Market Outlook | December 2, 2013

“With most men, unbelief in one thing springs from blind belief in another.” (Georg Christoph Lichtenberg, 1742 - 1799)

Digesting

Entering the last month of the year traditionally means embarking on a period where strategists participate in the guessing game for the next year. As 2014 approaches, forecasting the next twelve months might have a different twist than usual. As a start, digesting the explosive year in stock markets is one matter and in looking ahead, replicating this so-far 25%+ performance appears to be a tremendous hurdle to overcome. Of course, being swept away in recent price momentum is to be expected, but overemphasizing risks and dangers is not earthshattering either for keen observers.

Instead, one has to wonder if corporate earnings are a key driver versus the more tangible and more substance-driven economic growth. In fact, by the time one fully understands the dynamics of labor numbers or job surveys, the whole accuracy is a questionable science in itself. A few notable issues have been deferred and future risk is being quantified while sentiment may be more important. Yet, understanding the handful of market-moving narratives is crucial before speculating on a new narrative.

The relative message

Turning pages of articles and watching news of developing trends, it is hard to boast about visible global growth. How much of the broad indexes’ annual gains are attributed to quantitative easing? How much of the current landscape is shaped by a drop in commodities or severe decline in emerging markets? What is the true status of the Eurozone? Sometimes, a process of elimination is a beneficial factor and certainly there is a case to be made for that when viewing the stock performance of top US companies. Of course, multi-national firms at some point should feel the impact on earnings from overseas revenues. Even recently, IBM stated in the recent quarter that sales growth from emerging markets declined by 15%.

Certainly in looking ahead, earnings are an ongoing worry, but weak earnings have not been the main story for headline makers. For now, US real estate and US stocks confirm how American assets are highly preferred and regarded with value. Collective participants have “voted” through action, and that’s the takeaway in the past two years. Despite US domestic issues of a lack of growth in small business, government dysfunction and deflated optimism, there is a fragile US edge that’s been rewarding for risk-takers. The risk of being swept away is even greater, but denying the relative edge is undermining the visible market message. In fact, the relative edge of US financial markets has been rewarding to money managers who stuck through and doubled down on this thesis.


Global growth mystery

Commodity prices have weakened, and continue to reverse last decade’s run. Gold and oil are declining for two different reasons, but weakness is confirmed in the commodity cycle. Part of the slowdown in commodities is a result of weak global demand, which is the other big story this year. Unlike the low volatility index and very high stock market prices, the OECD forecasters are expressing a view that’s not as rosy:

“The world economy will probably expand 2.7 percent this year and 3.6 percent next year, instead of the 3.1 percent and 4 percent predicted in May, the Paris-based OECD said in a semi-annual report today.” (Bloomberg, November 19, 2013)

As witnessed in the first half of the year, emerging economies began to show signs of crumbling, leaving US markets relatively attractive both as an investment and an economy. For financial market observers, a not-so-stable emerging market economy should also signal a lack of stability and increased disruption from last-decade BRIC-driven markets. For example, Russia, which has ambitions of being a global power, reflects the slow global demand.

“Russia’s economy has recently been extremely weak. It fell into technical recession in the first half of the year and it looks likely to post growth of only about 1pc this year, down from an average over the past decade of just under 5pc.” (The Telegraph, November 24, 2013)

There is an ongoing theme underneath exchanges and economic forecasts. Globalization is being questioned more abroad, even religious leaders have questioned capitalism recently and possibilities of a reasonable recovery are the bigger question that waits. In fact, the macro climate these days is centered around avoiding damage rather than growth creation. Interestingly, within this context, the US maintains key advantages relative to other nations. These range from a strong financial system to dependable currency to adequate resources, which is noteworthy in recent oil expansion.

“The U.S. has gained more control of its energy supplies, thanks to the adoption of hydraulic-fracturing and horizontal-drilling techniques that have unlocked vast new oil and gas deposits in South Dakota, Pennsylvania, Texas and elsewhere. About 7.3 million barrels of oil a day were produced in the U.S. on average during the first eight months of 2013, according to the Energy Information Administration.” (Bloomberg, December 1, 2013).

