Market Outlook | December 16, 2013

“More important than the quest for certainty is the quest for clarity.” (François Gautier)

Lack of clarity

Participants and observers continue to buzz from recent appreciation in stocks and real estate prices. Certainly, the risk-reward in both areas has been fruitful as it restores the collective faith in the actions of central banks. Having a clear thought process on unfolding events ahead is not easy but leaving room for surprises and volatility is wise. Hence, the true risk of betting in risky assets is about to be revealed, and assessing this landscape is the collective challenge. Economic strength is somewhat visible and labor numbers have shown some promise, but the level of real economy strength is debatable.

And as debated all year, the sync between financial market appreciation and growth in the real economy needs clarity. Skeptics have pointed out this disconnect, which discredits some of the Fed’s messaging. Low interest rates are not quite the solution for job creation. Celebrating portfolio appreciation is not quite economic growth, either. Crafty tactics aside, the simple perception of QE success is not a clear-cut victory. To call QE a defeat at this point might be premature, but up for debate. In addition, inflation was feared for a while, but deflation might be the near-term concern. Thus, risk-takers demand a few answers, and collectively, the crowd waits.

The risk narrative

The buzz from a spectacular stock performance lingers for the casual observer, while the less settling topic of “taper” faith is speculated upon with pending clues ahead this week from the central bank’s meeting. In terms of the taper – changes to quantitative easing – most analysts expect the tapering to take place in the late first quarter of 2014; only very few suspect earlier. According to Bespoke Investment Group data:

“The January 29th meeting received 19% of the votes, so when combining the December, January and March meetings, 66% of poll participants think there will be a ‘taper’ announced before the end of the first quarter of next year.” (December 9, 2013).

Perhaps, there is a surprise is in the making, as odds makers give the taper a very small probability this month. However, one should not forget that in September, a taper was highly anticipated by experts and failed to materialize despite the fancy coined term – “Septaper.” It is fair to say that the fate and timing of quantitative easing is hardly understood by most experts and frankly, it is unknown. Again, risk is inevitable when guessing events or chasing returns – a reminder to those who are caught up in this bullish run. Equally, imagining the less imagined is not as crazy as it seems for risk-takers.

Amazingly, the substance of recent economic trends is mixed to most observers, yet the “art of messaging” from the central bank is what’s awaited to shape investor perception. The Fed’s ability to dictate what to think and how to act in terms of investment risk is such a powerful force. It is typical for suspense to build, especially when worries (and volatility) were suppressed for too long. Equally, markets are near all-time highs in which the status-quo trend became a profitable habit. Surely, near-term risk-taking habits are hard to change rapidly, especially when they have produced profitable portfolios for individual and institutional investors.

Early clues

The collapse of commodity prices in the last twelve months showcases a major shift in cycle from the previous decade, when gold and crude witnessed gains, along with high investor demand and tons of investor attention. Now, the pricing of commodities may appear cheap to some, but a loss of momentum is fair to declare at this point. Since May 2011, the commodity index (CRB), which serves as a barometer for 19 commodities, is down 25%. This illustrates the stage of the cycle where last decade’s run in commodity prices is slowing or at least taking a breather. Surely, a near-term recovery in commodities such as gold may entice bargain hunters.

As US markets continued to flirt with new highs and with European markets attracting new capital inflow, there is a trend worth noting. Emerging markets are far removed from all-time highs. In fact, the EEM (Emerging Market Fund) made all-time highs in October 2007. Currently, it is 26% below those levels, suggesting the relative weakness of emerging markets. Plus, EEM showed signs of peaking yet again late this October, as a new wave of weakness persisted. In some ways, the link between emerging markets and commodities tells us a similar story where growth has slowed. Weakness is felt among BRIC nations. Of course, some frontier markets have witnessed more quality performance than the traditional emerging markets. Nonetheless, this year has convincingly showed investors that all markets do not rise collectively, and any fruitful runs must come to an end. Interestingly, weakness in commodities and emerging markets ended up boosting already elevated US equities. Thus, clues from actual performance provide valuable signals.

Article quotes:

“As much as $US50 billion of proposed coal mine developments in Australia could be at risk due to changes in China’s anticipated demand, with these assets likely to become ‘stranded’ if they proceed. The study, by Oxford University and the Smith School of Enterprise and the Environment, found that China now accounts for around one fifth of Australia’s coal exports, up from less than 5 per cent a few years ago. And since China now absorbs half of global coal production, with a domestic market which is three times the size of the international coal trade, China has increasingly become the price setter in the Asian coal market. Pressure to improve air quality and to cut carbon emissions – China has begun to move to place a price on carbon – and switching to gas away from using coal, are also factors that are ‘all likely to reduce China’s growth in coal imports below levels currently expected,’ the study warned. … Not only would sub-par returns on these projects hurt their developers and financiers, but would also hit the developers of the required infrastructure needed to get the coal from the mine to port.” (The Sydney Morning Herald, December 16, 2013)

“How can the legacy of high debt-to-GDP ratios be addressed in a less damaging way (Crafts 2013 )? As the interwar experience underlines, a key starting point is for the ECB to ensure there is no price deflation in the Eurozone. Then, the alternatives to fiscal consolidation as a means of reducing public debt ratios are well known, namely, financial repression, debt forgiveness, or debt restructuring/default. Financial repression works on the interest rate/growth rate differential by way of the government being able to borrow at ‘below-market’ rates. Current EU rules severely limit the scope for this. History suggests that a combination of financial regulations designed for the purpose, the re-introduction of capital controls, and a central bank willing to subvert monetary policy in the interests of debt management might be required. Debt forgiveness would be very expensive for the creditors – forgiving a quarter of the debts of Greece, Ireland, Portugal, Italy, and Spain would cost about €1,200 billion – and, in the absence of watertight fiscal rules to prevent a repeat, risks a serious moral hazard problem. Paris and Wyplosz (2013) suggest that forgiveness could, however, play a part if the ECB were to buy up government debt in exchange for perpetual interest-free loans – in effect monetising part of the debt.” (VOX, Nicholas Crafts, December 13, 2013).

Levels: (Prices as of close December 13, 2013)

S&P 500 Index [1775.32] – Down nearly 2% for the week – a slight retracement after making new highs for several weeks. The next test is around 1760, where buyers have previously shown interest. Interestingly, that’s a point away from the 50-day moving average (1761.54).

Crude (Spot) [$96.60] – Technical/chart observers are noticing mild selling pressure developing around $98, where buyers are not quite convinced. The supply-demand dynamics continue to suggest further downside, which matches the trend since early autumn.

Gold [$1225.25] – Remains in its annual downturn. Barely above annual lows of $1217.50 reached on December 4, 2013. Trading at a key level where bargain hunters may take a risk here, yet the intermediate-term momentum is not sending a positive view.

DXY – US Dollar Index [80.68] – Since November 8, the dollar index has failed to make new highs. There have been minor signs of a weakening dollar over the last few weeks. Recent moves are not quite volatile or massive, so further clarity is needed.

US 10 Year Treasury Yields [2.86%] – In a slow and steady move since late October, yields are moving higher. Above 2.80%, as the next level stands at 3%.



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