Market Outlook | January 6, 2014

“Americans detest all lies except lies spoken in public or printed lies.” Edgar Watson Howe (1853 - 1937)

Cheerful expectations

Mixed emotions have surfaced and continue to resurface in this global market. Cheerfulness can describe some developed markets that have witnessed price appreciations. Sourness defines some emerging market trends, and unanswered and uncertain describes the rest of the investment and economic climate. Optimism is widely felt by financial market participants, but the real economy on a global scale is concerning, and remains fuzzy. Plenty of distractions resurface in headlines, but generating global growth is a puzzle that’s being deferred and the harsh consequences have yet to be critically addressed.

Cheerfulness and hopefulness are awfully common when entering a New Year, and the consensus market outlook is no different. When reflecting back to 2013, cheerfulness – as in risk taking in financial markets – was the appropriate and rewarding choice. Gauging the sentiment of economic weakness from Brazil to Turkey the US markets maintained their relative attractiveness. From global growth cooling to emerging market currencies struggling, it became quite clear that the investable options were limited.

When tracking only shares of large multi-national corporations (that make up the Dow Jones and most of the S&P 500 index), being cheerful is appropriate in view of last year. Regulatory and tax uncertainty has been overly discussed, but that uncertainty hasn’t trickled into day-to-day market activity. Neither interest rates being low nor corporate earnings being not quite amazing budged the volatility index. “Taper” fears and even the decision to “taper” did not faze the faithful risk-takers either. Thus, fear has vanished just like memories of 2008 in some ways. The chapter of investing for 2013 basically simplified and glorified risk-taking while laughing at the concept of risk and fear. This is a classic prelude to hubris, and now all that bravado needs some substance. But being cheerful is king for now – this is the loud message for money managers of all kinds.

Adding up disconnects

Much talk has persisted about the disconnect between stock markets and the real economy for a while. The perception may change if economic strength justifies stock market appreciation, which will satisfy naysayers and logic seekers. Surely, there will be more puzzles to untangle in upcoming months. There is a disconnect between mutli-national companies’ earnings and most small businesses. There is a disconnect between developed and emerging markets, which has played out for the last few years. Equally, a disconnect exists between political leadership and people’s sentiment toward government in the US, which is very low. Congress and presidential ratings are at a low, while key US broad indexes are at all-time highs. That in itself should set the tone for 2014, a mid-term election year where politics are deemed hopeless, stock markets attract the hopeful and the skeptic has plenty to chew on and tons to ponder. But suspense is the feasible reality.

Themes for 2014

Crude prices – The changing landscape of the supply/demand setup suggests lower prices, as was hinted at in the late part of 2013. Supply is expanding in the US and begs the question of whether crude prices will get closer to $85 rather than $100. Plus, the sluggish global growth has played a role in oil demand, as well.

“Shipments of foreign crude fell 1.1 percent to 7.41 million barrels a day, the fewest since January 1998, based on the four-week average through Dec. 27, according to data released today by the EIA, the Energy Department’s statistical arm. U.S. crude output surged to a 25-year high on rising production from shale formations.” (Bloomberg, January 3, 2014).

The impact of crude prices is bound to influence companies and consumers alike. That shift in behavior can impact earnings of select industries and policies of select nations, as the flow of capital may change. Therefore, preparing for shifting in crude prices might change the macro dynamics significantly.

Emerging markets – The highly tracked BRIC nations have cooled, with plenty of emphasis on China. Value seekers will make arguments that there are bargains worth exploring. Surely, the risk-reward is attractive for those daring bunches and surprise seekers. Last year, the vulnerability of emerging market currency was a theme in itself, which is one macro threat to volatility levels. One noticeable example is that the Turkish market in recent weeks has hinted that some developing markets are too fragile. Political risk is one matter, but when economic growth unravels, volatility persists and domino-like effects continue to send panic waves, with investors seeking a rapid exit. In fact, the market observers have zoned in on a few countries by coining the term “fragile five”:

“Those worried about an EM sell-off will be cheered by Société Générale’s outlook for the coming year. The bank reckons the currencies of the so-called fragile five EMs – Brazil, India, Indonesia, Turkey and South Africa – could drop from now until March, when the Fed is expected to start tapering. But not to worry: they should appreciate in the following three quarters as the Fed pursues a dovish policy.” (Financial Times, December 2, 2013)

