Market Outlook | March 23, 2015

“The hardest tumble a man can make is to fall over his own bluff.” (Ambrose Bierce 1842-1914)

Summary

The Federal Reserve continues to send mixed signals about the rate hikes that stirred a massive response from participants. However, the numbing effect of prior QE policy keeps comforting investors to not fear volatility or to seek shelter in equity markets. Ongoing chatter of rate hikes has yet to change the well established, current status-quo. Yet, the Fed is struggling to justify a critical decision regarding rate hikes when multiple macro indicators suggest a fragile economy.

Bluffing Games

A Fed bluff game is taking shape as it relates to interest rates. The bluff—in terms of potential rate hikes as the "economy is improving" statement—seems hardly tangible when digging further, of course. Unless one assumes the broad equities indexes tell the full story, the rate hike expectations by some for June or even autumn of this year remain rather ambitious.

Year after year threats of a Fed rate hike have been discussed and pondered, but there's been a lack of basis for it. At least no convincing evidence exists right now for those looking beyond headline employment numbers.

As the heating equity markets dance with new or near all-time highs, there is a clear message from investors based on behavior:

1) "We get it." There are not many places to put capital when various central banks are lowering rates. Especially in an already well documented low rate environment. The ECB decision of lowering rates is not noble, but rather follows the footsteps of the US and UK policies of boosting asset classes via low interest rates. In short, the message is quite clearly across regions.

2) "We don't mind." The indirect responses by investors regarding QE future consequences is ambivalence. This is felt in sentiment since worry (or volatility) has failed to influence near-term discussions. Both reactions are visibly based on increasing inflow into equities within the last two weeks, as well as the lack of any meaningful selling pressure. Short-term thinking continues to look at QE as good policies while disregarding the “unknown” future results.

The stock market appears to serve more as a distraction rather than a good measure of well being; however, it still manages to serve as a great tool for increasing asset values despite this. Surely, those looking to create wealth are amazed and impressed with the multi-year bullish run. Essentially that encourages irrational behavior, and some signs of too much “cheerfulness” are persisting.

Mind Games vs. The Tangible

Why would one suspect of a rate hike? How is that justified? The numbing effect from QE/low rates combined with feel good data emphasis may have most likely created an illusionary feeling about the reality of economic health. If wages fail to grow, as exhibited in US along with soft business activities, then why would rates rise? A questions that's been pondered and asked for a long while now: ‎

“Meanwhile, everything other than monthly job gains seems to be in the pits. Wage growth throttled back in February after showing a spark, U.S. factories felt the pinch from a stronger dollar, and credit-card use hit a 14-month low in January, to name just a few.” (Bloomberg, March 17, 2015)

Perhaps, the more press releases and crafty words from the Fed the more reason to be suspicious. As more and more capital begins to blindly trust the Fed, then nasty surprises await—so far the “surprise” has not arrived, and the market is chasing trends rather than unlocking economic mysteries. The trigger for the downside surprise is the revelation of the economic weakness from consumer spending to business expansion. All the signs are there if the collective market decides to pay closer attention.

Value of Risk

The volatility index for the S&P 500 index hit annual lows last Friday. This reflects the inverse response of those seeking further reward in equity markets. Once again, the perception of pending turbulence is very low. The impact of a strong Dollar on corporate balance sheets may be discussed much sooner than imagined. Plus, at what point are companies going to justify their valuations? Regardless of a rate hike (or not) the irrational nature of the markets will require a reality check. However, valuation is more of a historical exercise than a tool to anticipate the next move. The challenge today for capital allocators is to find alternative and rewarding ideas beyond the status-quo. Energy related areas have adjusted their value after massive sell-offs, while Technology continues to benefit. A collective decline in share value is not overly feared, and risk is downplayed mainly due to the Fed’s ability to convince participants of their solid plan.

The more trust in the Fed, the lower the volatility index. Perhaps, believers are too optimistic of the Fed’s plan, some going so far as to defend some of the unexplainable valuations. At least this is what the market is saying, and investors are left to make a choice for the months ahead.


Article Quotes:

“IN THE EVENT, the FOMC caught the Street napping. The latter was so obsessed with ‘patience’ that Dr Yellen‘s totally cool and dispassionate explanation that removing patience from its statement did not indicate that it was impatient took many millions of highly paid IQ points totally by surprise. Wednesday’s knee-jerk reaction to buy stocks and bonds and to sell the dollar – the spike in dollar/euro up to US$1.10 certainly triggered a few painful stop-losses – didn’t last, but what will last, I hope, is the lesson that the Fed is no longer given to spoon-feeding the markets. Markets have become complacent and have continued to believe that central banks and their monetary policy decisions are principally here for their benefit. Dr Yellen may be grey and boring and the least charismatic Fed President in many years – being less charismatic than Ben Bernanke takes quite some doing – but that does not mean she’s stupid. The decision to make policy data-dependent buries forward guidance ¬– in my view not a minute too soon – but also shows that she and her Merry Men are not being dovish for dovishness' sake but that they will not be pushed into a tightening cycle simply because that is what the market expects. In that, they are ahead of the game and the Street had better get its skates on if it wants to catch up.” (IFR, Anthony Peters, March 20, 2015).

“The problem with northern Europeans is that they regard Greece as a typical European nation. This is not true. Greece is different. It has not experienced all the ideological movements that formed western Europe. There has been no Renaissance, Reformation or Enlightenment. It is a border country between east and west. According to Samuel P Huntington (in his The Clash of Civilizations and the Remaking of World Order), it belongs to an entirely different civilisation: the Orthodox one, together with Serbia and Russia. Having had a lot of problems with the west (starting with the Fourth Crusade, which instead of liberating Jerusalem sacked Constantinople), Greeks have always felt a deep mistrust of western initiatives. Being insecure because of their problematic identity (east-west/ancient-modern) they tend to reject change and restructuring. Theoretically they like reforms – as long as they do not affect their life.(This is why Greek politicians have been consistently sabotaging all changes, in order not to confront their electoral clients and the almighty unions of the public sector.) So instead of reforms, Greeks got pay cuts and austerity measures that resulted in a 26% unemployment rate – and a 25% loss of national income.” (The Guardian, March 21, 2015)

Levels: (Prices as of Close: March 20, 2015)

S&P 500 Index [2108.10] – Few points removed from the intra-day highs of 2,119.59 reached on February 25, 2015. Again, the positive trend is reinforced.

Crude (Spot) [$46.57] – The bottom remains fragile and undefined. In the current round of near-term trading, the $44 range may create a new test for buyers and sellers. Clearly, the supply-demand picture continues to suggest that prices at current levels seem reasonable.

Gold [$1,166.00] – Following an over 10% decline in gold since late January, some investors are wondering if there is a bottom in sight. Longer-term indicators suggest the negative cycle takes a few years to shake-out as the decline remains intact.

DXY – US Dollar Index [100.33] – Stabilized after reaching another multi-year high. An explosive first quarter thus far as the dollar strength remains emphatically in place.

US 10 Year Treasury Yields [1.93%] – Continues to struggle to hold above 2%: A common, but powerful theme from the last few months.