Market Outlook | September 2, 2014

“The person who in shaky times also wavers only increases the evil, but the person of firm decision fashions the universe.”(Johann Wolfgang von Goethe 1749-1832)

Themes Rehashed

As August draws to a close, the month's theme only rehashed the unanimously accepted bull market that roared yet again. Of course, the dynamics of extended period low interest rates, low volatility and low regard for fear are brightly reflected in key indexes. Surely, the few sirens of danger have come and gone. Short-lived worries in financial markets were briefly attributed to rate hikes. As usual, the desperate yield-chasing remains an addictive habit fueled with assurance from the Fed. The central bank continues to marshal market movement and the prevailing perception of asset prices. Central banks resume the quest to justify stimulus efforts while pragmatic observers are more and more skeptical of actual growth particularly in Europe.

Meanwhile, the late summer days are known for low volume. There is a danger to making a lot of some minor moves witnessed in last two weeks. Nevertheless, there are certain victories that the bulls will point to because of record highs and the lack in selling pressures. Geopolitical events of a long-term nature, such as Ukraine tensions to fragile European economies, failed to rattle markets for now. Silently, the rising dollar and weak commodity prices are noteworthy hints that have not been fully understood by investors. That said, another month passes where risk-takers were unscathed as general sentiment turns into hubris in some circles.

Occasional Memories

Seven years ago this week, it was the quiet before the storm in Autumn of 2007— ahead of the 2008 crisis. Memories of those late bull market days linger for this generation. Back then, broad indexes flirted with all-time highs, then eventually topped in October 2007. Historic indeed. Surely, inerasable from modern memory. However, the comparison to today’s set-up might be overused as history rarely repeats in the same fashion. Yet, we know historical patterns do repeat, and there are plenty of reasons to ponder regarding a long-awaited market scare. Many sought downside protection, and others have expected a correction for several months. Thus, the test of conviction is setting up ahead (yet again) this autumn where talks of Fed policy change, mid-term elections and the questionable health of the global economy can suddenly shift the comfortable ride. One-sided markets are glorified and occasionally simplified when unwavering patterns (i.e stocks, volatility) become the norm quarter after quarter. This type of market behavior was seen from 2002-2007, therefore reflecting on the past is to be expected. As for looking ahead, fighting complacency while not overreacting to fear is the balance that can be very rewarding and key to survival for money managers.

Beyond Traditional Sentiment

Foreign policy (FP) concerns have mounted to new levels, but how exactly is that related to day-to-day market behavior? Perhaps, it is a puzzle that maybe rewarding for those willing to decipher. If S&P 500 company buybacks reduce the supply of shares and the markets go up, then that’s simply a function of the supply and demand of shares. Less to do with FP but more to do with market mechanics.

In other words, market intricacies drive movements more than any actual "danger" that may materialize. At least it seems so in recent market actions. Similarly when interest rates are low, risk taking is encouraged due to relative reasons rather than the absolute health of economies. Sure headlines do not translate into an instant panic or real-time shakiness as some would initially suspect. If a terror/extremist danger surfaces in Middle Eastern countries (and beyond) then how is one calculating the damages on global trade and global indexes? Is one able to? Is the impact even meaningful? If sanctions in Russia expand, how is the potential danger to the Eurozone translated into share price damage? Not to mention an escalating war in various regions is part of the consideration, as well. Surely, these are unanswered questions and markets have not fully bothered to contemplate the outcomes, unlike FP experts who passionately debate potential consequences. Plenty of day-to-day headlines can serve as an excuse for "selling" equities at this point, but other traditional financial/economic factors are sounding the alarm for those willing to listen.

1) Eurozone weakness persists:

a. Fragile conditions across key European economies

"Germany is teetering on the edge of recession. France is mired in stagnation. Italy’s GDP is barely above its level when the single currency came in 15 years ago. Since these three countries account for two-thirds of euro-zone GDP, growth in places like Spain and the Netherlands cannot make up for their torpor." (The Economist, August 30, 2014).

b. Russian sanctions by EU persists further doubts to interconnected economies

"Russia’s ban on imports of western food could cost the European Union an annual 6.7 billion euros ($9 billion) in lost production, according to ING Groep NV." (Bloomberg, August 20, 2014)

2) Despite rising shares of Emerging Market indexes this year, growth is visibly slowing:

a. Brazil faces technical recession after months of weakness

"Gross domestic product shrank by 0.6 percent in the April-June period from the previous three months, after contracting a revised 0.2 percent in the first quarter." (Bloomberg, August 29, 2014).

b. Chinese economy has slowed down for a while and evidence has grown recently

"The drop in the official [Chinese] PMI in August was broad-based, with the biggest falls in output and new orders. New export orders also fell but by a smaller margin, indicating that manufacturing weakness last month was primarily the result of lackluster domestic demand." (Financial Times, September 1, 2014)

3) Crude oil demand is down along with other commodities reiterating less global growth:

“The IEA[International Energy Agency] cut estimates for oil demand growth this year and next after the annual expansion in fuel consumption slowed to 700,000 barrels a day in the second quarter, the lowest level since early 2012… While demand growth will rebound next year, the pace will be 90,000 barrels a day slower than previously expected because of lower estimates for China and Russia.” (Bloomberg, August 12, 2014).

