Market Outlook | May 12, 2014

“Playing safe is probably the most unsafe thing in the world. You cannot stand still. You must go forward.” (Robert Collier 1885-1950)

Standstill

A waiting game is playing out in key corners of the financial markets. There is a pause-like feeling lingering as participants await a "big" catalyst (or two). Of course, the challenge for experts and novice risk takers is pinpointing the key factors for massive trend-shifting moves. At this junction, betting on massive collapse or ongoing re-acceleration is merely a guessing game rather than a collection of highly compelling arguments.

As a start, the S&P 500 index has not made a strong directional statement in eight weeks, as current ranges seem stable. Interest rates are not quite buying signs of re-accelerating or a vibrantly improving economy. US 10 year Treasury yields are well below 3%, but not quite below 2.60%. Crude prices are flirting at or around $100, not giving buyers or sellers the much-needed extra conviction or trend to make bigger moves. At this stage, the developing standstill is glaring. Risk-takers anxiously await a move in stocks, interest rates and commodities. Surely, forward thinkers are aware that positioning ahead now for pending moves is where the reward awaits.

Skittish or trendless: both seem applicable in assessing the real economic conditions. Skittish messaging is quite visible in the reaction and messaging from the Fed. On one end, the central bank is concerned about housing, while continuing to praise the "taper" and claiming a robust economy. Mixed signals of all kinds are set to test the patience of various investors. Is there a bubble that’s in late innings, or is this numbness to overstated fear? Potentially, a little of both is occurring.

Calmness – universal theme

These days, low yields are hardly a discussion point and are accepted as the norm. Even Spanish and Portuguese yield are much lower in the post-crisis period.

“Spain’s 10-year yields dropped to an all-time low as a separate report showed unemployment in the country fell last month, signaling governments in the region are overcoming the debt crisis that began in 2008. Portuguese and Irish bonds also gained as Fitch Ratings said there is potential for upgrades in the euro region’s peripheral nations.” (Bloomberg, May 6, 2014)

Basically, there is a sense of recovery and a perception that risk has vanished, at least for now. Investors, even in the most vulnerable European markets, are feeling a revival of sorts. Certainly this is hardly news, but worth noting, especially after the issuance of Greek bonds that stirred demand for yield-hungry investors. Is this desperation for yields or a lack of alternatives? It’s fair to say that “collapsing Europe” or default talk is not as prevailing when tracking investment bets versus the gloom-and-doom literature that pollutes the daily airwaves.

Talking about low levels, the volatility index is far removed from indicating hints of turbulence. Amazingly, the volatility index is not overly puzzled by the crumbling factors of slowing growth in innovation-driven themes (i.e. tech and biotech) and macro unrest potential due to fragile foreign policy as the global economy continues its search for solid footing.

Gearing up

There are hints of slowdown, unrest and wobbly sentiment resurfacing in the late spring season. As much as risk aversion has been out of favor, extracting signs of danger for evaluation is wise while not easily falling into the trap of sensational pessimism.

After all, it comes down to which assets are overvalued and which ones are undervalued. If there is a shortage of undervalued assets, then a correction is bound to occur. Money managers or proclaimed risk assessors have to decipher where a peak is. Is it in growth areas such as small cap or technology-driven areas? Is it a collective overvaluation, or is that less important when the market is more relative than absolute? Do areas in emerging markets (stocks and strength in local currencies) offer timely entry points? Is there plenty of noise on macro matters (tensions affecting commodity pricing) or is the gut-check correction about to occur in the next 3-6 months? Plenty to ponder, but maybe the time to act is during a trendless market when the majority is rather neutral, lacking conviction or waiting for further hints. The counterintuitive steps of reducing risk or finding value in areas less sought after may be rewarding. Perhaps, the standstill is calling the daring bunch in search of bigger rewards. Now is an intriguing time to answer the questions above and hope that the risk-reward concept will continue to work and the consensus chatter is just a distraction or casual entertainment.

