Market Outlook | March 24, 2014

“Political chaos is connected with the decay of language ... one can probably bring about some improvement by starting at the verbal end.” (George Orwell, 1903-1950)

Convergence

Plenty has been mentioned about the varying path between the real economy and financial markets. Perhaps, markets are debating corporate earnings trends versus the health of an economy from the ground level. Too often, misleading messaging is heard when talking about stock indexes and other wellbeing barometers measuring labor or wage growth. Equally, the health and sustainability of large corporations in developed market versus mid-sized to small business in all markets has a unique, not-so-clear path as well.

At the same time, the mid-sized to small business concerns are intertwined with the level of consumer spending, regulatory changes and policy-driven variables affecting overall confidence. Surely, this is a junction where financial markets and economies would be expected to come to an agreement and narrow some of the disconnect that’s persisted for a long while. For now, the recovering/sluggish economy and the roaring stock market tell one story. Surely, low interest rates have benefited larger corporate earnings and have been less influential in other areas. Yet, consumer spending and confidence is felt enough by large and smaller companies; therefore, how it impacts businesses might provide a better perspective. A convergence between larger firms and the real economy can demonstrate the real status of growth a few years after the last crisis. Maybe this can unlock the mystery, apart from financial tricks and a game of exceeding expectations.

Fragility

Meanwhile, financial markets are grappling and anticipating US interest rate hikes, ECB policies toward low rates and a shift in sentiment toward various economies. In recent decades, the collective pursuit of capital united the interests of leaders in emerging and developed markets. Overall, a perceived “peaceful” period in the last two decades has encouraged and emphasized borderless capital and risk allocation. Globalization swept away the mindset, expanded the real economy and synchronized most parts of financial markets. Now, fragility remains visible in these deeply interconnected markets.

“A world in which countries like Russia are doing things like they are in Crimea is one in which capital which ventures abroad is going to be more cautious. More cautious capital requires higher returns to entice it. Russia particularly is going to get hit by this, but there is a good chance it applies generally to emerging markets. Russia’s aggression in Crimea doesn’t just undermine this by itself, it does so through the very timid response it has thus far generated internationally. German interests seem inclined to block sanctions based on energy, while British ones seem wary of anything, such as seizure of the Russian elite’s assets abroad, which might threaten London’s banking franchise.” (IFR, March 23, 2014)

Additionally, last year showcased some EM nations’ failure to sustain growth – Turkey and Brazil being examples of social, political and economic weakness that attack in waves. Equally, China is too vital and interconnected to many economies, and softening data (PMI numbers over the weekend) creates some suspense and more unease. Surely, the Chinese slowdown or perception of a slowdown has big implications, and markets are anxiously watching. The Eurozone solution requires commonality and it presents its own challenges, as documented in the post-2008 crisis. Yet, the overwhelming shift toward developed markets such as US markets illustrates the ongoing search for safety. However, even broad US indexes are becoming more crowded with more questions asked. Justifying future potential with high predictability is challenging corporate leaders, central bankers and asset managers alike.

Next move – contemplation

The multi-year rally results in the S&P 500 index trading near or at all-time high levels, which is now all too familiar – even tiresome on some levels. There is a sense of comfort that a rate hike is not a near-term event and escalating turbulence is not overly feared, either. Thus, participants are virtually re-evaluating similar patterns that were witnessed early in the year, last fall and last summer. What has changed in the dynamics besides time? Perhaps, some growth and high beta sectors like biotech, tech and retail are susceptible to pullbacks as investors evaluate stretched valuations. At the same time, banks did well after the Fed’s comments on rate outlook. In addition, banks overwhelmingly met the capital hurdle requirements set by the Fed. Although positive and negative stories persist, overall corporate earning concerns may soon be reflected more in day-to-day market movements. Plus, geopolitical behaviors are sensitive to western corporate interests. For now, the general assumption is that matters are contained. If not, a true test waits for the conviction level of risk takers.

Amazingly, the concerns over Fed policy or Ukrainian implications continue to showcase that fear is short-lived. Thus, long-term holders who accept the risk may not be overly compelled to trim or exit exposure to US equities. Bargain hunters who looked into Europe last year might handpick select emerging and frontier market opportunities. However, the list of shrugged-off issues is accumulating, especially in developing markets. In some ways, it is daring to ride the current wave as much as betting against it.

