Market Outlook | June 1, 2015

“Truth lives on in the midst of deception.” Friedrich von Schiller (1759-1805)

Summary

A mixture of outrage and dullness are playing out in financial markets. Two opposite feelings that co-exist and paint a picture of today’s inter-connected market realities. Outrage is driven by the disconnect between deteriorating economic conditions for business operators versus a near all-time highs stock market. Meanwhile, the known trends of the Central bank led to low rates, elevated equity prices, weaker commodities, and an increased demand for US assets define the dullness. Similarly, the known risks of Eurozone uncertainties, BRIC slowdown, and low inflation are also dull in providing a game changing catalyst. Interestingly, this dullness might be deceiving, but the ultimate judgment (or truth discovery) has not arrived for this bull market.

Outrage & Dullness

Some observers are outraged by the under emphasis regarding increasing signs of a weak global economy. Weak commodity demand, low inflation, and slow growth rate appear both in Developed and Emerging Markets. Here is one example last week: “The Institute for Supply Management-Chicago Inc.’s business barometer fell to 46.2 in May from 52.3 the prior month, a report showed Friday. Readings lower than 50 indicate contraction” (Bloomberg, May 29, 2015).

Yet, these fragile revelations day after day are quickly trumped by the long drawn out “miracles” of QE. In turn, low rate policies have driven asset prices much higher and as a consequence have created some ease from massive collective and visible worries. However, the verbal artistry in the Fed’s public statements and ongoing posturing regarding rate hikes are turning out to be massively misleading.

Dullness is when volatility is nearly dead, while the synchronized lift off in equities remains in full gear. This is navigated and credited to central banks that have influenced asset appreciation while calming nerves and dramatic worries. In addition, the constant over-glorification of the US recovery is triggering a misleading feeling of safety. The more the bull market extends, the more the trust in the Fed strengthens. Sure, there are some bright spots in the economy, but these are very limited and not quite broad based. The discussion points regarding catalysts and trading patterns of this market are dull, but the uncertainty that’s building up is huge (and has been a plenty). Deciphering when this dullness turns into outrage is the question for money managers of all kinds. Inevitably, that’s how it ends, but timing is the mysterious element that determines one's fortunes in this game of speculation.

Mechanical Drivers

Beyond the low rates, there are forces that elevate stock prices:

1) Companies buying back their own shares and reducing the available supply of shares.

• “In April, a staggering $141 billion in buybacks were authorized—the most ever in a single month and an increase of 121 percent from April 2014. If this pace keeps up, a record $1.2 trillion in buybacks could be reached by year’s end, crushing the all-time high of $863 billion set in 2007.” (Valuewalk, May 31, 2015)

2) Increase in Merger & Acquisitions continues to reduce available company shares in the market place.

• “There have been $406 billion in deals to buy technology and telecommunications companies so far in 2015, on pace for the highest yearly total since 2000, after hitting a nearly decade-high mark last year, according to research firm Dealogic.” (Wall Street Journal, May 29, 2015)

3) The lack of reliable, safe, and liquid markets with stable currencies results in another favorable reason to own stocks. In this respect, US markets remains resoundingly attractive for capital allocators.

These technical or mechanical factors play a massive role in driving price direction. Surely, this is not the best fundamental description of the real economy in terms of wages, job creation, and sales. Nonetheless, these factors cannot be dismissed when assessing liquid markets.

Dealing with paradoxes

There are few contradicting factors that tell the story about trading and investing in this market. A multi-year bull market is adored, of course, given recent success, but also feared since it has had a good run. Thus, recognizing these points is vital:


• The more the Fed talks about the “strong” possibilities of rate hikes, the more confirmation of economic slowdown.

• The more interest rates remain low, the more folks feel justified taking additional risks by chasing yield.

• The more the volatility index declines, the more unforeseen risk ahead due to complacency.

This is a mind game, after all, where the trickery is plenty and truth discovery requires sharpness and some luck as well.