Article Quotes:

“A serious flaw was exposed in the European Central Bank’s policy strategy this week, setting up the Euro for a potentially rough few weeks going forward. With ECB President Mario Draghi saying that the Governing Council felt ‘comfortable’ enacting further dovish policies at the June meeting once the new staff economic projections were released, the market’s growing calls for new dovish action has been materially altered into a full-blown expectation of a substantive policy change in four weeks. Market participants gleefully hopped on board the Euro bear train midway through President Draghi’s press conference on Thursday, taking the latest episode of jawboning a bit more seriously now that a veritable checkpoint down the road has been established for action that should undermine the Euro (the selling on Thursday and Friday is evidence of the market pricing in a small rate cut, with the number of basis points priced out of the Euro over the next 12-months moving from -4.3-bps on Wednesday to -11.4-bps on Friday).

Even though President Draghi indicated that the Euro exchange rate was not a policy tool, he did specifically say that it would be necessary to address if it undermined price stability. Incidentally, traders have taken this as a sign that persistently low inflation for the region is being blamed on the single currency (rather than the policies which got us to this point, of course) – and this is now the most daunting corner the ECB has painted itself into to date as it has essentially guaranteed some form of easing. We can’t say that Euro weakness into the June meeting is guaranteed; but, in the sense that market participants needed a reason to offer the Euro lower, they’ve been granted one: the ECB wants a weaker currency, and it has promised a dovish policy response in return. And the market has responded, with the EURUSD dropping from a fresh yearly high of $1.3993 on Thursday to the close of 1.3760 on Friday.” (Daily FOREX, May 10, 2014)

“China is attempting to restructure its economy, reorienting the manufacturing sector toward the production of more technology-intensive goods and expanding the service sector in order to move up the economic ladder from a middle-income country to a high-income country. Premier Li Keqiang stated in his Work Report at the National People’s Congress in March that China needs to rebalance away from investment and trade and toward domestic consumption and service industries. This is in line with the Fisher-Clark theory of structural change and a very common view that as economies modernize, they must shift from a focus on primary industry (agriculture), to secondary industry (manufacturing), to tertiary industry (services). Yet could moving up the value chain be a mistake for China? Contrary to common belief that to move up the economic ladder a nation must transition out of a focus on manufacturing to a stronger emphasis on services, we proffer the cases of the United States and Japan. The U.S. and Japan have service sectors that contribute close to 70 percent of GDP and manufacturing sectors that represent about 20 percent. Manufacturing has moved abroad to places like China and Vietnam, where labor has been far cheaper, while the services sectors in these countries have become increasingly sophisticated and skill-intensive. Both the U.S. and Japan are now mourning the loss of manufacturing jobs overseas, as sources of economic growth have diminished and economic inequality has widened. A major argument in favor of moving up the structural ladder is that increasing economic productivity should be reflected in increased modernization of sectors away from labor-intensive processes and toward more technology-infused or skill-intensive processes. This should be accompanied by a heavy policy emphasis on educating the work force, so that individuals can continue to find employment in a more mentally demanding work environment. Increased productivity will lead to a shifting out of the production possibilities frontier and sustained economic growth.” (The Diplomat, May 5, 2014)



Levels: (Prices as of close May 9, 2014)

S&P 500 Index [1878.48] – In the last two months, moving above the 1880 range has proven to be difficult or short-lived. Some signs of slowing bull market but still lacking further signs of major sell-off.

Crude (Spot) [$99.99] – The 200-day moving average and the 15-day moving average both are $100. Basically, uneventful action last week awaits any signs of movement away from a very familiar and common $100 range.

Gold [$1287.00] – Based on trading actions, a base is forming around 1280, while the upside potential lacks significant momentum. Clearly, the “hot” or “quick” money has vanished from the sector, and a range-bound action will follow in years ahead.

DXY – US Dollar Index [79.90] – Closed at annual lows. Prior lows were achieved in late October 2013, confirming the weak dollar trend.

US 10 Year Treasury Yields [2.62%] – As seen in September 2013 and January 2014, yields failed at 3% or so. In the last nine months, the 2.60% range has been rather familiar to most, but signs of a breakout are not overly convincing.



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