­Market Outlook | January 7, 2013

“Our great weariness comes from work not done.” (Eric Hoffer, 1902-1983)

Isolating substance

Worrisome theatrics and collective confusion resurfaced in a holiday-shortened week. The first part of the US cliff matter reassured to avoid surprises in global market. The suspense associated with the fiscal discussion mostly resulted in lawmakers participating in a mind games while having less impact on market turbulence. Eventually, a short-lived market rally signaled a relief from the saga, rather than a confirmation or further certainty toward a new trend. On the surface, fears of another credit “downgrade” were mildly discussed, given the short memories from the overly volatile and historic summer of 2011.

Overall, the perception of the US government as being overly dysfunctional at times may not reiterate the required confidence, but the relative edge of the US is not bound to vanish overnight. Theatrics aside, periods of flux and political jargon end up being too loud for the taste of calm market observers. Keeping that in perspective helps avert near-term confusion but fails miserably to present a tangible long-term explanation.

Re-focusing

Through all the unavoidable noise, the economic stability of the current trend remains in place. The relevancy of these trends should not go unnoticed (as fiscal cliff part two awaits) since the goal after any crisis is stability in the financial system, followed by well-felt growth across the board. The labor and housing data continue to showcase a recovery mode. Importantly, corporate earnings should not be confused with economic growth, since that dynamic is quite different. Despite the S&P 500 Index reaching a five-year high, earnings growth has reached escalated ranges, at least for odds makers. Escalated expectations for fourth-quarter results do create room for legitimate disappointment. “Despite the reductions in estimates, analysts are still calling for a return to earnings growth in Q4 (2.4%) after a decline in Q3 (-0.9%). Seven of the ten sectors are projected to report earnings growth for the quarter, led by the Financials sector (15.5%) sector. On the other hand, the Industrials (-4.6%), Information Technology (-2.8%), and Health Care (-2.6%) sectors are predicted to have the weakest earnings growth.” (Factset, January 4, 2012). Similarly, the run-up in emerging markets is following the US market leadership in the last three years.

Grappling with the question of overreaction or persistent trends is the question around macro indicators. For example, the recent signs of mild increase in interest rate might prop up thoughts of a trend shift as the US 10 year treasury yields inches closer to 2%. This has few wondering if the low-rate environment has run its course. Surely, it’s a question that has been asked many times before in the last few years. The faith in quantitative easing, the engine of current markets, lingers in the background, specifically as to whether the “end” of this policy should dictate the overall sentiment and tone for the early part of 2013.

Open-minded approach

Printing more dollars to keep rates low and stimulate the economy appears to have achieved its goal. Despite the politically slanted talks, the solution has rejuvenated confidence, as evidenced in 2012. Thus, those entangled with Federal Reserve bashing might to take a breath or two to visualize the whole picture: “In short, Ben Bernanke has made it more expensive for the government to borrow money. And that's good news. Just consider the counterfactual where there was no quantitative easing. Asset prices, like stocks and homes, would almost certainly be lower, and that would make households try to save more. That doesn't exactly sound like a problem, but it would be a massive one right now” (The Atlantic, January 4, 2012).

Fund managers have to balance the less-known macroeconomic issues of interest rates and currency behaviors while diligently finding specific themes that present an attractive balance. Until the macro picture provides a clear path, some may struggle to simply buy attractively valued US companies. At the same time, perception alone can extend global rallies beyond logical sense; therefore, staying nimble in risk management will continue to require further alertness. Finally, the less controllable and frustrating part of anticipating policymakers’ decisions is inescapable this first quarter. Thus, having a curious and open mind will be collectively required.

Article Quotes:

“Market watchers say after more than two decades of economic pain for Japan, local pension executives are just as likely to use the 20% gain Tokyo's benchmark Nikkei index has enjoyed since mid-November as an opportunity to take profits as to rethink long-standing moves to lower allocations to domestic equities. According to data compiled by Towers Watson K.K., the Tokyo-based subsidiary of investment consulting giant Towers Watson & Co., between Dec. 31, 2000, and Dec. 31, 2010, Japanese pension funds' average allocation to local bonds rose to 41.9% from 31.5% while allocations to domestic equities plunged to 16.2% from 34.7%. More recent data compiled by Japan's Pension Fund Association show a similar trend for domestic equities, with an average allocation plunging to 17.4% as of Dec. 31, 2011, from 34% as of Dec. 31, 2000. The PFA data, which break out insurance ‘general account’ products as a separate category, show those general account allocations rising to 14% from 11.3%, and domestic bond allocations climbing to 27.2% from 21.3% over the same period.” (Pensions & Investments, January 7, 2012).

“Almost everybody would agree that Greece was living beyond its means for a long time and that this should have been corrected. Consumption spending supported by rising disposable incomes and ample and cheap credit after the country joined the eurozone in 2001 was behind it and the obvious culprit which had to be dealt with. The economic adjustment programs sought to correct the fiscal and external account imbalances by imposing higher taxes and cuts on salaries and pensions and other measures to improve competitiveness, such as lower minimum wages in the absence of a national currency that could be devalued. … Private and public consumption spending contracted by about 36.4 billion between 2009 and 2012 at the same time economic output fell by about the same amount or 36.1 billion. GDP is estimated at 195 billion in 2012 from 231.1 billion in 2009. Therefore, it comes as no surprise that households and the government are consuming less but the share of total consumption as a part of GDP has remained resilient, easing to 91.4 percent last year from 92.8 percent in 2009, according to our calculations. … In other words, the much-desired and sought-after decrease in consumption spending has been analogous to the drop in GDP during the 2009-12 period. Of course the EC projects the share of consumption spending in GDP will fall faster this year and next to about 89 percent and 86.4 percent respectively. However, these are still projections and even so the drop is not as big as the proponents of a different economic model hoped for.” (Ekathimerini, January 6, 2012).

Levels:

S&P 500 Index [1466.47] – Closed near the highs of 2012 after a quick relief rally. Anticipation increases for a run-up to the 2007 high, which is less than 100 points away.

Crude [$93.09] – Nearly a 10% rise since the November lows. Weekly trends suggest a floor of $85 and an upside around $100 for several weeks.

Gold [$1648.00] – Slightly below its 200-day moving average. This emphasizes the existing multi-week downtrend in the last three months.

DXY – US Dollar Index [80.49] – Ended the week with a sharp rise. This is mainly an event-driven reaction until a significant break above $82-84.

US 10 Year Treasury Yields [1.89%] – Noticeable recent acceleration suggests a revisit of 1.90-2%. Certainly since the summer 2012, it’s safe to conclude that rates have kept going higher.



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