Market Outlook | August 18, 2014

“The opposite of a correct statement is a false statement. But the opposite of a profound truth may well be another profound truth.” (Niles Bohr 1885-1962)

Mesmerizing & Misleading

It is abundantly clear that more Central bank “stimulus” effort does not quite translate into economic growth. This tactic of low rate reinvigorating the real economy has been overly discussed in US and Europe. Yet, this discussion of stimulus has become a joke to close observers, who for several years heard the potential and promise of growth. Meanwhile, a closer look of recent evidence suggests the opposite. For example, here is one summary, “After four quarters of meager growth, the fragile economic recovery in the 18-country eurozone creaked to a halt in the second quarter” (AP, August 14, 2014). Sure the markets have translated bad news as good news because that sets the expectation more stimulus. This in-turn has driven shares much higher merely on fragile expectation, rather than substance. By any sane measure, the trickery is not only disruptive to market flow, but paints a grossly false picture of current conditions and sentiment. Cheerleading a bull market is understandable for those keeping score and tracing wealth; however basic questions need to be asked.

Growth Over-promised

If the economy was growing then why is the US 10-year yield at 2.31%? That’s one major question. Similarly, key European 10-year bonds are also trading at very low interest rates. Despite the awareness of slowing 2nd quarter growth data in Europe; it still had a positive weekly finish in European stocks. Delusional or the current “normal” remains to be determined, but that's been the nature of market dynamics for the past few years.

Surely, the low rate climate affects investor behavior more than real economic factors, which are drivers of misery, unrest and political decisions. Layers of messaging regarding economic strength are misleading. A well documented disconnect remains evident between rising stocks and the over-perceived health of economic conditions despite data that might showcase a few positive signs here and there.

Interestingly, a fair amount of skepticism about the Fed’s tactics has not led to an overly volatile market . At least it is not dramatically turbulent so far. On one end, to have a “bubble”, an overheating economy is needed, first. Certainly, this stage is not quite where it can stir a major scare at the top. On the other hand, a dull growth rate would make one think that corporations would be concerned and that shares prices would reflect that natural concern. Instead, the overwhelming demand for higher returns is more dominating than assessing absolute risk in developed markets. It remains a relative argument that the US is favored; and that is visible with the S&P 500 index near all-time highs.

Unease Revisited

The troublesome Emerging Markets (EM) climate witnessed massive sell-offs in 2013. BRICS struggled along with commodity related themes. Basically, the last decade fueled the emerging market and commodity run, and the cycle has possibly shifted from a l0ng-term cycle perspective. In the near-term, Crude is pulling back and Gold is neutral as the CRB index (commodity index) is more than 20% removed from 2011 highs. Changing dynamics were triggered in the first half of last year and similar symptoms are now reappearing. In fact, even if there has been desperation for higher yield with risk-taking highly encouraged, the lingering headline concerns are simply too hard to ignore.

“One trader said that following the African Bank rescue, as well as problems in other emerging markets, such as Argentina, which has entered into a technical default and Russia, which continues to be embroiled in a political standoff with Ukraine, Swiss investors have become acutely aware that emerging markets bonds pay a higher yield because there is a higher risk.’”(IFR August 14, 2014)

The emerging market (EM) fund has recovered so far this year. Key indexes are entering a fragile territory where conviction regarding risks are set to be tested. Plenty of headline concerns (e.g. Russia, Iraq) continue to build, but the hints of a slowdown in EM have been hinted at since last year. The risk-reward has increased as investors realize that not many areas are keeping up with growth expectations. Plus, the strengthening of the Dollar in July may serve as a key event in the perception of risk, especially in Emerging Market currencies. Certainly, sensitivity to Federal Reserve rate decisions are highly expected to impact the mindset of EM. In an inter-connected global market this is another clue worth tracking as the Dollar maybe more attractive than EM currencies again.





Article Quotes:

“Japan is a wild card in global credit markets. The central banks of the United States, the Eurozone, and Britain are far more independent than Japan's, and their leaders coordinate policies more closely as well. But a shift in domestic political winds can change economic policies dramatically in Tokyo, as it did when Shinzo Abe led the Liberal Democrats to a huge victory in 2012. Within weeks, the Bank of Japan initiated a whatever-it-takes quest for inflation. The next general election is in 2016. If Abe's policies fail to yield growth by then, Japan could be under new management once again. A sudden disruption in the global economy's ample supply of liquidity is most likely to come from here. The Bank of Japan currently buys about $70 billion in securities every month as part of its credit easing program, which is only a bit less than the Fed bought at the height of its activities. The Fed has tapered its purchases slowly and with plenty of warning. Japan might not.’”(Foreign Policy, August 14, 2014)

“Facing sanctions from the West for its actions in Ukraine earlier this year, including the annexation of Crimea and supporting Ukrainian separatists, Russia will increasingly turn to China for its military and aerospace components. According to a RIA Novosti report citing a Russian-language report by Izvestia, ‘Russian aerospace and military-industrial enterprises will purchase electronic components worth several billion dollars from China.’ The information is based on a source ‘close to Roscosmos, Russia’s Federal Space Agency.’ According to the Roscomos source: ‘[Russia does] work with the China Aerospace Science and Industry Corporation (CASIC) … Its institutions have already offered us a few dozen items, representing a direct alternative to, or slight modifications of the elements [Russia] will no longer be able to acquire because of the sanctions introduced by the United States.’ Currently, Russia’s extensive military and aerospace industries do not source their components in China. ‘Over the next two, two-and-a-half years, until Russian manufacturers put the necessary space and military electronic components into production, plans call for the purchase of such items from China amounting to several billion dollars,’ the source adds…..If Russia is indeed looking to China for military and aerospace components, it further signals that the Beijing-Moscow relationship continues to tilt in the former’s favor. The recent $400 billion natural gas deal between the two sides also showed another aspect of the changing dynamics in bilateral relations. Reports suggest that Moscow acquiesced to Beijing’s price demands in order to seal a 30-year deal.” (The Diplomat, August 12, 2014)

Levels: (Prices as of close August 15, 2014)

S&P 500 Index [1,955.06] – Approached the all-time highs from July 25 of 1991.39. Perhaps, there is a psychological level of 2000 which may influence movements in the near-term .

Crude (Spot) [$97.35] – Very close to a 200 day moving average, ($96.07) as signs of stability and are awaited after a sharp sell-off. Over the past year or so, strong evidence suggests buyer’s interest around or below $95. This prior trend sets to be tested yet again.

Gold [$1,313.50] – Sideways patterns in place as a new definitive range has formed between $1280-1320. Yet, eclipsing annual highs will require further near-term momentum. July highs of $1340 will be on the radar for many observers.

DXY – US Dollar Index [81.42] – The recent strength that started in July remains intact. Continues to stabilize.
US 10 Year Treasury Yields [2.33%] – Downtrend in yields continues to be profound this summer. Once near 2.70%in early July, now closer to 2.30% continues to make a strong macro statement. This wave of downtrend begs the question if 2% is first more reachable than 3%.

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