The quest for creditability

Meanwhile, the financial system that was once fragile is facing a challenge of creditability with ongoing low interest rate policies both in the US and the Eurozone. If QE is more of a driver for growth than earnings or economic strength, then long-term investors must reevaluate. The influence of status-quo trends (low interest rates and higher asset prices) may have numbed and forced a capitulation of skeptics who relied heavily on data driven by the real economy. Sure, risk takers and money allocators seek what works, while chasing returns and capitalizing on the common perception. Yet, the nuances and paradoxes of the current marketplace are where the drama and truth quietly reside. At some point, the edgy crowd may not be satisfied by calming words and policies of the Federal Reserve. Perhaps, the lack of alternatives is what keeps the fuel of this bull market going. “All-time highs” sound appealing, of course, but misleading as well. The slogan of increase in asset values only welcomes further greed, which is around the corner. Inflow of capital into risky assets is making a splash and even subprime is booming as short memories evaporate so quickly. Thus, if investors’ memories are short-lived, then why should one expect next year to offer amazing returns like this year?

Article quotes:

“The first problem with deflation is that it tends to raise the real (inflation-adjusted) interest rate above its equilibrium level. As there is a zero lower bound to the nominal interest rate, the central bank may well find itself unable to drive the interest rate/inflation differential to a low enough level, which may result in a slump and even a downward spiral. True, some central banks (Sweden in 2009 and Denmark in 2012) have charged banks for taking deposits, thereby posting negative interest rates. But there are limits to such tactics, because if depositors are being charged, at some point it becomes preferable for them to buy safes and store banknotes. This problem is highly relevant for the eurozone, which is emerging from a long recession, with GDP still below its 2007 level and the recovery, though real, still lacking momentum. Having recognized the danger, the ECB has lowered its benchmark interest rate twice in recent months, to 0.25%. The problem is that this may be too little too late to move the real interest rate to where it should be in order to foster sufficiently strong enough economic recovery. The second problem with deflation is that it makes economic rebalancing within the eurozone much more painful. From October 2012 to October 2013, inflation was negative in Greece and Ireland, and zero in Spain and Portugal. But these countries still need to gain competitiveness by lowering the relative price of their export goods, because they need to sustain external surpluses to correct accumulated imbalances.” (Project Syndicate, November 30, 2013).

“Between 2010 and last year, brands from the comparatively small and exclusive Hermès to the bling of Louis Vuitton have seen the mix of China’s emerging wealth and its population’s love of all things luxury fatten an entire industry – during the leanest times almost anyone can remember. But the mighty Chinese engine is moderating – at least by its own high-revving standards – and the new government is cracking down on exuberant personal spending and gift-giving by officials. As a result, people in the €217bn-a-year luxury industry find themselves staring at an uncomfortable but inescapable question: is the era of double-digit growth over? The answer has huge implications for brand strategy in the world’s most populous country – as it does for luxury groups’ approaches in other markets. It also has direct implications for the valuation premium that investors have placed on the sector compared with other companies. For the past three years, revenue in the luxury sector has grown at an average of more than 11 per cent a year in euro terms, spurred on by Greater China, where revenue grew a heady 19 per cent in 2012, according to a study by Fondazione Altagamma and Bain & Company. But this year, growth in Greater China is expected to fall to 4 per cent, dragging down overall revenue growth to just 2 per cent.” (Financial Times, November 29, 2013)

Levels: (Prices as of close November 29, 2013)

S&P 500 Index [1805.81] – Another week where the key broad index finished a few points above the prior week’s high. Again, that ended up registering new record highs. Before Thanksgiving, the index made its 38th all-time high for 2013, reflecting a momentum-driven year.

Crude (Spot) [$92.72] – Downtrend intact. In more than three months, the commodity has dropped by $10 per barrel, signaling a noteworthy shift. A similar trend was visible between February and June 2012, where crude fell from $110-$77, then rebounded. Worth tracking if the same pattern takes hold.

Gold [$1245.00] – Further price erosion, as gold is below the 200-day moving average, which stands at $1390. Amazingly, last year’s highs stood at $1791.75, reinforcing the cooling commodity cycle and the misunderstood supply-demand dynamics.

DXY – US Dollar Index [80.68] – Mostly unchanged the whole month of November. Catalyst for currency movement has remained relatively quiet, which mirrors the volatility index.

US 10 Year Treasury Yields [2.74%] – Since the start of November, Treasury yields have moved higher from the 2.50% range, potentially suggesting that economic numbers are not viewed as overly weak. The 3% mark remains the key benchmark, and it’s unclear if that’s achievable from year-end.


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