Market Outlook | February 17, 2014

“Better be wise by the misfortunes of others than by your own.” Aesop (620 BC - 560 BC)


Demise turned bargain

In some ways, value seekers are fascinated by the bargains available in commodities and emerging markets (EM) early this year, after both themes underperformed last year. Certainly, these were two areas that were disliked and let many investors down in 2013. Recent signs of revival are not overly surprising, given that investors are known to naturally revisit neglected ideas, especially when there are signs of being cheap. In addition, investors who made good fortune in these areas in the past decade share a nostalgic feeling and play into the investor’s mindset, as well. In other words, commodity and EM bulls have promoted the fundamental case for years (and were backed by the surging prices), and now it is only a matter of participants observing that prices are relatively low. Surely, the fundamentals will not improve overnight, and crisis mode has not been cleansed. Thus, it’s fair to say the risk-reward remains colorful, from gold to BRIC nations. The risk of being a short-lived rally is a matter to consider as the rush for risk-taking continues to persist.

From the contrarian point of view, entering now seems attractive; however, the driving force behind recent resurgence is mostly about bargain hunting and a lack of investable ideas rather than the absolute attractiveness of emerging markets and commodities. Not to mention that, with US equities flirting with all-time highs, there is skepticism and a search for new rotational ideas, as well. Interestingly, it’s critical that money managers of all kinds are looking to reengineer their capital allocation process. Of course, the argument of cheapness alone is not enough and has been heard before in prior months – even in late 2013. Certainly, price drives the early wave of buyers, and whether this momentum is short lived, perception driven or legitimate remains to be seen. After all, it is a game of relative attractiveness, and January 2014 already demonstrated that these markets are wobbly; thus, the second-best option is to buy cheaply. It is not only gold and crude that are attracting investor interest; soft commodities are displaying similar patterns:

“The net-long position in arabica coffee surged 97 percent to 15,728 contracts, the highest since September 2011. Futures in New York gained 29 percent this year, the most among the 24 commodities tracked by the GSCI. In Brazil, the top producer of coffee, sugar and oranges, the driest January since 1954 drained dams and seared plants. Investors held a net-long wager in corn of 34,340 contracts. That’s the first bullish position since June and compares with a net-short of 5,314 a week earlier.” (Bloomberg, February 16, 2014).

Hints and confusions

Increased volatility was a short-term threat that came and went. After a turbulent January, a sudden reversal to a sense of normalcy has taken place. From December 26, 2013 to February 3, 2014, the volatility index rose from 11.69 to 21.48. This marked a sudden rise in expected turbulence, with ongoing concerns of emerging market currency woes. However, since the peak on February 3, 2014 (21.48), the turbulence indicator for US markets has retreated to 13.57 – a sudden drop in volatility. This brought on a sense of calm and a collective signal that market concerns are subsiding at a rapid pace. At least, that’s the hint. Similarly, the US 10 year Treasury yields peaked at 3.05% the first day of trading in January this year. Then, with ongoing turbulence and concerns about US economic growth, the shift toward safe assets drove yields below 2.60% at the start of February. Now, signs of recovery in yields are visibly matched with a decline in volatility, which continues to support a rise in stocks, as witnessed for months. It is important to state that volatility has really declined since 2008; therefore, calm seems too normal, especially in the last 3-5 years.

Amazingly, the S&P 500 index is just a few points away (less than 1%) from recouping the losses from mid-January and making record highs. The up-and-down session witnessed recently may persist in coming weeks. However, this post-2008 recovery is marching on with strength, despite changes in Fed leadership, mild currency turbulence and a never-ending appetite for equities over most assets. Now the question is, if the S&P 500 and US broad indexes are set to make new highs, what happens to the buying appetite? Is there more demand for equities? Did the volatility fears vanish quickly yet again? In a matter of 30 days, how could fortunes turn from massive nervousness to promising? Has the market settled on the acceptable theme? Is there rotation from US markets to emerging or European markets? These are all intriguing questions that desperately require answers in the weeks ahead.

The growth mystery

Clearly, there are prolonged moments of disconnect between forward-looking stocks and actual economic data – hence, the long mystery that tricks/challenges speculators and simple observers who dismiss the paradoxes and complex nature of markets. The strength of the economy is marketed by some (conveniently to make a point) and questioned by others, but the financial market responses showcase a mixed reaction. Certainly, panic is not at the forefront of deliberations.

