Market Outlook | January 19, 2015

“All genius is a conquering of chaos and mystery.” Otto Weininger (1880-1903)

The Scramble

The start of the year opened all kinds of worries on matters that influence financial markets. To be fair, some of the headline worries were "known” for a while—even 2-3 years ago. Other concerns were “less known” a few quarters ago. Those who put all their faith in Central banks are realizing that surprises are part of risk-taking. Risk is unavoidable and volatility can erupt at anytime. The sole reliance on the message of policymakers and central banks is awfully dangerous at times, particularly during this chaotic junction. If one struggles to "dance with the unknowns" then the current market conditions maybe more treacherous, especially after a period of complacency.

Some of the “known” worries have been on the radar especially in recent months. Examples of this include: pending interest rate policies by central banks (i.e. anticipated rate cuts by ECB), impact of the strong dollar on companies' balance sheets and the lack of growth in the real economy globally. This is in addition to the lower global yields and inflation.

Meanwhile, less expected matters that require further digestion are now on the radar of average and casual money managers. At the forefront of investor curiosity is the massive oil sell-off and its impact on oil rich nations. Sure, this is part of the commodity cycle peak, but the crude price reset has reshaped the status-quo thinking of many analysts. In weeks and quarters ahead, the impact of energy fallout on US banks' balance sheets will be discovered and certainly pondered. In addition, damaging results from natural resources stir further questions of possible political unrest from Russia to other Eastern European nations.

Dealing with the Expected

The so called “known worries” is highlighted by the slow global growth environment, which is not only highly documented but is now presented in generic headlines. From the Eurozone to China to other Emerging Markets, finding growth is a massive struggle as confidence remains scarce by some measures. The evidence of frail economic conditions is piling on, especially in the Eurozone:

“The eurozone is struggling to avert a third recession since the financial crisis as the currency union grapples with high debt and a lack of international competitiveness. The [World] bank cut its outlook for growth in the region by 0.7 percentage point to 1.1% this year” (Wall Street Journal, January 13, 2015).

Clearly, Eurozone leaders are scrambling from dealing with an economic crisis that has quickly turned into a political mess. Of course, the very low yields in Europe illustrate the lack of growth along with the lack of inflation. Perhaps, this simply explains the desperate search for stimulus or reform.

Surely, the ECB talks of lower rates spark massive speculation as the currency markets continue to react. In fact, for months, the Dollar has been getting stronger, the Euro is weaker and further interest rate cuts in Europe are widely expected. Therefore, the Swiss announcement to unpeg the Franc is hardly a surprise when considered within this context. Importantly, the takeaway of Swiss disassociation from the Eurozone itself hints of ugliness to follow.


Colliding Forces

In this anxious period, it helps to reflect back to the sequence of events to enhance ones perspective. Before the markets were swept away with the rattling actions of the Swiss Franc, there were other factors to ponder in the currency and commodity world. Before Oil prices collapsed, the commodity indexes signaled an ongoing cooling cycle for Oil, copper and other hard commodities. Not to mention, weak global demands were also a prelude to Crude demise. Before the spike in volatility in early 2015, the unsettling actions during last October and December served as vital clues to the wobbly inter-connected markets. The dramatic shifts following the September hints are visible in various macro indicators:

On September 19th 2014, US 10 year treasury yields stood at 2.65%, VIX (Volatility index) was hovering around 11 and Crude prices closed at $92.41. What a difference few months make. US 10 year yields now trade at 1.83%, VIX spiked to 20 and Crude sits a little above $48.

Similarly, before Oil price's dramatic drop, the US dollar already began to strengthen—making it the story of 2014. Before the Swiss franc announcement, it was vastly expected that the Euro was set to go lower, especially with ECB expected to cut rates. So, what’s the new discovery? What’s the new surprise? Perhaps, the status-quo of low volatility, and the unshakable trust in Central Banks are not as stable as some imagined. The narrative of the financial markets is changing regardless of the foreseeable or unforeseeable events that have transpired. Crude below $50 and developed market yields near zero and the dollar at multi-year highs illustrates ultimate change. Stale models and expectations are forced to adjust, but before an adjustment some emotional responses are inevitable. Change is chaotic and expecting no change in the market narrative might be even more deadly than imagined.