Trust in central banks – This is probably the most obvious catalyst that’s talked about. The multi-year appreciation of US stocks and housing has restored confidence in the Federal Reserve. Similarly, the Federal Reserve has more confidence that its messaging is followed, and goals are easier to achieve with a compliant consensus base. Any change in the Fed-investor relationship is clearly the vulnerable catalyst to stir a massive dent in financial markets. Perhaps, the thrilling part for speculators is to guess when the status-quo mindset is set to change. That’s a lot to ask of a forecaster, and speculating on timing of this can be deemed reckless by some measures. The discussion of inflation vs. deflation has been ferociously debated in the same manner as folks argue about whether the economy is growing or weakening. Thus, the Fed’s creditability is on the line, especially with a new Chairperson needing to answer several disconnects in the marketplace. That itself should create unease if the messaging continues to derail from tangible, observable realities. Plus, if risk-taking participants who are pouring money into elevated markets begin to lose capital, then early outrage may emerge. Typically, when consensus begins to lose money on Fed-supported bets, then market paths are reset to new perceptions.

Article quotes:

“Pay is dropping too. At Goldman Sachs and JPMorgan Chase average pay slipped by about 5% in the first nine months of last year, a figure that is probably representative of the wider industry. Over the longer run, average pay at the world’s biggest investment banks has barely changed which means it has fallen slightly after inflation. The pace of pay cuts is likely to accelerate, senior bankers say. The biggest reason for the cutbacks is that after decades of growth in revenues (punctuated by brief declines), the investment-banking industry is facing a structural downturn. Regulators in America have banned banks from trading securities for their own profit. Higher capital standards everywhere are forcing investment banks to shrink their balance-sheets and regulations are making banks move much of their derivatives trading from opaque and profitable ‘over-the-counter’ transactions onto exchanges and into central clearing-houses, where fees are likely to fall. In fact, the industry’s revenues and profitability have fallen far more sharply than pay and employment. McKinsey, a consultant, reckons that for the 13 biggest investment banks revenues have fallen by 10% a year since 2009, while costs have dropped by just 1% a year. The main reason for this mismatch is the relentless optimism of those who work in the industry. Most big banks hired energetically after the financial crisis, hoping to gain a greater share of the market as rivals cut back.” (The Economist, January 4, 2014)

“Consumer inflation expectations turn out to be above the central bank’s inflation target in all three countries. In the United Kingdom, inflation has been running above target for a while now, which may explain some of the gap. But that is not the case in the United States and especially Japan, where inflation expectations do not appear to have responded fully to relatively long-lasting shifts in the inflation rate. Above-target consumer expectations are ironic since the Fed and the Bank of Japan have been worrying, to different degrees, about deflation. The data also show that consumer inflation expectations are extremely sensitive to oil prices. Somewhat alarmingly, those expectations seem to be related to the level of oil prices, not the rate of change as economic theory would suggest. These two characteristics of consumer inflation expectations may be related and could arise from the way consumers form expectations. Rational inattention theory, which emphasizes the costs of processing information, suggests that households may not spend a lot of time and effort rethinking their estimate of the prevailing inflation rate (see Sims 2010). These information processing costs tend to make consumers update their inflation expectations infrequently, especially during periods when inflation is relatively stable. Moreover, instead of using sophisticated models to predict inflation, consumers are more likely to rely on a few simple rules of thumb. Because oil prices are highly volatile, one such rule of thumb could be linked to the price of oil. The apparent importance of the level of oil prices may be related to this casual way of forming expectations. Consumers may well have been feeling the pinch of rising oil prices over the past few years. In an era of stagnant incomes, they could be equating high oil prices with high inflation, an association that presumably will weaken over time.” (Federal Reserve of San Fransisco, November 25, 2013).

Levels: (Prices as of close January 3, 2014)

S&P 500 Index [1831.37] – 2013 highs of 1849.44 (set in December 2013) also mark all-times highs, which is the benchmark. Clearly, the bullish trend is intact, without signs of cracks.

Crude (Spot) [$93.96] – There has been a massive selloff in the last few trading sessions, from $100 to below $94. The supply-demand dynamics support the recent move and suggest further possibilities of a downturn.

Gold [$1225.00] – Digging out of the bottom. December’s lows of $1195.25 and July’s low of $1192.00 make a strong statement about a potential floor. Gold optimists view the next key target as $1400, as the long climb awaits.

DXY – US Dollar Index [80.79]– Hardly showcasing any movement for the last two years. Interestingly, on January 3, 2013, the index stood at 80.38.

US 10 Year Treasury Yields [2.99%] – Signs of strengthening yields since July 2012. Breaking above and staying above 3% is the challenge in months ahead.





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