now, the Fed’s puzzle of deciding whether to slow stimulus efforts under the assumption of a growing economy is also the investor’s dilemma. Finding a middle ground is no easy task, considering it has been a smooth-sailing bull market. Certainly, a change in tone serves as a catalyst for unexpected responses.

Moving parts

The current stability is fragile when looking at global markets, which have expressed powerful responses. 2013 so far has showcased the struggles of emerging markets. From Turkey to China to Brazil, the performances of these nations’ stock markets have not been as pretty as last decade – not to mention currency volatility, which has expanded into countries like India. Frankly, drumming up growth in these nations is challenging, and keeping up previous growth rates is overly ambitious. At this point, the concern of emerging markets is hardly news. The flow data demonstrates the current status:

“Of the $155.6 billion investors poured into developed-market equity exchange-traded products in the first seven months this year, North American funds received $102.4 billion or 65.8 percent, according to BlackRock Investment Institute. Japan attracted a record $28 billion, while Europe-focused funds got $4.3 billion. In contrast, $7.6 billion flowed out of emerging-market funds.” (Bloomberg, August 20, 2013).

In the last four years, the US’s relative edge versus other markets stood out, especially based on stock market performance. Now, it is questionable whether the US markets may need to correct and adjust their pricing despite the increasing capital inflow. Surely, new money is chasing returns in the US. The psychology of missing out is playing a vital behavior role. It is quite clear that liquidity is drying up in developing markets and the relative argument for US markets hasn’t quite run its course.

Questions to ponder:

• Is this unloved US bull market now accumulating more momentum, given increased capital inflow into stocks? Are stock prices are set to overshoot to the upside (further irrational behavior)?

• Is this Fed-led bullish market set up for an inevitable correction, given the escalating uncertainty of earnings, policymaking and macro dynamics?

• Are emerging markets valuations cheap enough versus the US market, potentially presenting a better risk-reward for forward-thinking participants?

Increasing awareness

Adjusting expectations is the big challenge ahead with all the speculation surrounding the stimulus efforts. The interconnected nature of this global market plays a vital role in a period when central banks are examining a change of plan, i.e. taper. Key models were built under the assumption of a low US dollar and low interest rates. As these dynamics shift, adjustments will need to be made and a new normal will need to be established. In a year with heavy emerging market correction along with commodity price adjustment, one has to wonder if this process will be painless. Even the definition of “risk-less” assets needs to be redefined. Otherwise, the best alternative might be the current status quo, which we have experienced in the last few years. Geopolitical tensions and exchange glitches and failure only add on to an already edgy climate. Perhaps, the edginess has been felt profoundly despite the deceiving sense of calm when viewing US broad indexes. As the autumn approaches, nagging but accumulating issues can materialize more quickly than imagined. Thus, preparing for the unknown is not so strange in the weeks ahead.

Article quotes:

“Indonesia has lost 13.6 per cent of its central bank reserves from the end of April until the end of July, Turkey spent 12.7 per cent and Ukraine burnt through almost 10 per cent. India, another country that has seen its currency pummelled in recent months, has shed almost 5.5 per cent of its reserves. Central bank reserves are held to act as a safety buffer against turmoil, and are on average still far larger than during past emerging market crises. But the pace of the drops [has] spooked some investors and analysts. Many central banks are likely to have suffered further reserve depletion in August, as the turbulence caused by the US Federal Reserve’s plans to end its monetary stimulus has resumed, and compounded concerns over slowing economic growth in emerging markets. Palaniappan Chidambaram, India’s finance minister, said on Thursday that India’s reserves were currently $277bn, compared with $280bn at the end of July, according to Morgan Stanley’s figures. … The US bank’s economists pointed out that excluding China and the oil-rich Gulf states, the current account balance of emerging markets as a whole has deteriorated from a 2.3 per cent surplus in 2006 to a 0.8 per cent deficit this year – the biggest shortfall since 1998, the last time the developing world was gripped by crisis.” (Financial Times, August 22, 2013)

“The actual numbers (not seasonally adjusted) behind the seasonally adjusted headline number showed that the drop in sales last month was larger than typical for July, so to that extent, the big miss in the headline number wasn’t all that misleading. The average monthly decline for July over the previous 10 years is 6%. Last year the drop was just 2.9%. This year, July saw a drop of 18.6%. It was the biggest July drop of the past 11 years. Buyers apparently stopped buying after mortgage rates surged. … Regardless of whether the current trend is still rising or not, it’s important to keep this in perspective. In the context of historical norms, this is not a recovery. Sales remain extremely depressed relative to the normal levels of the past couple of decades. Housing may no longer be a drag on US economic growth, but its contribution to overall economic activity relative to its past share is minuscule.” (Wall Street Examiner, August 23, 2013)

Levels: (Prices as of close August 23, 2013)

S&P 500 Index [1663.50] – After failing to hold above 1700, early signs of a pause. Early signs of stabilization around 1650, which will be tested in a few days.

Crude (Spot) [$106.42] – In the last two months, crude is trading in a very narrow range between $104-108. Potential macro events can spark short-term moves, yet it’s key to remember that crude bottomed in late June ($92.67).

Gold [$1375.50] – After the hard sell-0ff earlier this year, there is a 15% bounce from the lows. $1400 appears to be the next goal. Perhaps, there’s an inevitable bounce that’s building some momentum. Yet, revisiting $1895.00 (the all-time high) seems a long distance away at this point.

DXY – US Dollar Index [81.36] – Lots of swings in recent months, suggesting mild volatility. However, the recent range is in familiar territory. It’s premature to declare a new trend.

US 10 Year Treasury Yields [2.81%] – Since May 1, 2013 lows, yields have moved up noticeably. Yet, many wonder if yields will hit 3% and hold that level for a sustainable time. The last time 10 year yields stayed above 3% for a while was in first quarter of 2011.


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