Article Quotes:

“Some of the developing world’s larger countries, flush with capital after being recognized by investors as ‘emerging-market economies’ (EMEs), have been pursuing policies with little regard for the lessons of the financial crises of 1997-1998 and 2008-2009. As a result, countries like India, Brazil, South Africa, and Indonesia have been hit by the US Federal Reserve’s gradual exit from so-called quantitative easing (QE) – not just capital-flow reversals, but also a sharp decline in domestic asset prices. Various developments last year raised expectations that the Fed would begin to taper its $85 billion-per-month open-ended bond-buying program sooner rather than later. This drove up US government-bond yields, and reduced the appeal of higher-yielding EME currencies. As a result, several EME currencies, from the Indian rupee to the Turkish lira, declined sharply. Moreover, some EMEs have experienced financial-market disruptions and slowing economic growth. Such developments often lead to perverse economic behavior, as rumors and pessimistic predictions become self-fulfilling. Typically, after international investors ‘discover’ an EME, it receives massive – but easily reversible – capital inflows. The influx of cash fuels domestic asset-price bubbles and booms in related sectors of the real economy, pushing up the real exchange rate and, in turn, weakening incentives for domestic producers. This drives investors to put even more of their money in non-tradable sectors, such as construction and real estate. The growing current-account deficit is largely ignored, as long as capital inflows continue to cover it and economic growth remains strong. Short-lived market rallies make matters worse, frequently inducing further unfounded exuberance. And when officials recognize the problem, hurriedly announced policy measures, such as capital controls, are usually too little too late, and can have adverse effects in the short term.” (Project Syndicate, March 14, 2014)

“U.S. population growth had been around 1.20% per year post-1980, though it has slowed to a current level closer to 0.70% more recently, as the Baby Boomer generation passes on and both immigration and birth rates slow. If high debt levels in the U.S. are associated with 1% less GDP growth, perhaps half of this 1% drop in economic growth rates will coincide with the 0.5% drop in population growth rates. The drop in population growth could exacerbate the decline in GDP growth unless productivity fills the gap. As we noted in a related series, productivity growth rates are also falling with population growth rates, which is a very disturbing trend. On the other hand, perhaps Rogoff and Reinhart data surrounding high debt or low growth account for an associated decline in population growth. The challenge is that if investment is crowded out due to excess consumption and government spending or taxation in a high debt environment, investment-related productivity growth could slow—resulting in declining standards of living and consumption. In other words, too much consumption and too much debt could lead to real lower growth rates going forward. A shrinking labor pool equipped with greater productivity can mitigate some of these negative effects of excess consumption and high levels of debt. However, if current levels of consumption are crowding out investment in productivity growth, the U.S. economy could be facing a lower growth rate in a slower growing labor pool that has an even lower rate of productivity growth. That means slower GDP growth rates going forward, as well as declining purchasing power for the U.S. consumer. (Market Realist, March 20, 2014)





Levels: (Prices as of close March 21, 2014)

S&P 500 Index [1866.52] – Recent move above 1840 marked a new upside territory for this bullish run. Similarly, the 50-day moving average is 1832 and will be watched closely.

Crude (Spot) [$99.46] – As witnessed in the past few weeks, prices are attempting to hold above $98, while signs of a pause are visible. The 200-day moving average is around $100, which is a hurdle commonly mentioned and tracked.

Gold [$1327.00] – Signs of retracement after reaching a peak of $1385.00 (March 17, 2014). A move below $1300 can trigger further responses of slowing momentum. Long-term buyers are still exploring a recovery at this pricing range.

DXY – US Dollar Index [80.10] – Early pause to the recent downside move that has persisted since late January 2014. A turnaround for a strengthening dollar is expected in the near-term and closely linked with reactions regarding interest rate policies.

US 10 Year Treasury Yields [2.74%] –On three occasions this year, the market has signaled that the 2.56-2.60% range is a sort of a bottom. Perhaps, this is a hint that’s developing, as the retest to 3% is the next landmark move.








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