Market Outlook | December 29, 2014

“I am not afraid of tomorrow, for I have seen yesterday and I love today.” (William Allen White 1868-1944)

Many predictions for next year have been made in the recent past. The season for reflection is in full gear as forecasts continue to be made publicly by many experts. The following quote comes to mind when reading predictions in general, “When in doubt, predict that the present trend will continue” (Merkins Maxim). Interestingly, betting on the status-quo, as in going with the consensus (i.e Fed’s script), has proven to be a winner at least in this roaring bull market. Perhaps, this showcases that doubts are always there and sometimes too complex to deal with until an ultimate all-out crisis. Amazingly, doubts only matter when general perception turns sour; otherwise, it can be like a background noise that lacks attention. So doubts are plenty, but knowing when and how they'll impact the markets is the mystery and “the gamble” that keeps observers intrigued.

In looking ahead, the much talked about QE/Fed/interest rates, Russia’s fate and stock market valuations dominate financial discussions and annual predictions. However, beyond the usual headlines, having a road-map of interconnected themes might shed some light into the suspenseful year ahead. Here are few themes and trends to ponder.

Seven Themes for 2015:

1. Status of Emerging Market Currencies

The dollar strength is a profound theme in 2014. It also reflects the weakness in emerging market currencies’, while mildly hinting at the growing geopolitical risk. The “troubled” world has yet again resoundingly chosen the dollar as the preferred currency. The dollar remains the dominant currency despite the noise from goldbugs (a.k.a Gold aficionados) and a minor digital currency hype (i.e. Bitcoin) that came and went.

Interestingly, the dollar strength emerged way before the massive oil price collapse. Certainly the collapse of commodity prices has affected the economies of commodity-dependent nations. Both oil-rich nations and economies that heavily depend on natural resources have witnesses decline in their currencies. Recent examples include, the Brazilian Real, Indonesia’s Rupiah and the South African Rand—all demonstrating weakness versus the Dollar.

Bargain hunters seeking notable surprises may want to believe: 1) China’s economy turns out better than expected 2) Eurozone avoids another crisis 3) further commodity price decline is less likely. That’s the wishful list for the more daring risk-takers. Yet, the historical data for the last two years suggest deterioration of commodities and lackluster global growth as more of a reality than just a worry. If this continues, then a further mess in geopolitical conditions and rotation to the dollar is hardly surprising. If there is a massive turnaround in EM and Commodities growth, it will inevitably lead to stability in EM FX (a very big “if” of course). Surely, the optimists here might be dancing with the highest risk-reward trade for 2015 in terms of surprises. That said, the EM FX behavior and trends will serve as a vital barometer for global markets, as well as the Dollars’ ongoing momentum.

2. Tangible Revelation About China's Economic Weakness

Is the slowdown in Chinese growth real? Worse than imagined results pose some knee-jerk reactions. This could potentially impact global Western corporations. China serves as a symbol of the emerging world and the leader of the new frontier. China has become the lifeline of global trade in a period of inter-connected economies. For many years, pundits have written about the bubble-like traits from housing to shadow-banking to manufacturing. Some data points have merits as growth appears to cool down, even if finding trustworthy data remains a challenge.

“Chinese industrial profits dropped 4.2 percent in November to 676.12 billion yuan ($108.85 billion), official data showed on Saturday, the biggest annual decline since August 2012 as the economy hit major unexpected headwinds in the second half.” (Reuters, December 27, 2014).

Meanwhile, foreign policy strategists remind us the important role of China as a nation in the chess game for leadership. Here is one example:

“Beijing's move to bail out Russia, on top of its recent aid for Venezuela and Argentina, signals the death of the post-war Bretton Woods world. It’s also marks the beginning of the end for America's linchpin role in the global economy and Japan's influence in Asia…. Beijing's move to bail out Russia, on top of its recent aid for Venezuela and Argentina, signals the death of the post-war Bretton Woods world. It’s also marks the beginning of the end for America's linchpin role in the global economy and Japan's influence in Asia.” (Bloomberg, December 25, 2014)

With every geopolitical concern (i.e. Russia’s turmoil or the drop in oil prices) there is one persistent and common question: Where does China stand on this? This question illustrates the importance of China on the international stage regardless of day-to-day financial market behaviors. Thus financial speculators debate the direction of a recovery versus prior expectations. At the same time, political strategists look to sort out the rhetoric versus the actions of Chinese leaders as they relate to global policies.

