Market Outlook | January 26, 2015

“Speech was given to man to disguise his thoughts.” Charles M. de Talleyrand (1754-1838)

Divergence of Markets

The currency and commodity markets are in screaming crisis. Both markets have factored in the slowing global economic activity. Meanwhile, the equity markets from US to Europe to Japan paint an illusionary perspective of asset price appreciation, which disguises the pain felt at the ordinary economy. Sure, equity markets are not (and should not be) a reflection of well-being, but there is something troubling about masking the soft global demand. QE is one part, but the power of perception is an age old art, after all. At least those checking their own sanity can rely on the currency and commodity markets. These markets have not been shy in confronting these daunting and unavoidable realities. Unlike the stock markets of developed markets, notable and massive moves have been expressed from Crude to US Dollar. Perhaps, VIX (the volatility measure for S&P 500 index) is not always the best measure of current or potential turbulence—a lesson that’s been learned by various observers and risk takers in recent years.

The currency markets have showcased the profound rotation into US Dollars as the Euro continues to lose its popularity. The UK pound is trading at a seven year high against the Euro, and the Dollar is at multi-year highs as the scramble for safer asset continues. Capital has shifted away from Emerging Market (EM) currencies as unstable geopolitical climate becomes visible. Surely, the lack of demand in Emerging markets has benefited the US Dollar. Of course, the rush to safety is the main takeaway when dissecting the dollar strength. Importantly, the EM currencies tied to commodities were impacted the hardest, forcing a major adjustment.

Similarly, the commodity index peaked a few years ago. The exclamation point seen in Crude prices reshaped the whole landscape with oil trading below $50. It is remarkable to think on July 3, 2014 Crude oil stood at $104.06 going in to the July 4th holiday in the US. A stunning event even for those that expected price corrections, of course. Several months later, the soft global demand is not a speculative or theoretical statement. It is in fact here and participants have accepted these facts slowly. A dramatic drop in Crude and other commodities reflect the new era of soft global demand, unlike the 2003-2007 periods. Regardless of US QE efforts, the bust cycle in commodities has been in full gear since mid-2011 (CRB Index).

In addition, global yields agree with the message above. Overall yields are at or around historic lows. It was last January when US 10 year yields peaked at 3.05%. Since then staying above 2% has been a challenge, which reflects the lack of growth mixed with the rush to safer assets.

Same Ol’ Formula

The QE stimulus efforts do cause a sense of stability, which justifies higher stock prices. However, the QE actions reflect an act of desperation just as much as a stimulus effort. The idea is certainly nothing new and the attempt to reignite optimism does not guarantee solid results, other than a calmer market that has grown accustomed to this behavior.

Last week was highlighted by the roaring responses to QE. How familiar does this sound for close market observers? Further stimulus is here again, as seen before in the US, UK and Japan. Interestingly, the Eurozone has plenty of wounds to heal on tangible, real matters that impact economics and politics. Yet, from the visible crisis, the magic of QE is a proven model to create further wealth for investors while maintaining distractions for the rest.

Before the cheerleading on the impact of QE resumes, let’s remember that DAX (German stock index) already traded near or at all-time highs even before the ECB decision last week. Plus, QE announcement by ECB was hardly a surprise. Thus, the QE narrative as a solution is merely an effective marketing tactic by central banks and established leaders. Yet, if there is any lesson learned in crude prices, it is that when the truth comes out markets rattle and tumble and believers of deception get destroyed financially without mercy. With that perspective, investors are forced to take the easy option of believing the QE story or pausing to dissect matters further. As one famous hedge fund manager said:

"[QE] This is the biggest redistribution of wealth from the middle class and the poor to the rich ever" (Stanley Druckenmiller, CNBC, September 19, 2013).

A powerful statement considering the message is from someone worth $2 billion and who is quite the keen observer of financial markets. Perhaps, European investors should revisit these comments even while anticipating further rise in asset prices.