Article Quotes:

“The Soviet war in Afghanistan was followed by a long-term decline in oil prices. The recent price slide – to $50-60 per barrel, halving the value of Russia’s oil production – suggests that history is about to repeat itself. And oil prices are not Russia’s only problem. Western sanctions, which seemed to constitute only a pinprick a few months ago, appear to have inflicted serious damage, with the ruble having lost nearly half its value against the US dollar last year. Though financial markets will calm down when the ruble’s exchange rate settles into its new equilibrium, Russia’s economy will remain weak, forcing the country’s leaders to make tough choices. Against this background, a stalemate in the Donbas seems more likely than an outright offensive aimed at occupying the remainder of the region and establishing a land corridor to Crimea – the outcome that many in the West initially feared. President Vladimir Putin’s new Novorossya project simply cannot progress with oil prices at their current level. To be sure, Russia will continue to challenge Europe. But no amount of posturing can offset the disintegration of the economy’s material base caused by the new equilibrium in the oil market. In this sense, the US has come to Europe’s rescue in a different way: Its production of shale oil and gas is likely to play a greater role in keeping Russia at bay than NATO troops on Europe’s eastern borders.’’ (Daniel Gros, Project Syndicate January 14, 2015)


“National central banks in the eurozone, with the notable exception of the Bundesbank, are not really worthy of the name; they are glorified think-tanks. It is the ECB that effectively “prints” the money that will be used to make the asset purchase necessary for quantitative easing (although how exactly this will happen remains unclear). While the credit risk of those bonds might sit on the books of the national central banks, that distinction would quickly be rendered irrelevant in the event of a disorderly default.To understand why, consider what would happen if a central bank lost money on its sovereign debt investments. The country’s treasury would have two options: It could exclude the central bank from the restructuring (in which case the other investors in the debt would demand a premium to hold the paper in the first place – the precise opposite of what quantitative easing should achieve) or it could demand that the central bank take the losses (a “haircut”, in the financial jargon).How would the central bank make good that loss? It could ask the country’s treasury to issue more debt. But, remember, it’s just defaulted, so that’s going to be tricky. Or, as it would effectively now owe euros to the wider eurozone, it could ask for the debt to be forgiven. If the rest of the club didn’t forgive the debt, the forlorn country would be forced to leave the eurozone; if they did, then – sorry, Germany – it would rather suggest that, despite appearances, the risk was actually being shared all along. So, the purchase of government bonds by national central banks will either drive up sovereign debt yields in the market (which somewhat neuters the quantitative easing programme) or the default risk must ultimately be shared among all the different eurozone countries (which is exactly what it was designed to avoid).” (The Telegraph, January 18, 2015)


Levels: (Prices as of close: January 16, 2015)

S&P 500 Index [2019.42] – Attempting to hold between 2000-2050. A wobbly pattern develops as the uptrend pauses. A break below 1950 may trigger a sell-0ff.

Crude (Spot) [$48.36] – In September 2008, Crude peaked at $147 and then bottomed at $32 in December that year. Of course, that transpired very quickly during a period of financial crisis, which resulted in a bottoming process around $32-40. Now, the bottom is mysterious as the intra-day lows of $44.20 are closely watched and on the radar.

Gold [$1,259.00] – In the last two and a half years, Gold has bottomed or attempted to bottom around $1,200. Surely, technical and non-technical observers have noticed this even before this current mild run. A break above $1,400 may send a strong message to observers of a noteworthy trend shift.

DXY – US Dollar Index [91.08] – Since July 1st 2014, the index has appreciated over 16%. Amazingly, in this 6+ month period showcased a steady uptrend. Strong signs of confirmation of a strengthening dollar are appearing.

US 10 Year Treasury Yields [1.83%] – Unlike during October and December 2014, treasury yields were not able to stay above 2%. This downtrend remains as the search for safety continues by investors. A notable point would be the 1.37% lows from July 2012 which serve as a key downside target.


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