Big Picture Perspective

These are three macro factors that point to less stable growth conditions when compared to the last decade. Also, the three catalysts are worth tracking weekly between now and year end. Potentially these factors may impact corporate profits and sentiment alike. Despite fear being out of fashion this is the time to reexamine. At least any damage to perception can stir an unknown response. A smooth-sailing market has plenty to justify, what’s the next upside hurdle if it is already at all-time highs? Fed appears to be in the late innings of the stimulus plan. The same can be said about the buyback phenomenon. Thus, a trend shift is not wishful thinking or a fear mongering tactic (many got it wrong before); rather, it is more tangible than in 2013 or 2012. Even the most optimistic bulls must wonder what is the next upside target when all bullish dreams have been fulfilled.


Article Quotes:

"The European Central Bank has talked up the chances of launching a bond-buying programme to ward off deflation and having led markets down that path there could be a serious adverse reaction if it does not follow through. ECB President Mario Draghi pledged on Aug. 7 to use all necessary means to avoid deflation, including ‘quantitative easing’ if necessary. He upped the ante at a U.S. Federal Reserve symposium in Jackson Hole on Aug. 22 by insisting ‘all the available instruments’ would be used to preserve stability. Markets needed no more invitation to start pricing in QE, no matter how difficult it remains for other ECB policymakers to swallow. Long-term borrowing rates for euro zone governments from Germany to the ‘periphery’ in Spain tumbled to new record lows and the euro currency shed almost 2 percent against the dollar. Ten-year German bond yields shed 26 basis points in August, the biggest monthly fall since January, and 30-year yields lost 31 bp, the biggest loss since May 2012. Equivalent Spanish yields dropped half a percentage point. If the ECB does not meet market expectations, government bond yields could spike in countries like Italy, which is already back in recession, and fellow high-debtor Spain. Deutsche Bank estimates bond investors have now factored in a 50-70 percent probability of some ‘QE-infinity type’ programme from the ECB." (Reuters, September 1, 2014).


“EM’s ‘fragile five’ back under pressure: The two moons that govern the fortunes of emerging market investors are starting to wane in unison. China’s investment spending – the lodestar for EM commodity exporters – is slowing and the US Federal Reserve is sounding more hawkish toward unwinding monetary stimulus. The last time such a lunar aspect held sway – in early 2014 – EM market mayhem ensued. Hit particularly hard were the currencies, equities and bonds of the so-called ‘fragile five’ countries – Brazil, South Africa, Indonesia, India and Turkey. But is history set to repeat itself this time around? ‘Growth in emerging markets has been driven by Chinese demand and easy global liquidity, but both of these are now under pressure,’ says Maarten-Jan Bakkum, strategist, emerging markets equity at ING Investment Management.’ Generally, EM equity is probably less vulnerable than EM debt . . . because EM hard currency debt markets have been pushed up more by liquidity (under the easy money conditions supported by the US Fed),’ Mr Bakkum adds. His concerns are underlined by Institute of International Finance (IIF) statistics published this week showing that estimated portfolio inflows to EM assets fell sharply in August to $9bn, down from a monthly average of $38bn between May and July.” (Financial Times, August 28, 2014).

Levels: (Prices as of close August 29, 2014)

S&P 500 Index [2,003.37] – From August 7th lows to Augusts 26th highs, the index gained over 5%, highlighting an explosive month while surpassing the 2000 mark. Given all these bull mark achievements, expectations are set even higher as the room for disappointment increases as well.

Crude (Spot) [$95.96] – After a very steep sell-off, there are mild signs of bottoming. August 21st lows of $92.50 suggest that the selling pressure is on pause. The $200 day moving average is nearly at $100 ($99.77); observers wait to see if a sustainable bounce is in play.

Gold [$1,292.00] – Stuck in the $1,300 range for a while. Has settled at a neutral place and is lacking momentum on either direction. In the near-term reaching above $1,320 can trigger additional questions, otherwise it is range bound.

DXY – US Dollar Index [82.74] – Since early May, a convincing upside moves with very limited interruption. One of the more notable summer trends as the Euro is expected to weaken.

US 10 Year Treasury Yields [2.36%] – Potential bottoming around 2.35% based on last week’s action. Further evidence is needed to confirm that there is a change in rate directions.