Growth Desperation

It has been discovered that the BRIC's are struggling, especially in 2014. Brazil has felt pain for a long while, Russia is affected by several visible forces, and China is reevaluating its status as a growth story. The investment returns and excitement are not the same as last decade, and as usual frontier markets offer more risk and more reward for high return seekers. In the context of a sluggish developed world, where rates are low and "safety" is the driver, some growth stories will be sought after. For now, the biggest EM story revolves around China as bubble like symptoms persist. Last week's sharp and heavy sell-off’s in Chinese markets begs another question about inter-connected "risk" and early awakening of crisis-like mindsets:

“Were Chinese stocks to plunge, that would weigh heavily on the economy — and, in turn, the rest of the world. It’s worrying, then, the Shanghai Composite fell by almost 7pc on Thursday, one of its steepest single-day drops for 15 years.” (The Telegraph, May 30, 2015)

Meanwhile, the dollar strength is reviving, as it seems to do during chaotic climate for Emerging Markets. Unlike the woes of Brazil and Russia, any sensitive response in China can spark far greater reaction. Perhaps, that’s the catalyst for another tangible reminder of the slowdown in BRIC’s.

Article Quotes:

“Ironically enough, such monetary binge from a heavy-loaded easing by the PBoC can only harm the Chinese economy. The key reason is that it will continue to feed leverage by Chinese agents, by artificially lowering the cost of funding, at the worst of all times, namely that of a renewed reform push. The low shadow of the FED’ recent history, namely the complacent idea of a Great Moderation right before what has ended up being the US worst financial crisis in decades should constitute an important warning signal for the PBoC in its current deliberations. China has already pushed reforms during other periods of financial fragility. The most recent of all occurred during the early 2000s, when the banking system was saddled with bad debts. However, there were a number of key factors that helped the Chinese authorities manage that situation without major consequences. First and foremost, China’s debt level was very moderate. Second, potential growth was much higher since China was enjoying an earlier stage of development and urbanization. Third, the economy was smaller and closer so the rippling effects on the rest of the world remained much more limited. Today’s situation is not only more worrisome but also much harder to cushion. First of all, China’s overall debt level has more than tripled from its 2007 level and it is also very large when compared with other emerging markets in terms of its percentage to GDP.” (Bruegel, May 5, 2015)


"With the fourth-highest yields among developing nations, South African debt attracted foreign investors even as the global sell-off accelerated. Non-residents bought a net 909 million rand ($77 million) of South African bonds on May 13, bringing inflows this month to 1.4 billion rand, according to Johannesburg Stock Exchange Data. Rising gasoline and food prices, together with above-inflation wage demands by government workers and gold miners, have reignited price pressures in Africa’s most-industrialized economy, weighing on fixed-income investments. The yield difference between five-year fixed-rate bonds and similar maturity inflation-linked securities, a gauge of investors’ expectations for inflation over the period, climbed 1.93 percentage points to 6.46 from a record low in January." (Bloomberg, May 14, 2015)


Key Levels: (Prices as of Close: May 29, 2015)

S&P 500 Index [2116.10] – Despite dancing with all-time highs recently, surpassing the 2120 level for a reasonable period has been a challenge. Certainly, doubt is building in bulls' minds based on the narrow trading range for weeks.

Crude (Spot) [$60.30] – The spring rally from $42-60 showcased: 1) After a multi-year lows, a recovery bounce was inevitable 2) Last summer highs of $100 are not on the radar in the foreseeable future 3) Stabilization in pricing is taking place within the cyclical downtrend.

Gold [$1,225.00] – For almost two years, Gold has struggled to rise above $1,200 and refused to drop below $1,200. Basically, the bulls are realizing that gold trades like a commodity unless there is major shift in financial markets. Lack of catalysts keeps it in a narrow trading range.

DXY – US Dollar Index [96.90] – After a three month pause from the explosive dollar strength, some revival is visible, especially since May 14. Signs of dollar re-acceleration loom as the strongest and highly demanded currency.

US 10 Year Treasury Yields [2.12%] – On three occasions yields failed to hold above 2.30%. Seemingly they are stuck between holding above 2% and lacking upside momentum.







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