Market Outlook | February 3, 2014

“Turbulence is life force. It is opportunity. Let's love turbulence and use it for change.” Ramsay Clark (1927-present)

Turbulence lurking

Volatility has for a long while been tame, until the recent awakening from emerging market woes and outflows. Interestingly, the volatility index reached its lowest point both in March and December 2013. This illustrated that US equity markets were not overly bothered by risk-related items and stocks were highly favored. As many experts pointed out, this reflects the overhanging complacency that has been brewing for a while.

The end of the 2008 crisis until the end of 2013 marked a period of calmness led by the Fed’s plans, which are credited for navigating out of the crisis. Brilliant or not, Bernanke is now no longer the captain of the ship. This Fed succession plan is marketed as smooth, but investors will have the last say. In fact, in the last five years or so, it appears that confidence has been restored and the relative US edge is apparent despite recent wobbly behavior. However, the relative edge is being questioned and doubts are resurfacing, especially if economic and earnings strength cannot justify these elevated market levels. More suspense now awaits on inflation/deflation, taper implications domestic and abroad and sustainability of corporate earnings. Several forces are building up at once; thus, the pressure is adding up.

Adjustment period

As one Fed leader departs, observers wonder if the low volatility and favorable climate for risky assets are also in danger of leaving. Similarly, a new month is here where the tone on earnings and stability is more shaken than in previous months. Currencies are unraveling, few central banks are hiking and global growth remains sluggish. The dawn of the taper era is in full gear and its implications are still being felt. Yet, a pending correction in developed markets versus ongoing sell-offs in emerging markets shouldn’t be evaluated equally. On one hand, emerging markets have fallen along with commodities in the last 12-18 months. The mass exodus by investors has been evident for a while and is now playing out viciously.

“Almost $9 billion was pulled out of ETFs that track developing markets in 2013, the first annual outflow since the securities were created.” (Bloomberg, January 30, 2014).

The struggle in performance with the BRIC nations is well documented. The China growth slowdown triggered many investors to prepare for potentially disappointing news. At this stage, it will not be a major surprise if China and other major economies begin to showcase bubble-like traits. Instead, the missing piece is grasping the magnitude of concerns that are in the minds of risk-takers beyond BRIC nations such as Turkey, Argentina and South Africa. Lack of stability in the currency markets is already factored in, but how this ends will be discovered in the upcoming weeks.

“Emerging markets are now half the global economy, so we are in uncharted waters. Roughly $4 trillion of foreign funds swept into emerging markets after the Lehman crisis, much of it by then ‘momentum money’ late to the party. The IMF says $470bn is directly linked to money printing by the Fed.” (Telegraph, January 29, 2014).

In terms of developed markets, the US has stood out despite ongoing concerns. It was a few days ago, on January 15, 2014, when the S&P 500 index made all-time highs. Since then, the sudden drop is a wake-up call for a long-awaited correction. Surely, some pullback is to be expected and other macro concerns are brewing to serve as a downside catalyst. It has been a while since a correction (10% decline) has materialized, and some wonder if that’s been deferred for too long.

For portfolio managers, these two points are worth considering when thinking about the broad markets:

1) If further sell-off, then how and where to reduce risk exposures
2) If the sell-off continues, then it’s worth looking into themes (both in developed and emerging markets) that can offer cheap entry points

Preparing and positioning for the next moves is worthwhile, especially early in the year, when uncertainties have to be unraveled, discovered and eventually understood by participants. The unexpected is common, but preparing and refining an investment thesis might be best suited in this first quarter.