The Chinese –Western relationship is not as rosy as the mid-2000’s. Slowdowns or rifts on an international level can stir mild volatility and impact Western corporate interests (i.e. protectionist policies). Essentially, this is one critical market moving items to follow in China for long and short term investors.

In looking ahead, three key items await regarding China: 1) GDP numbers and economic trends 2) Recovery (or lack of recovery) of demand for commodities and 3) Policies regarding western companies' abilities to conduct profitable businesses. If Chinese domestic concerns mount, then a negative response (result of ripple effects) to Western companies' investments is not quite a far-fetched idea.

3. Commodities Cycle Adjusting to a New Paradigm

Supply-demand adjustments are shaping new realities in commodities, as exhibited in Oil prices this year and Gold prices last year. As mentioned in point 1 and 2 above, the commodity cycle directly impacted (impacts) currencies and key EM economies. Fair to say the 2000-2008 paradigm of booming Emerging Markets and overly optimistic demand expectations for commodities has run its course. A new cycle is here and expectations have been greeted by reality and the markets have loudly responded.

For cycle observers, the commodity cycle bust or adjustment period is in full gear. Amazingly, the CRB index (which includes soft and hard commodities) peaked on July 2008. Since that point, the index has lost over half its value and dropped from 473 to 234. Amazingly, that same July in 2008, is when Crude peaked at $147.27. Of course, that price now looks so much more expensive and simply unimaginable in retrospect. Gold peaked on September 2011 at $1,895 confirming the multi-years cycle slowdown for hard commodities. What’s the point of these trading ranges? This confirms the boom and bust cycle of commodities and surely the “bust” is explosive and it takes time to bottom.

Where 2015 stands in this commodity cycle slowdown is a great unknown. It is safe to assume that stabilization from the selling pressure might be one angle to consider. The most optimistic investor may feel that these distressed or deeply discounted levels present an attractive entry point. Surely, the last six months clearly confirm commodities as the out of favor market. Speculators will take a stab at this versus other areas that are perceived to be overvalued (i.e. US Stocks). Yet, finding justification for rising commodities must be related to changes in the supply-demand perceptions. In addition, unfolding macro events can spark intermediate-term reactions.

4. Non-Market Tensions as an Indicator for Real Economic Weakness

When discussing the Dow surpassing 18,000 and record highs, we often disregard the social outbursts and expressions that may serve as a secondary sentiment indicator for the real economy. From Hong Kong to Brazil to Western countries, protests have been a common theme. Sure, the subjects vary from economic policy in Europe to immigration related issues or civil liberties in the US. So, do lack of wage increases, troubling student loan stats and rising cost of living contribute further to the outbursts? A period where “hope” seems dark for opportunity-seeking middle class and small business owners lends to frustrations being expressed. There is a disconnect between financial market asset appreciation and the well-being of citizens. Buybacks and corporate cost-cutting can elevate share prices, but the post-2008 recovery has mixed emotions.

At some point are protests stirred by frustration of wages and rise in cost of living? If so, then paying attention to this unorthodox market sentiment can help us gauge the real economy. The QE policies and sophisticated Washington tactics can boast about the impressive growth from near-death levels in 2009. However, the Fed’s or financial market script may need to pay attention to the general issues and outbursts. These events could provide a non-traditional indicator that may come handy to measure the pulse from ground level sentiment.

5. The Role of Federal Spending in US GDP

The negative first quarter GDP suddenly saw a boost and that abysmal (weather related) result is long forgotten. The 5% GDP number in the 3rd quarter of 2014 sparked various reactions. On one hand, simple headline readers can quickly celebrate and justify the positive sentiment. On the other hand, these numbers find a way to jump around from quarter to quarter. Defense and healthcare spending by the government attributed to growth in GDP. Notably, the 5% GDP quarter related to an increase in government spending. A 16% increase in defense spending (to combat ISIS) stood out to many analysts in last quarter’s result. The sustainability of this spending remains to be seen. Interestingly, recent policy for defense spending might continue to suggest that GDP growth is heavily reliant on government spending:

“The U.S. Congress approved an annual defense policy bill on Friday [December 12] that authorizes American training for Iraqi and Syrian forces fighting Islamic State rebels and sets overall defense spending at $577 billion, including $64 billion for wars abroad.” (Reuters, December 12, 2014)

The defense spending trend is vital to track, especially to see if it plays an influential role in headline GDP results. Meanwhile, healthcare expenditures remain the main driver of GDP after revision.

