Market Outlook | March 3, 2014

“Thoughts are forces.” Ralph Waldo Trine (1866-1958)

Forces behind resilience

Throughout the last 12 months or so, moments of edginess have persisted but failed to materialize into an actual major sell-off. In fact, hindsight shows that the momentum of markets is a force that marches to its own rhythm in digesting the importance of key events. As long as participants have a “thought” that the prevailing theme supports risk-taking, then stock market rallies remain, like a self-fulfilling prophecy. Of course, improving signals of economic strength or corporate earnings are needed to fuel a rally. In some cases, glimpses of improvement have been hinted at in the last five years when tracking government data at face value. Certainly, the low point of 2008 and early 2009 still serves as a benchmark and a worst-case scenario. At this stage, one has to wonder about whether the numerous occasions may have signaled looming troubles but been misleading, too. Amazingly, a few concerns have come and gone as stock markets approach new highs:

1) Disconnect between the pace of real economic growth and stock market appreciation
2) Geopolitical events and socio-economic-driven tensions across various established and emerging nations
3) Emerging market growth slowdown, capital outflows and a few currency crises
4) Uncertainty around taper discussions and QE plan changes
5) Questionable sustainability of high corporate profits
6) US government dysfunction, including a period of shutdown
7) Regulatory risk associated with banks and increased regulatory cost for various industries
8) Shifting sentiment toward business leaders and excessive skepticism of past business models

Drumming to its own beat

Despite all these day-to-day issues related to the topics above, the US broad indexes live in their own reality and at their own pace of creating value for shareholders. Also, everyone has his or her own perception and interpretation of what transpires. Perhaps, the wise have agreed that limited investment options and a limited number of shares in larger companies end up contributing to the ongoing run of record highs. Not many markets, currencies or ideas are deemed as safe or relatively attractive as the US markets. Sure, that’s been true for a long while. Capital outflow from developing nations and into US assets further illustrates investors’ perception. Political and international antics aside, the markets know how to puzzle participants, or maybe broad indexes are unfazed by unfolding events, surprising observers plenty. Driven by illusion or not, the basis for market movements so far has been diffused or misunderstood. In some cases, expectations are so low that outperforming (i.e. earnings) has become a justifiable “reality.”

Surely, retirement accounts and pension funds have recouped pre-crisis losses, and the optimism has become a force that’s a bit beyond reason but in line for experts. Toppling this bullish run has been categorized as a dangerous activity, and fighting the Fed is seen as an intimidating act against the status quo. Yet, a new month is here, and the tiresome argument of invincibility is not enough to deflect and ignore all the pressures to this cyclical run. Risk managers are not in a position to rewrite the definition of risk, but rather confront the risky conditions of a market that has promoted and rewarded risky assets. Amazingly, the doubters of turbulence are now armed with historical performance as their biggest evidence, and that in itself is known to spark trouble ahead.

Brewing catalysts

Unfolding events in the Ukraine saga will impact energy prices, specifically in crude and natural gas. Clearly, gas has big implications for EU, and Russian gas supply and markets will begin to track this, at least in commodities. Plus, international oil companies that have signed deals in Ukraine might feel some impact on revenues. Whether this will serve as a catalyst for risk-aversion broadly is questionable for now, as the political jabbing continues to make noise. As stated above, a lot of crisis events have come and gone unnoticed or without being harmful to this lively script favoring US equities. However, the looming and accumulating factors in the recent saga over energy and strategic global powers can stir some sense of unease. Of course, lack of stability hurts both EU and Russia, where sensitivity is high in this inter-connected world. Not to mention, capital outflow from BRIC nations has been a sensitive theme itself, especially in 2013. Even this year, the trend continues:

“Withdrawals from U.S.-based ETFs investing in emerging-market equities and bonds totaled $11.3 billion this year, already surpassing the redemption of $8.8 billion for the whole of 2013, according to data compiled by Bloomberg.” (Bloomberg, February 27, 2014).

