Market Outlook | August 3, 2015

“Reality is merely an illusion, albeit a very persistent one.” (Albert Einstein 1879-1955)

Summary
‎
• US equity markets continue to trade sideways as credible upside catalysts remain very scarce.
• The justification of a US rate hike due to improving economic conditions is not fully convincing to observers despite the Fed’s optimism.
• The commodities cyclical downturn has reaffirmed negative results on resource-based companies and countries.
• Chinese regulators panicking, bond yields remaining low, and softer housing data raise more growth questions.


Same Message, Different Paths

‎In a world where Private Equity firms are desperate for investment ideas or are waiting for distressed opportunities, we can surmise that the health of the global economy is not that vibrant. The current status is more like an ongoing struggle to find favorable yields and growth stories. Real economies are in a rut, policymakers have failed to generate growth policies, and stock markets march to a different rhythm.

Larger private equity firms are looking ahead and are not chasing existing or riskier returns. In fact, the continuation of recent demises is viewed as creating wealth in future years ahead. Perhaps, this is one clue for the casual observer from an operator in the investment world:

“The firm [Oaktree] has prepared for a coming crisis by gathering almost $10 billion for a new distressed debt vehicle, Opportunities Fund X. A further slump in commodities prices or the Chinese stock market may set off enough opportunities for Oaktree to seek more money, Karsh said.” (Bloomberg, July 28, 2015)

Certainly, the commodity and emerging market weaknesses, which are inter-linked, are visible now. The CRB index, which tracks major commodities, is near 2008 lows, which reflects the multi-year demise in commodity pricing. Crude oversupply is quite obvious now, and the weaker demand only adds to further selling pressure.

Certainly, the impact of commodities is being felt in China as much as Texas. Thus, the commodity bearish cycle is too inter-connected to dismiss and signifies a slowdown relative to last decade. In terms of China, it is a much bigger impact of a slowdown. Despite the headline 7% GDP number (which is doubted among seasoned investors), there is desperation and pain, which explains the numerous stimulus efforts. A 7% GDP does not require various stimulus efforts if it was real and natural. In fact, the whole Chinese rally was induced by policymakers rather than forming naturally. Now the same Chinese regulators that were celebrating a market rally are the same folks panicking these days:

“Their [Chinese regulators] determination to support the stock market has undermined all their earlier rhetoric about wanting to open up investment opportunities in their local markets. Stock suspensions, short selling bans, forced purchases of shares by state owned investors and a ban on sales of shares by leading shareholders have all the hallmarks of a regulator panicking in the face of market forces it can’t even begin to comprehend or control.” (CMC Markets, July 30, 2015)

That said, China’s regulators are panicking; their shares are selling off fast and commodities based economies are hurting growth, as well. Would justifying a 7% GDP be more daring than raising interest rates in the US this fall? Perhaps. In other words, leaders of the financial world may aim to use crafty calming words, but the markets/data points are screaming massive warnings.

Substance vs. Hype

When considering housing data and consumer well-being, there is further reminder of the slowdown. The momentum of recent growth is showing signs of pausing, as well:

“New U.S. single-family home sales fell in June to their lowest level in seven months and May's sales were revised sharply lower, in what appeared to be a minor setback for the housing market recovery.”(Reuters, July 25, 2015)

The Q2 GDP was mixed and the Fed's messaging of the rate hike in 2015 is seeming less plausible, especially from highly skeptical participants. Job creation and wage growth are not quite materializing as desired. Personal consumption is one area optimists find some encouraging news, meaning the consumer is spending more. Plus, the hope is for better second half recovery, but seeing a dramatic rosy picture (outside of increasing government spending) is becoming a daunting task.

Housing, GDP, and commodities were at the forefront last week as the US 10 year yield closed below 2.20%. Now, with that said, how can the Fed justify a rate hike? A nerve-racking question that creates further questions while waiting for a suspenseful answer. Yet, the Fed narrative might be disconnected from the day-to-day tangible matters. That’s the frustrating element in which illusionary narratives trump harsher realities.

Large, new tech and biotech are innovative enough to be in demand. After a quick glance of investment opportunities in China, Greece, and Brazil, folks are quickly rushing to own Nasdaq-based shares and dollar-based currencies. Innovation is expanding as commodities remain deeply out of favor.

