Market Outlook | January 13, 2014

“Magic becomes art when it has nothing to hide.” (Ben Okri, 1959-present)

Art or magic?

The Federal Reserve is credited with having engineered an appreciating stock market while cooling volatility and reviving investor optimism. Certainly, based on the last few years, there is some truth to actual index return numbers. Asset appreciation and improving fundamentals are not quite highly correlated. It is a tenuous relationship that requires daily examination. Plenty of questions about the real economy are being asked, and frankly, markets are deciphering answers to driving forces for global growth. What’s the end goal for central banks to inflate assets, revive confidence or claim to have (or not to have) magical powers? And does investor confidence translate to a vibrant economy? Are these disconnects simply noise or distraction, or artistic presentation for mainstream followers?

Surely, being an investor in up-and-down markets (specifically stock) is one matter. Tracking the social trends of economic activity is another, but the thrill of risk-taking is a powerful force. Thus, analysts are consumed with “taper” discussions, which at times seem like a magic-like trickery or artful messaging. Either way, there is no one magical catalyst, and clues have been mounting for those curious enough to look beyond this status-quo-driven explosive rally.

Interconnected

The low interest rate period by developed markets fueled the stock market indexes and has also been credited with appreciating the currencies of emerging markets in recent years. Clearly, low-yield policies force US investors to seek higher yields in riskier assets, both domestically and abroad. The stimulus efforts were beneficial in lifting EM currencies, and recent expectations of changing policies and slowing global demand (especially in China) led to the near-term demise of emerging market currencies. Basically, further taper announcements and an appreciating US dollar are suspected to have a negative impact on EM currencies. Therefore, the interconnectedness of markets is on full display, where the US economy and currency play a major role for investors of all kinds. While emerging markets remain relatively small:

“The role of EM currencies as an internationally traded asset class is still remarkably limited compared with the increasing weight of their base economies in the global economic mix; of the $5 trillion or so daily FX volume reported in the Bank for International Settlements’ 2013 triennial survey the top-three EM currencies totalled less than 7%, with the Mexican peso at 2.5% (compared with 1.3% in 2010), the Chinese renminbi at 2.2% (0.9% in 2010), and the Russian rouble at 1.6% (0.9% in 2010).” (EuroMoney, January 9, 2014).



Unease accumulating

Several uncertainties have lingered for a long while amidst the current upbeat market – a reminder for those sidetracked in recent established trends. Certainly, economic strength has been up for debate beyond the headline results. Last month’s labor numbers were slightly puzzling and somewhat concerning if not a seasonal matter. Secondly, the taper announcement did not shock the market last time. The outgoing Fed chairman should typically create some unease, but the pending policies are not fully clear. However, a general belief circulates that the transition is going to be smooth, without disruption to financial markets.

In the near-term, watching treasury yields is essential as bond investors debate the strength of the economy and potential upside GDP potential. There is lots of chatter in this area. Thirdly, oil prices continue to decline and growth demands are slowing, as well. Thus, major macro shifts continue to brew with volatility being so low and compliancy running high. Finally, the inflation feared in prior years has not been visible recently, but it’s unclear if deflation is the near-term concern. A series of surprises in the inflation or deflation debate adds to the ongoing list of unknowns, where experts are merely speculating. Putting together all these pending catalysts, one is well served to grasp the nuances of each before doubling down on tempting risky assets. Interestingly, pension funds began reducing risk from stocks into bonds:

“U.S. pensions, which control $16 trillion, shifted out of equities and into bonds in the third quarter [2013] at the fastest rate since 2008, latest data compiled by the Federal Reserve show. The plans were more willing to own stocks after the Fed dropped interest rates close to zero and pushed down yields to record lows with its bond buying to support the U.S. economy crippled by the financial crisis.” (Bloomberg, January 12, 2014).