Equally, Chinese bubble talks are brewing on the side as well, given low PMI manufacturing data. Therefore, the slow economic growth environment can stir agitating responses and reactions. A complacent market may not be ready to grasp the overnight panic-like responses. The tricky part is not relying on the history of the last five years as indicative of the next five months.

In terms of US markets, a few innovative areas such as technology and biotech have witnessed massive runs, especially in smaller and growth-driven companies. The run-ups here have been explosive, based on charts and technical observations. If a pullback awaits, these high-performing areas appear vulnerable where the money can exit quickly, as seen in a few emerging market countries (i.e. Turkey). Perhaps, the catalysts are adding up, a breather is needed and a reality check like earlier in the year awaits. March historically has produced periods of sell-off, and last week’s GDP numbers did not excite the optimists. Thus, the reasons for a sell-off were never scarce before, but now genuine optimism seems harder to find for seekers. Even bargain hunters may decide to wait before deploying capital to new ideas.

Article Quotes:

“The recent volatility in the offshore renminbi exchange rate has turned the spotlight on to a little-followed corner of the derivatives market that may have attracted the attention of China’s central bank. A persistent weakening of the PBOC’s onshore reference rate has been amplified in the offshore market, where the spot rate for renminbi, or CNH, slid on Wednesday afternoon to 6.113 against the US dollar, a 1.29% drop in just six trading days from 6.034 on February 18. It is the largest fall in the spot CNH rate since it was first quoted in mid-2011. Analysts believe the apparent intervention of the Chinese central bank in the currency market was designed to show that the currency could go down as well as up, but it has had the biggest impact on investors holding unhedged currency derivatives as a leveraged bet on future appreciation. Speculators piled into the trade as the CNH spot rate gained 4% against the dollar on an annualised basis in the fourth quarter last year. Deutsche Bank estimates the total of offshore renminbi structured forwards traded so far this year is already close to US$100bn, about 40% of the US$250bn traded in the whole of last year. Market observers believe the PBOC has deliberately introduced volatility to the currency market as part of larger plan to increase the market’s role in setting prices.” (IFR, March 1, 2014)

“Eurozone policymakers are struggling simultaneously to strengthen the balance sheets of banks and governments, but each is dragging down the other: banks facing large loan losses are increasing their already outsize exposure to eurozone sovereign debt, which falls in value as fears rise that the governments will be called on to bail them out. Each is therefore weakened by financial exposure to the other. One of the chief economic challenges facing the eurozone is that action taken by the ECB to stimulate lending to the private sector is being rendered ineffective by the weak condition of the banking sector. Cheaper ECB borrowing rates for banks have encouraged them to lend more to their governments, but not to businesses and consumers. Particularly in Italy, Spain, Portugal, and Greece, the ECB is now largely powerless to lower the interest rates that matter most to economic growth. European banks have been trying to repair their balance sheets by raising capital, but uncertainty over the quality of the assets they hold makes such capital expensive. Many eurozone bank stocks trade at less than book value, which means that investors believe the banks are overstating the value of their assets. Rather than raise capital, therefore, banks have resorted to cutting back on their lending. This further weakens the eurozone economy by reducing the supply of credit available to the private sector.” (Council of Foreign Relation, March 3, 2014)


Levels: (Prices as of close February 28, 2014)

S&P 500 Index [1859.45] – Continuing to make a bullish run. Showing signs of holding above 1800, but the sustainability of this momentum is showcasing resilience.

Crude (Spot) [$102.59] – In the last eight months, prices have swung from the $110 to $92 range. Yet the recent rise in crude prices since early January has been explosive.

Gold [$1332.25] – The recent bounce-back has prices reaching near the 50-day moving average. The near-term test is surpassing the $1350 point to re-accelerate further. Whether the buyers’ momentum is
intact will be tested in upcoming weeks.

DXY – US Dollar Index [79.69] – A move below 80 is the lowest close in several months. Signs of weakness in the dollar, although it’s too premature to declare based on this index.

US 10 Year Treasury Yields [2.64%] – Recent pullbacks have driven yields closer to the 200-day moving average (2.63%). Yet, the 50-day moving average sits at 2.80%.




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