Market Outlook | January 5, 2015

“We must never neglect the patient's own use of his symptoms.” Alfred Adler (1870-1937)

Symptoms Reawakening

In summer 2011, the Eurozone (EZ) crisis mesmerized the financial markets by making “never-ending” headlines. Of course, those realizations shocked various markets, forcing European bond yields to go much higher. Doubts were raised about the Southern European market as bailouts averted disastrous conditions. Fascinatingly, those were only temporary solutions.

As some pundits have pointed out, the EZ economic crisis converted into a political crisis. The structural set-up for policy making is inefficient and helped drag out this unsolved matter even longer. That’s the core issue brewing today, as political leaders use this crisis as the basis for talk rather than plans for economic revival. Basically, it’s challenging to solve problems when various nations have diverse interests. The mainstream media has documented the conundrum that continues to plague Europe. This conundrum has provided a relative edge for the US financial and political system, which became a major market theme from 2011-2014.

Since then the EZ debt crisis symptoms were not eliminated from the banking system; even though bailouts via bond-buying calmed markets. But the political debate lives on. Surely, economic revival is hardly visible, which increases the tensions on the street level. In the last two years, bond yields in Europe are quiet and calm, and in Germany 10 year bond yields are near 0%.

“German five-year yields dropped below zero for the first time ever, touching -0.007pc on the first day of new year trading, implying that investors are willing to pay the German government to store their money for the rest of this decade.” (The Telegraph January 2, 2014).

Risk and volatility have been priced low recently, which has been part of the on-going global theme. Additionally, inflation remains way below prior expectations in developed markets. This mirrors the decline in commodity pricing and some wonder if too little inflation is an even a bigger problem. That said, it is difficult to visualize organic growth in the real economy, even in periods where financial markets' turbulence was held in check. This begs the question if markets are pricing risks in an accurate manner.


Revisiting Old Notes

As 2015 approaches, revisiting the notes from the volatile European summer of 2011 is a worthwhile start. This is better suited than the calm 2014, where ECB promised stimulus and most EZ concerns seemed under control. There will be future trading days where the EZ will dominate global market action. In the days ahead many anticipate volatility spikes driven by talks of Greek bonds or Greek exit from the Euro area. Other times, false signals (or rumors) will emerge due to bluffs by political actors. This may lead to irrational financial market spooks and chatter. The narrative of economic concern, mixed with politics, is set to create substantial discussions or worries. As for tangible growth or solutions, plenty of issues remain uncertain.

Realizations

In the last few years a few lessons have become clearer:

1. When bond yields continue to reach extreme lows, one concludes that growth is less visible.

2. Similarly, when Crude prices drop dramatically, then it is fair to say emerging market (mainly China) growth slows. This at least serves as a confirmation for doubters.

3. When the US dollar makes multi-year highs, it reflects the trouble of other currencies including weakness in Euro.

These three points are being digested by the market. They even give US stocks further reason to seem attractive—better returns than government bonds and less riskier than commodities or Emerging Markets. Obviously, these conclusions can lead to investors chasing returns and an “oversimplification” of risk. The danger in weeks and quarters ahead is the understanding of the risks rather than understanding what’s transpired during the last 5-6 years.

Thus, quantitative easing is the crux of policy discussion. If low rates fail to fuel a substantial economic stimulus (at least a meaningful one), then shouldn’t markets respond? Many wonder if the time for outrage in markets is long overdue. Beyond the outrage, analysts are trying to figure out if low oil prices boost consumers' spending and if a weaker Euro helps the German economy. Maybe there are new trends to exploit as realizations are digested.

However, what’s the cost of betting on the status-quo (high stocks, low volatility and low yields) staying the same? A suspenseful question with no convincing alternative answer thus far. If something seems without risk for too long, then some would presume it is likely dangerous. Yet danger has not affected the markets for a sustainable period. Perhaps, this first quarter could provide clues as to what markets call or view as “danger.” Until then, the status-quo remains the easy choice, but it is unknown if that’s the right choice for this year.

Article Quotes:

“But the ECB is not wholly responsible for the Eurozone disaster - after all, it has been forced to act as fiscal enforcer because of the absence of a unifying fiscal authority. The truth is that the Eurozone is in an unstable equilibrium. Inexorable forces are forcing it towards either consolidation or breakup. Consolidation means creation of a supranational fiscal authority with tax-raising and bond-issuing powers of its own. Breakup...Well, we all know what that means. QE will do nothing to fix this. Indeed nothing the ECB can do will deal with the fundamental problem of an incomplete and unstable monetary union. There is no political will for consolidation, and the growth of nationalistic political movements makes the disorderly exit of one or more Euro member states increasingly likely. This is the "black hole" theory of the Eurozone. Inexorable gravitational forces draw the countries of the Eurozone ever closer together. To start with, only the smaller and weaker countries experience the severe economic dislocation that is an inevitable consequence of the pull towards consolidation. But as they approach consolidation - the "singularity" - the economic depression of the periphery spirals out to core countries, including the most powerful. Even the mighty Germany is slowing...” (Pieria, Frances Coppola, January 2, 2015)

“Russian Arctic offshore energy efforts are in a period of unwelcome pause, and the flight of Western companies in the face of sanctions imposed by their home countries has left the future of these efforts up in the air. But this state is unlikely to last for long. Western firms have left incredible opportunity in their wake, and China is in the perfect position to benefit. Over the past 10-15 years, the People’s Republic of China (PRC) has systematically increased its activity in the high north through various avenues. Russia’s current relations with the West are likely to substantially boost this enterprise, which should concern the international community given the importance that the Arctic will play in the years to come. The region’s massive resource reserves, China’s growing presence, Chinese challenges to regional Arctic governance, and the current standoff between Russia and the West are a potentially potent combination. This situation should be recognized and efforts should be made to mitigate possible negative consequences. These efforts, however, should not be directed at preventing Chinese Arctic activity. China’s wealth and capital make it an important partner for Arctic nations in developing the high north, and it holds legitimate interests in the region. Rather, China’s entry into the Arctic must be managed responsibly through international channels to mitigate or prevent any harmful effects. Doing so may also create a rare avenue through which the West can seek common ground and understanding with Russia that can be built upon.” (The Diplomat, January 3, 2015)

Levels: (Prices as of close: January 2, 2015)

S&P 500 Index [2058.77] – After few days of trading above 2080, the index has retraced a bit. Of course, given light trading volumes of late December, jumping to a conclusion is pre-mature. All-time highs were set December 29th at 2093.55.

Crude (Spot) [$52.69] – Struggling to find a bottom after the bloody sell-off. Early signs of a bottom remain difficult to call as Friday’s lows near $52 are on the radar for keen observers.

Gold [$1,206.00] – More evidence of a bottoming process around the $1,200 price range. Interestingly, the 50 day average stands at $1,195.

DXY – US Dollar Index [91.08] –Another multi-year high put an exclamation point to the Dollar’s strength in 2014. From a long-term point of view, this strength appears set to continue as positive momentum continues to develop.

US 10 Year Treasury Yields [2.11%] – A drop below 2% would not be surprising at this junction. An October 15th low of 1.86% is in the realm of possibilities.



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