Gauging catalysts

There is a constant shift between the search for growth and the shift toward shelter. The growth phase has been in play when considering low interest rates. Similarly, last decade’s growth was mainly driven by the commodities boom, which has slowed down since late 2012. The last period of noticeable nervousness was seen in summer 2011 with the US downgrade. Now in 2014, choppiness in the market pattern is expected, even if major catalysts fail to overtake the collective mindset. Commodities have been out of favor, emerging markets are deemed even riskier and risky loans are back in the US. Long-term trend seekers are forced to explore frontier markets or go safe, but the familiar and liquid instruments such as Treasuries, Dollars and established larger stocks will attract some attention For a while, panic has been suppressed; thus, the rush to safety may appeal to most in the near-term. In an inter-connected world, minor catalysts can be part of a bigger catalyst that’s damaging. Thus, having an open and flexible mind is required to navigate a reflective period when a reality check is a necessary cyclical occurrence.



Article quotes:

“The emerging markets currencies sell-off intensified last week but not every asset class is in a doom-and-gloom scenario. In the emerging bond markets at least, investors are taking a more nuanced and discriminating view. The primary market remains open, although issuance opportunities are rare. (See EM section.) In the secondary market, corporate credits in particular are holding steady. JP Morgan’s CEMBI index, which measures the performance of US dollar-denominated corporate bonds, is actually showing a positive return of 0.50% for the year to January 28, although on a spread basis it is 18bp wider. The best credits from Turkey and South Africa are also performing relatively well, despite the fact that both countries are at the centre of the storm in the FX and rates markets. Turkish bottling company Coca-Cola Icecek, for example, has seen its 2018 bonds fall by just 35 cents in cash terms since mid-January, with the note trading up 1/2 a point for the year up to January 30. In spread terms, the bond is trading 65bp tighter than where it priced last April. South African miner AngloGold Ashanti is another credit bearing up well. A rally in the gold price over the past month has helped tighten the yield on its 2020 bond to 7.40% mid-market from 7.75% at the beginning of the year. By contrast, South Africa has seen the yield on its benchmark 2025 note jump to 5.55% from 5.30% over the same period.” (International Financial Review February 1, 2014)

“Top banking regulators in the U.S. are being urged to reconsider risk-retention rules for collateralized loan obligations on concern they would increase financing costs for speculative-grade borrowers. BlueMountain Capital Management LLC, Invesco Ltd. and Blackstone Group LP-controlled SeaWorld Entertainment Inc. are among the more than 30 firms that wrote to the Federal Reserve, the Federal Deposit Insurance Corp. and the Securities and Exchange Commission, and asked them not to enact the rules, according to letters posted on websites of the regulators and the U.S. central bank. CLO issuance in the U.S. surged last year by 49 percent to $82 billion. The CLO market had its most active year since 2007 in 2013, mirrored by record volume for the high-yield, high-risk loans these funds invest in, with $349.3 billion of new debt issued. The borrowings have been used to finance some of the biggest buyouts in history including the purchase of Energy Future Holdings Corp. Implementation of risk-retention rules may raise annual interest expenses faced by junk-rated companies by as much as $3.2 billion, according to a study sponsored by the Loan Syndications and Trading Association, the loan market’s main trade group.” (Bloomberg, January 13, 2014)



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

S&P 500 Index [1741.89] – After nearly hitting 1850 on January 15, the index has pulled back moderately. A move below or around 1650 may suggest a meaningful pressure.

Crude (Spot) [$96.67] – Traders question whether crude can surpass the $98 level at this junction after failing to do so in December 2013. Again, the supply continues to expand, but that factors is not fully realized.

Gold [$1257.30] – Early signs suggest that $1260 was a resistance point where buyers’ momentum faded. Summer lows of $1192.00 remain the noteworthy price for those expecting further decline. For now, the 50-day moving average stands at $1236.77.

DXY – US Dollar Index [81.01] – In the last 30 days, the dollar has gained versus other currencies. Perhaps, a new wave of strong dollar is shaping up. Yet, the recent move is too mild to make a strong case for a sustainable run.

US 10 Year Treasury Yields [2.57%] – Since the January 2nd highs of 3.05%, yields have continued to come down. The yields-down trend matches the weakening economic conditions.



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