Market Outlook | November 2, 2015

“The first step toward change is awareness. The second step is acceptance.” (Nathaniel Branden)

Summary

The status-quo continues to be well defined as low interest rate policies remain in place from Europe to Japan to the US. The ultimate risk is not clearly pinpointed by the consensus in the current narrative despite identifiable economic worries and looming global tensions. Market ‎participants are not overly bothered by a massive near-term risk or volatility based on recent actions. However, there is a very clear distinction between developed and developing markets, yet again. Developed markets are deemed safer and more liquid. Meanwhile, the uncertainty in Emerging Markets (EM) is still high, as practical economic concerns go beyond BRICS given recent weakness.

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Innovative themes in technology and healthcare have been a bright spot from shareholders perspective. Unlike commodities and EM themes, innovative areas have mostly evaded the cyclical global downturn, while keeping investors optimistic on future potentials. This is illustrated by the Nasdaq 100 index which is around all-time highs, reflecting the massive appeal of large cap technology over financials, energy and materials. The more EM based groups crumbled the more Tech themes became relatively attractive for capital allocators. Of course, questions about tech valuation linger‎: Is it a bubble or not? Amazingly, investors have showcased willingness to pay-up for growth companies even now late in bull cycle. Of course, when the options of "encouraging" ideas are vastly limited, then premium is paid by purchasers of US tech. surely, this momentum may lead to “over-valuation” discussions in some circles, as that's only natural. Nonetheless, the demand for growth ideas (especially US dollar based investments) outweighs the grumblings of further risk at this movement.

Sour chess match

Chinese markets summer woes are not fully digested by some in financial market. Still the depth of financial crisis /slowdown in China is not bluntly discussed or clearly discovered. One thing is certain, the weakness in China (i.e declining GDP) is strongly tied to the softer commodity demand. In terms of foreign policy, “desperation” (after shaky economic conditions) is a key factor that may leads to multiple war or tensions. This is possible especially when leaders feel they have less to lose. Clearly, the Crude oil collapse last year has reshaped the mindset of key global leaders. Russia's economy has collapsed leading Putin to showcase further aggression and explore military options from Ukraine to Syria. Saudi Arabia is not thrilled by Oil collapse, as Iran enters the oil market that's already seeing softer demand and expanding supply. Similarly, the affliction in the energy sector further damages the US economy as well, given last decade’s critical contribution to the real economy. Thus, non-democratic nations have less to lose when the global and inter-connected economy’s slowdown leading to bitterness and hostility. Eventually, this creates danger in foreign policies which eventually turn into market risk quicker than imagined. Perhaps, "foreign policy" risk deserves more consideration these days as it impacts global wealth creation.

Current Setup

For now, beyond fundamentals or day-to-day macro data points, there are few key points to consider.

Three factors helping elevate US stock prices:

1) Lack of alternative investment options as EM currencies, economies and investments remain very sour. US Dollar based assets are believed to be the best option as high demand for US equities is clearly visible in the past few years.


2) Share Buybacks - Companies buying own company shares leads to less available shares in the marketplace which ‎reduces the overall supply of available shares for investors. Limited shares essentially contribute to a bullish bias as that trend remains intact.

3) Low and lower yields drive investors’ behaviors as investors seek shelter into overcrowded "safe assets". In a world where one is risk sensitive, then US stocks and government bonds stand out versus other markets.‎ A sign of slow real economy growth in which the Fed lacks basis for a rate hike.

The major question that lingers is which of the three factors above will change first? In other words, what catalysts will change the status quo? At this stage, Fed's hints of rate hikes have come and went filled with tons of posturing and limited substance.

Meanwhile, buybacks seem addictive as a mechanical tool that enables companies to increase their share prices. Finally, the EM fundamentals are not going to turn positive overnight. That said, there is a surprise element awaits, in which a synchronized global sell-off can be triggered anytime (like the August short-lived panic). Like most shocks, the timing is unknown but the clues are hardly mysterious. Until then, these status-quo factors remain annoyingly in place for market observers.

Article Quotes:

“That is what’s happened among US businesses as their aggregate return on capital has increased. Intellectual property–based businesses now account for 32 percent of corporate profits but only 11 percent of capital expenditures—around 15 to 30 percent of their cash flows. At the same time, businesses with low returns on capital, including automobiles, chemicals, mining, oil and gas, paper, telecommunications, and utilities, have seen their share of corporate profits decline to 26 percent in 2014, from 52 percent in 1989 (Exhibit 2). While accounting for only 26 percent of profits, these capital-intensive industries account for 62 percent of capital expenditures—amounting to 50 to 100 percent or more of their cash flows. Here’s another way to look at this: while capital spending has outpaced GDP growth by a small amount, investments in intellectual property—research and development—have increased much faster. In inflation-adjusted terms, investments in intellectual property have grown at more than double the rate of GDP growth, 5.4 percent a year versus 2.4 percent. In 2014, these investments amounted to $690 billion.” (McKinsey & Company, October 2015).

“Emerging markets such as Brazil, Indonesia, and Turkey among others, have become darlings of international investors over the past decade, attracting capital to their fast-growing industries and delivering a boost to the global economy. But unlike the United States, United Kingdom, Japan, and, increasingly, China, emerging markets have an inherent weakness: few investors are willing to stockpile their currencies. If cracks are detected in an economy, investors will dump the local currency and extract dollars, leaving behind devalued reais, rupees, and liras. This dynamic has caused crises in several regions over the past decades. …. Private capital inflows to emerging markets surged to over one trillion dollars in 2010. Inflows to emerging markets hit a record of $1.35 trillion in 2013 and declined to $1.1 trillion in in 2014, according to the Institute of International Finance (IIF), representing the reversal of a trend of elevated outflows from developed economies since 2009. (There was a "flight to quality" in 2008–2009, when investors bought U.S. financial assets in the depth of the global recession). Net capital flows to emerging markets were forecast to decline in 2015 for the first time since 1998, the IIF said in an October report.” (Council on Foreign relations, October 28, 2015)


Key Levels: (Prices as of Close: October 30, 2015)

S&P 500 Index [2,079.36] – Most of the year the index has spent plenty of time between 2050-2100. Attempting to climb back to 2100 after a near 12% run since September 29, 2015 lows.

Crude (Spot) [$46.59] –Once again prices remain below $50 as buying momentum remains tame. The supply/demand imbalance is being sorted out as participants reset expectations.

Gold [$1,142.35] – Failed to hold above $1,180 in mid-October which reiterates the cycle slowdown is still in effect. The bottoming formation is taking much longer than desired by goldbugs.

DXY – US Dollar Index [97.12] – Remains strong. Although not above annual highs of 100.39 reached in March, on a relative basis the strength is intact. This highlights the fragile conditions of emerging market currencies.

US 10 Year Treasury Yields [2.14%] – In August and early October yields reached the 1.90%, reflecting a slow growth environment in which rate hikes are not justified. Recent bottoming around 2% requires follow-through to showcase some shift in trends.