“In fact, the U.S. spends two-and-a-half times more than the average of the 34 countries in the Organization for Economic Co-operation and Development. No other country comes close to spending almost 18 percent of gross domestic product (GDP) on health care.” (The Center for Public Integrity, December 22, 2014)

The question remains if this trend leads to a broad based growth by smaller private companies. Surely, the government spending benefits earnings for larger corporations (in defense and healthcare), but it begs the question about the well-being of the real economy. Especially for areas/industries that do not rely on federal spending. The impact of these expenditures into wages and consumption are vital to see beyond political banter. Otherwise, select companies in the S&P 500 index might reap the rewards while the real economy remains stuck in a sluggish form. Surely, that disconnect between real economy and share prices/stocks has been visible. Essentially, the government spending trends will either widen or narrow this highly documented disconnect.

6. Perception of Corporate Cost-Cutting

The health of corporate profits is well documented. Surely, the share buyback trends mixed with cost-cutting have contributed to the elevation of key companies’ share prices. This trend falls under the more established status-quo theme. However, recent developments at Coca-Cola and McDonalds, for example, begin to raise some doubts about sustainability. This headline sheds some light into the developing trends relating to cost-cutting:

“Atlanta-based Coke plans to ax at least 1,000 to 2,000 jobs globally in the coming weeks, the biggest thinning of its ranks in 15 years. It is also introducing stricter budgeting, telling executives to swap limousines for taxis, and dropped its lavish Christmas party for Wall Street analysts.” (Wall Street Journal, December 23, 2014)

Of course, the corporate model of cost-cutting has led to share price appreciations. At what point will investors not accept cost-cutting as a positive long-term strategy? That’s when the stock selling pressure may mount, but for now investors choose to live in the present. As soon as investors stop rewarding companies that are too short-term oriented, then a sentiment shift is very likely.

7. Dissecting Recent Clues in US Volatility

The VIX (Volatility Index) reached 31 on October 15th and it touched 25 on December 16th this year. On both occasions, the short-lived spikes in volatility ended up quickly brushing off concerns and going back to euphoric responses. Ultimately, that led to new stock market highs. In the last 90 days or so, the spikes in volatility beg some questions that may understate brewing concerns. The anxiousness that persisted in October and December 2014 may turn out as an indicator for valuable clues for 2015. There is value in understanding the slight panics that took place.

Turbulence has been mostly absent in this low interest rate climate. The overarching theme of US relative edge has been clear and proven by market behaviors. This fourth quarter has already witnessed some macro shocks given oil price correction. Nonetheless, US stocks seem heavily unaffected. One would think that the crumbling of EM, uncertainty in Russia, slowdown in China and Eurozone mess are all enough to raise volatility. Yet, the resilience in US markets has been appreciated by investors and the perception of “safety” is building conviction. There is a danger of hubris that’s been dismissed because markets have not punished the bulls, yet. For now, the market observer’s obsession is heavily focused on interest rate polices, which is the most dominate issue that’s constantly discussed and debated. However, the subdued volatility index has quietly signaled unease and unrest. The magnitude of pending doubts may not be as calm as in the past few years. If and when the investors decide to look beyond the Fed, there might be a collective realization that the world has been burning underneath. Perhaps then these slight dangers could convert into rude responses.


Levels: (Prices as of close: December 26, 2014)

S&P 500 Index [2088.77] – Another record was set for the fifty second time in 2014 during last week's holiday-shortened week. The index closed over 6% above its 50 day moving average.

Crude (Spot) [$54.73] – Not far removed from December 16th lows of $53.60. There are pre-mature signs of bottoming around $54. Investor's anxiousness builds in search for a new bottom.

Gold [$1,195.25] – On several occasions, the technical charts suggest a bottom at $1,200. This has brought about mixed feelings from investors. Nonetheless, a follow-through above $1,200 has not been visible.

DXY – US Dollar Index [90.03] – In March 2008 DXY stood at 80, which was a very familiar place. Now surpassing the 90 level marks a new era. This reflects the ongoing decline in other currencies and a decline in commodities. However, momentum remains positive.

US 10 Year Treasury Yields [2.24%] – Interestingly, December 16th lows yields of 2% may have set some near-term lows. Similarly, the last few trading sessions suggest 2.15% as a possible low point as well. Observers await to see if recent stability is a prelude to a bottoming process.

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