Market Outlook | January 12, 2015

“Something unpleasant is coming when men are anxious to tell the truth.” (Benjamin Disraeli 1804-1881)

Murmurs of Anxiousness

The last three months of trading have produced mixed emotions ranging from moments of edginess to reaffirmation of all-time highs. At times the volatility index has awakened from a deep sleep, especially as witnessed in October and December last year. But in most cases, the status-quo of higher stocks, lower volatility resumes in a customary and familiar manner. Of course, the commodity index tells the loudest story beyond oil’s recent price demise. The pricing of natural resources is adjusting as global investors re-think prior demand assumptions. Basically, global demand for commodities is slowing and that’s not breaking news. In fact, the summer of 2014 confirmed the collective collapse of commodities as exhibited by the CRB Index—a barometer for various commodities. Stability in commodity prices is desperately needed.

In a similar manner, the global yields that continue to dip lower in developed markets emphasize the lack of tangible growth and dropping inflation expectations. The US 10 year Treasury yields are now below 2%, and it may not be a short-lived stay considering other developed market yields. Spurring growth in an inter-connected world is a daunting task for governments and corporations these days. It’s evident in the struggles of Emerging Markets that capital is flowing into the US dollar at a faster pace. That said, tensions define most of the set-up that has formulated in recent weeks.

The Rate Challenge

The “rate hike” chatter is obsessive in financial circles, but justifying a strong economy in classic terms is rather difficult. The Fed’s narrative is hazy in many ways. To hike rates there needs to be growth, while keeping rates near zero is unnaturally risky. To explain, the economic numbers (i.e GDP, unemployment data), if taken at face value (without skeptical analysis), may lead one to conclude that there is a strong economic improvement. Yet, wage growth was not overly convincing, increasing healthcare costs led to the creation of more part-time jobs, and consumers’ financial health were not as vibrant as some painted.

“Wage growth is currently so low the Fed can afford to wait to see it actually pick up. Indeed, to be consistent with the Fed’s 2% inflation target, wages would need to be increasing by 3% to 4%.” (WSJ, January 9, 2014)

Thus, the Fed faces a known challenge between justifying and pleading that there is strength in real economy. At the same time, low inflation expectations and lower yields in financial markets do not support the glossy theory of low rates leading to more growth. Regardless of stock markets record high-like behavior, to claim a victory on the success of QE is misleading. Amazingly, in 2009 and 2010, many skeptics claimed that the zero interest rate policy is unhealthy and unsustainable. Now, a soaring stock market fails to reflect the angst in the consumer market. Therefore, for the Fed to blatantly ignore the behavioral responses of the financial market does not seem reasonable. The mystery of how the Federal Reserve responds draws a lot of opinions, but no hike approach should not be as surprising as some pundits think. In the same way that inflation did not end up being a major issue, there is a chance that higher US interest rates do not materialize as forecasted.

Bargain Search

Opportunist participants will seek bargains in oil prices as well as in Emerging Markets. Certainly, the drop in oil prices is still being understood. The speculation of a bottom in crude prices remains a big and unknown debate. Similarly, the impact of oil prices on the US junk bond markets remains suspenseful, which raise questions about both the risk and reward ahead. The Russian and Brazilian markets also seem appealing given the recent plunge. In the case of Russia, overcoming the big blow from the energy crisis surely is one of the highest risk-rewards lurking in the current market. The stimulus for an upside EM move is not fully understood as commodity based economics and currencies limp and attempt to recover. If investors feel that the US stock market is overvalued then a migration to EM’s is a possibility. However on an absolute basis, grasping the upside potential of developing markets seems much more difficult to decipher. Perhaps, the mystery is what attracts the risk-takers that seek to catch a new trend.


Article Quotes:

“The announced merger last week between China’s two train makers will enhance the country’s ability to penetrate foreign markets and expand transport infrastructure into the periphery. State owned CSR Corp and China CNR are already the world’s leading manufacturers of rolling stock with annual revenues of $16 billion each and combined capitalization of $26 billion, FT reported. Their main customers are China Railway Group (CRG) and China Railway Construction Corporation (CRCC), the nation’s builders of railways and other infrastructure. These companies are also refocusing their attention overseas. CSR and CCNR were split off from the same parent in 2000 to promote domestic competition. As China’s business increasingly looks abroad for projects, the combined company will rip benefits from economies of scale and compete more effectively with foreign companies such as Germany’s Siemens, France’s Alstom, Canada’s Bombardier, and Japan’s Kawasaki. This move gains from the nation’s favorable political course. In November 2013, China’s leader Xi Jinping proposed to build the “Silk Road Economic Belt,” envisioning the development of transport networks from the Pacific Ocean to the Baltic Sea. Towards this goal, China is willing to invest the initial sum of $40 billion for building ports, roads and rail links. Undoubtedly, the combined CSR-CCNR company is determined to play a key role in the revival of the Silk Road transport corridor.” (Silk Road Reporters, January 9, 2015)

“A more interesting perspective on Brazil’s lack of trade openness can be obtained by looking at the number and characteristics of exporting firms. The first result is that very few Brazilian firms export (see World Bank 2014). The share of exporters among all formal-sector firms is less than 0.5%. Indeed, the absolute number of exporters in Brazil – less than 20,000 – is roughly the same as that of Norway, a country of just over five million people compared to Brazil’s 200 million. This means that, while in Norway there is one exporting firm for about every 250 Norwegians, the ratio in Brazil is one for every 10,000 Brazilians. Of course, Norway and Brazil are vastly different countries. Norway is one of the richest countries in the world; its GDP per capita is almost ten times that of Brazil. Norway’s total GDP is about a quarter of Brazil’s, indicating that Norway can be more aptly described as a small open economy… Out of all Brazilian exporters, a much smaller number of firms make up the overwhelming share of exports – the top 1% of exporting firms generates 59% of total exports, while the top 25% of firms account for 98% of exports (Exporter dynamics database). We also observe little dynamism among Brazilian exporters. Even given the small number of exporters, Brazil has a very low entry rate – very few firms become new exporters. On the flipside, Brazilian exporters have a very high survival rate, meaning that the few firms that export are likely to continue doing so.” (VOX, January 11, 2015)

Levels: (Prices as of close: January 9, 2015)

S&P 500 Index [2044.81] – Early signs of slowing momentum. A break below 2250 is noteworthy for technical observers. Plus, a break below the 200-day moving average can spark additional selling. For now, a sideways range between 2000-2080 is forming in this wobbly set-up.

Crude (Spot) [$48.36] – Struggling to settle at a bottom. A few weeks ago the $54-58 range appeared to be the bottom. Now, the January 7, 2015 lows of $46.83 stand out as a potential low, but the chaotic sell-off is still unsettled.

Gold [$1,206.00] – Over last two months, Gold prices continue to indicate the bottoming process at around $1,200. After surpassing the 50-day moving average ($1,191), signs of very mild momentum appear. At least a pause in the selling pressure is visible.

DXY – US Dollar Index [91.08] – Multi-year highs continue as the momentum is heating up further. The unsettled global markets prefer the dollar over other currencies. Cyclically a recovery in the DXY appeared long over-due and is not materializing.

US 10 Year Treasury Yields [1.94%] – Below 2% mark an alarming new level. Last time, in October 2014, yields reached 1.86% and quickly bounced above 2%. After peaking at 3.05% in January 2014, yields have been on a constant decline reaffirming the bond rally.

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