Reconciling Mixed Messages

There is a collective realization that there are very few liquid assets that generate attractive returns. This has been clear especially in the post-2008 period. At the same time, reliable assets with low odds of default appear scarce. Thus, after weighing various options, it is no surprise that developed markets and select currencies attract inflow of capital. In a relative world, someone must find a place to allocate capital that inflates not-so-rosy assets across various sectors. This has been witnessed in US junk bond markets in 2013, where the yield desperation drove investors into unattractive assets. Thus, a world of low rates fueled by additional QE only sets up future worries that may not be confronted right away.

However, at any given time markets have the right to respond by having a gut check and realizing the silly game that goes on. Alternatively, at some point investors that believed the Central Banks' stories may have a rude awakening. Perception is powerful, but when reality sinks in then sourness does not take too long to materialize. Thus, the risk of sole reliance on Central Banks is being understood and the conditions of the global economy are, more or less, known. Anything else beyond this is a choice left to investors who want to test their luck.


Article Quotes:


“Mario Draghi’s announcement of approximately €800bn in sovereign asset purchases by the European Central Bank over a 19-month period is what informed observers should have foreseen. If you expected less, then either you did not believe that the ECB president meant it when he promised at the end of last year to increase the ECB’s balance sheet by about €1tn, or you counted wrong. The additional quantitative easing is merely consistent with the goal he had already stated. The positive surprise, however, was the explicit link to the ECB’s inflation target, which carried a faint whiff of Mr Draghi’s 2012 pledge to do “whatever it takes” to save the euro. The phrasing of the actual statement was more circumspect. Each word was carefully chosen, as Mr Draghi said himself. The goal was not stated in terms of inflation rates or expectations, but in terms of the “path of inflation”. This is about the journey, not the destination. Asset purchases can stop before inflation is back to the official target of just under 2 per cent. This leaves the ECB a maximum degree of discretion on when to end the programme. The first question therefore is: how will the central bank use that discretion? This is where it becomes tricky. I struggle to come up with a scenario that would extend QE beyond September 2016. If the policy succeeds, it will rightly be stopped. If it fails to lift inflation rates at all, opponents will argue that it is ineffective and should be abandoned.” (Financial Times, Wolfgang Münchau, January 25, 2015)


“Morgan Stanley cut its estimate of where the euro will end 2015 to $1.05 from $1.12 previously. Bank of America Merrill Lynch sees the euro now falling to $1.10 by the end of the year, from $1.20 in an earlier forecast, while HSBC Holdings PLC analysts cut their year-end expectation to $1.09 from $1.15. The downgrades have echoed Wall Street’s failure to predict outsize pullbacks over the past year in global government-bond yields and oil prices. Those declines have increased investor unease over the risks facing the global economy….. U.S. Bank Wealth Management, which manages $126 billion, said the falling euro is causing eurozone sovereign bonds to lose their allure. U.S. Bank has positions in almost all eurozone sovereign bonds. But the low yields and dim prospects for the euro have the asset manager considering reducing them, particularly in German bunds… AllianceBernstein LP, which manages $473 billion, added to its bearish euro currency bets one week ago in expectation of a bold move by ECB President Mario Draghi at the central bank’s meeting this past Thursday, said Scott DiMaggio, director of global fixed-income investments. The move surpassed the asset manager’s expectations.” (Wall Street Journal, January 23, 2015)


Levels: (Prices as of close: January 23, 2015)

S&P 500 Index [2051.82] – The next hurdle on the upside is 2080. On three occasions the index has held above 2000. Bulls and bears battling out the next move between 2000-2080 is the near-term takeaway.

Crude (Spot) [$45.59] – Attempts to settle from the multi-month carnage. Mid- January lows of $44.20 are not far removed from Friday’s close. Meanwhile, the extreme lows of December 2008 at $32.40 are on the minds of technical / chart observers.

Gold [$1,295.00] – On November 6, 2014, the commodity bottomed at $1,142. A turning point when looking back as the near-term momentum is showing signs of life. Re-testing $1,400 is the next test for the gold bulls.

DXY – US Dollar Index [94.76] – A remarkable run in the last few months. The strength of the Dollar is not only reaffirmed, but showcases that the trend is relentlessly intact. Reaching 100 is the next milestone and that has not seen in over a decade.

US 10 Year Treasury Yields [1.79%] – The last few trading sessions suggest a bottoming attempt between 1.69% and 1.89%. A move above 2% is not quite convincing at this stage.




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