“Surprises”

Thus, the risk-reward of past returns is known and remains influential in shaping collective minds, but the months ahead are set to surprise. Perhaps, risk takers who are open for surprises might find what’s ahead suspenseful and thrilling in some ways. As an example, 2013 witnessed a not-so-intuitive result in a sector that many thought were near dead. “In a booming year for the stock market, newspaper stocks actually more than doubled the return of the S&P 500 in 2013. Newspaper stocks rose by 79% in a year when the S&P 500 rose by just under 30%, a whopping performance few would have predicted.” (StreetFight, January 7, 2014). Maybe this is a reminder to throw out the consensus expectations when thinking about the events ahead. Betting on surprise is a risk just as much betting on what is supposedly “known.”

Article quotes:

“Prior to the crisis, inflation rates in the periphery were well above 2 percent, while the German inflation rate was below 2 percent. The EU experience in this respect was different from the US experience. Easy monetary conditions with negative real interest rates generated bubble-driven growth in the periphery and pretty high peripheral inflation rates. As part of the ongoing adjustment process, inflation rates had to fall in order to regain competitiveness relative to the euro-area core. But in this process, the ECB failed to achieve its mandate, the stabilisation of euro-area inflation at close but below 2 percent. Some in Germany fear that higher German inflation would devalue German savings. But in a monetary union, the value of money is defined at the union level. The ECB should therefore act to fulfill its mandate and restore inflation to close to 2 percent, accepting higher inflation rates in Germany. But will the ECB action be enough to prevent further disinflation in the euro area? Will it be enough to generate enough demand to end the recessionary tendency, which is still plaguing the euro area? The ECB’s current rate reduction will mostly support the banks in the euro-area periphery while relatively little new lending will reach corporations and households. In the core of the euro area, the rate cut will basically go unnoticed.” (Bruegel, January 10, 2014)

“The 2011 Anholt-Gfk Roper Nations Brands Index, which annually measures the image of 50 nations, ranked China an impressive third for its ‘culture/heritage’ brand. Countries with long histories and rich cultural resources tend to do well in terms of this branding attribute, with France and Italy perennially topping the rankings. China’s cultural pull is nowhere more evident than in its meteoric rise as an international tourist destination....In relation to other attributes, however, Brand China’s performance is largely disappointing. Of the 50 countries listed in the Reputation Institute’s 2012 global RepTrak overall rankings, which surveys respondents in G8 countries, China ranked 43rd, below Egypt (39th) and Ukraine (42nd) and just above Colombia (44th) and Nigeria (47th), placing China in the bottom 15 percent. The 2012 FutureBrand country brand index, which surveys opinion leaders in 18 countries, ranked China well back in the field at 66th out of 110. The Anholt-Gfk Roper Nations Brands Index lists China’s poorest performing brand attribute as ‘governance,’ followed by ‘exports.’ One may find any one of the nation brand ranking methodologies to be unconvincing or unrepresentative given that many tend to draw respondents from the world’s richer countries. Yet each tells a similar story: brand China’s major strength is culture, and its major weakness is in governance and the political sphere.” (The Diplomat, January 11, 2014)

Levels: (Prices as of close January 10, 2014)

S&P 500 Index [1842.37] – A few points away from December 31, 2013 highs of 1849.44. The positive trend is in place until a break below $1800 (50-day moving average); not much of a major discussion regarding pullbacks.

Crude (Spot) [$92.72] – The last time crude reached around or below $92 was in late November 2013 ($91.77). Meanwhile, last year’s lows of $85.61 stand out as the next critical level. The combination of slowing Chinese demand and expanding US supply continues to play out in the oil market.

Gold [$1226.00] – Slight signs of a recovery, as bottoming is taking place at $1200. Elevating above $1300 may entice new buying, but the vast majority of participants have decided to bail out of gold holdings.

DXY – US Dollar Index [80.65]– Remains in the steady range bound between March 2012 lows (78.09) and July 2013 highs (84.75). This level of calmness mirrors the low volatility that’s resurfaced.

US 10 Year Treasury Yields [2.85%] – There was a short-lived move above 3% earlier this year, and now a pullback to familiar territory of being above 2.50%.



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