With that being said, much attention has been dedicated to the Federal Reserve’s plans and diagnosis of current economic strength. For a while, the narrative shifted to improving economic growth and justified taper plans. That’s still the case for now. The economic strength is not clear-cut enough to make a unanimous statement. Corporate earnings in some instances showcase the pain from the emerging market slowdown, which is being felt in companies’ earnings. Plus, elevated expectations are set to disappoint at some point. GDP numbers in Japan turned out below expectations, the Eurozone is not overly convincing despite fourth-quarter growth, BRIC nations are not overly impressive and the US economy is talked up, but positive momentum needs more follow-through.




Article Quotes:

“The risk of the euro zone sliding into an economically and financially damaging spiral of deflation similar to Japan's 20-year experience from the mid-1990s is rising, according to a growing number of leading economists. This counters the prevailing consensus among policymakers, who insist there is no threat of deflation, and financial markets, which are not pricing in or positioning for such an eventuality. In its widely read annual ‘Equity Gilt Study’, Barclays drew parallels between Japan and the euro zone, concluding that the risks of a prolonged period of falling prices in the 18-nation bloc was significant. Economists at JP Morgan are more sanguine, but they wrote in a research note on Thursday that given Japan's experience, ‘no one should be surprised if it happens’. Inflation across the euro zone is falling fast, and was last measured at an annual rate of just 0.7 percent, well below the European Central Bank's target of ‘below, but close to’ 2 percent, the lowest in the developed world, and down from 3 percent barely two years ago. Deflation tempts consumers to postpone spending and businesses to delay investment because they expect prices to be lower in the future. This slows growth and puts upward pressure on unemployment. It also increases the real debt burden of debtors, from consumers to companies to governments. … The euro zone is at the very early stages of its fight to ward off deflation, while Japan took 20 years to defeat it. Consumer prices in Japan are now rising twice as fast as those in the euro zone.” (Reuters, February 13, 2014)

“Ever since the Communist Party came to power, high employment has been a priority for China’s leaders. Hu Jintao, China’s previous president, famously confided to his U.S. counterpart George W. Bush that employment was the issue, above any other, that kept him awake at night. More recently Li Keqiang, China’s premier, stated ‘Employment is the biggest thing for well-being. For us, stable growth is mainly for the sake of maintaining employment.’ In the days of the planned economy, achieving full employment was relatively easy. Rural workers were collectivized on state-managed farms and urban workers were assigned to city work units. Following reform and opening up, China’s leaders maintained high employment through annual double-digit GDP growth that became an engine for massive job creation. Such was the effectiveness of this jobs engine that in the late 1990s, when China restructured its vast network of state-owned enterprises (SOEs), making tens of millions of workers redundant, the labor market only briefly flinched before the booming economic quickly picked up the slack. However, the economic restructuring the current generation of leaders is embarking on is unlikely to offer the same luxury. There are several important reasons for this. First, the reforms will result in a prolonged period of much slower growth. Speaking last year, Chinese President Xi Jinping said, ‘China must undergo structural reforms even though it will sacrifice faster growth.’ Growth is already half the rate achieved at the height of the mid-2000s boom, with further moderations expected as the adjustment cost of reform becomes increasingly evident.” (The Diplomat, February 12, 2014)



Levels: (Prices as of close February 14, 2014)

S&P 500 Index [1838.63] – A more than 2% gain last week, propelling the index to revisit prior all-time highs. Momentum is positive, but this short-term rally needs confirmation to ensure a new wave of buying momentum.

Crude (Spot) [$100.30] – In an impressive manner, after reaching the $91 range in early January, the index has made a ferocious rally back to the commonly noted $100 range. Psychologically, this range triggers reactions, given the key psychological level. However, surpassing this $100 range proved to be difficult in late December.

Gold [$1318.60] – Signs of bottoming being confirmed. In looking ahead, $1360 can be a bigger hurdle to restore the gold bugs’ growing optimism of a further surge in prices.

DXY – US Dollar Index [80.13] – Since January 31, 2014, the index has declined mildly back to its multi-year average. It remains between September 2012 lows of $78.60 and July 2013 highs of $84.75.

US 10 Year Treasury Yields [2.74%] – Early signs that yields have bottomed after declining from 3% to 2.56% within a month. However, the 50-day moving average stands at 2.83%, a hurdle that’s closely watched.






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