The last twelve plus months reaffirmed the strength in the dollar. Now looking ahead the next year or so, the impact of the dollar strength on corporate earnings is a vital indicator to shareholders:

“The sharp rise in the US dollar may slice more than $100bn off dollar-denominated revenues at some of America’s largest multinationals this year, a sum larger than the sales of Nike, McDonald’s and Goldman Sachs combined, according to a Financial Times analysis. The FT analysis showed a $28.9bn loss to sales in the second quarter so far, or roughly 3.3 per cent of the $863bn in reported revenues. The figures compare with $23bn in the first three months of the year, or 2.7 per cent of first-
quarter revenues.” (Financial Times, August 2, 2015)

Managing Disconnects

By now the massive disconnect between equity markets (in US and Europe) and tangible economy is not a shock to most observers. At the same time, share prices rose due to low rate policies across many countries, which reiterates lack of real economic strength. The moment of truth for markets is long overdue, at least in developed markets. At least Emerging Markets felt some pain both in the illusion driven markets and real economy. As the Fed touts a strong message of rate hike, one should be alert enough not to dismiss other realities and warnings that are glaringly visible. The rest is the art of messaging, politics, and calming attempt by Fed to slice and dice at convenient truths. Yet, markets have been at the mercy of the narrative sculpted by the Central Banks. Thus, risk takers and risk managers must be prepared to distinguish hype from reality.

Article Quotes:

“European Central Bank (ECB) President Mario Draghi wants stricter rules for the banking union. French President François Hollande is calling for a separate economic government for the monetary union. And in Brussels and Berlin alike, financial experts are devising plans to provide the Euro Group with the same tool that has proven to be so successful throughout history: its own tax. If the plans were implemented, it would constitute the breaking of a taboo for the Continent. The people are used to the fact that some powers are shifted to Brussels as part of European unification. But there is one thing even the most devoted proponents of Europe had shied away from until now: giving the EU the right to impose taxes, a power many felt the member states should retain. It had long been a given that this was something the European people would never accept… But with European leaders shuttling regularly back and forth to Brussels to attend crisis meetings on an almost weekly basis, public opinion has shifted. Proponents of a European tax say that if revenues and expenditures were centrally administered, at least in part, a single government could no longer blackmail the others.” (Spiegel Online, July 30, 2015)

“Revisions to the U.S. gross domestic product since 2011 reinforce the shift to a slower era of economic growth and underscore the difficulties the Federal Reserve faces in gauging just when to inch interest rates away from the zero-lower bound.
According to the Bureau of Economic Analysis, real GDP from 2011 to 2014 increased at an annual rate of 2 percent, a downgrade from the prior estimate of 2.3 percent. The Fed's July statement, meanwhile, indicated the central bank will raise rates when it has seen ‘some further improvement in the labor market’ and is ‘reasonably confident’ that inflation will trend toward 2 percent. During the press conference following the Fed's June statement, Janet Yellen made a reference to the role that the output gap—the cumulative difference between estimates of how much the economy can grow and how much it has actually grown—plays in the formation of monetary policy. ‘I think we need to see additional strength in the labor market and the economy moving somewhat closer to capacity—the output gap shrinking—in order to have confidence that inflation will move back up to 2 percent,’ she said. Since potential growth cannot be observed directly but only estimated, economists typically turn to other indicators, such as inflation and unemployment, to get a sense of just how much excess capacity exists.” (Bloomberg, July 30, 2015)







Key Levels: (Prices as of Close: July 31, 2015)

S&P 500 Index [2079.65] – An ongoing tug of war between 2060-2120 keeps occurring with a directional battle playing out. Suspenseful, wobbly action occurs as the 50-day moving average of 2099.36 tells most of the story.

Crude (Spot) [$47.12] – The recent severe drop in prices from $61.57 (June 24, 2015) to below $50 remind us of expanding supply and limited demand—A deadly combination, especially in a bearish commodity cycle. Observers are wondering if current levels can stabilize the sell-offs.

Gold [$1,098.40] – Like all commodities, the sell-off continues. Holding above $1,200 proved to be a major challenge for buyers. Long-term charts suggest further downside pressure ahead despite the near-term appeal of being “discounted.”

DXY – US Dollar Index [97.24] – After months of making an explosive run, the dollar index is pausing. March highs of 100 remain the upside target and the lows of 94 are at the low end of the range.

US 10 Year Treasury Yields [2.18%] – For weeks a tight range formed between 2.20-2.40%. This is a fragile state in which yields may go lower if the status-quo remains in tact. A potential move below 2% could spark a noteworthy reaction.






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