Market Outlook | December 28, 2015

“Don't tell people how to do things. Tell them what to do and let them surprise you with their results.” (General George S. Patton)

Summary

The first wave of global weakness is being recognized as uncertainty looms even greater than in years prior. The market and participants have observed and reacted already. The disconnect between the investor world vs. the real economy cannot be sustainable for too long. Thus, a second wave of discovery and responses awaits for this cycle as we head into an election year. That said, there are a few thoughts and themes to ponder for early 2016.

Slow Economic Growth Escalates Global Tension.

The demise of EM and drawn-out negative cycle for Commodities come with major consequences beyond investors. There is a critical Foreign policy element to this cycle slowdown where wealth creation has dissipated. Clearly, Russia has felt the pain from oil decline as much as Saudi Arabia and other oil producing nations. The Turkish economic slowdown has led to a regime focused on arrogance, nationalism and anti-secular behaviors. All these impact the business world. The proxy war in Syria reflects the sharp escalation in desperation; and leaders build nationalism, since glorifying poor economic growth is not an option. Iran entering the Oil market not only impacts supply, already filled with glut, but also creates more tension with rival neighbors in sectarian wars (Saudi Arabia). Brazil's abysmal performance has failed to revive creating more capital outflow, as social tensions have been brewing a long while; and shattered investors’ confidence of all kinds has yet to be flushed out.

The impact on oil-heavy economies is huge. It is being felt and will continue to be felt. The fall out is ugly and uglier as exhibited in Nigeria recently:

“Nigeria is running against strong economic headwinds right now with oil prices below $40 and foreign reserves below $30 billion—enough to pay for maybe six months of imports at most. The Central Bank governor, Godwin Emefiele, has introduced ‘demand management’ in response to the challenges he’s faced with.” (Quartz, December 24, 2015)

Clearly, the weak eurozone has triggered political changes (via vibrant responses) from immigration to "Brexit" to varying resolutions to the Greece collapse, which is still playing out. ‎The far-right is gaining a voice in Europe as nationalism appears like a substitute to the failed "globalization" model. In other words, a nostalgic approach by politicians is gaining traction rather than the ambitious wealth creation hopes of the past. This is due to the sluggish, "barely above-zero" growth rates that have created frustration rather than optimism. Of course, the low interest rate policies can actually lift stocks, so investors might take a closer look. For example, the German stock market has had a positive 2015. Perhaps, momentum chasers look to double down in Europe by betting on some help from ECB and the relative attractiveness given the limited options. This would be hardly surprising.

‎Varying Central Bank Policies Create Opportunities and Volatility

The uniform approach by central banks to maintain low interest rates has been a common and overly-familiar ‎approach in recent years. With US raising rates, albeit symbolically rather than meaningfully, it sets the stage for further suspense. Is the Bank of England going to raise rates? And is the ECB going to maintain low rate policy? Further divergence in interest rates creates a new dynamic to markets as the risk-reward paradigm begins to shift. In other words, global equities may not dance in tandem; some moves can turn out more pronounced than others and set the stage for a new era/ cycle. Not to mention, the merits of interest rate hikes are still questionable. The set up of slow growth and vastly declining commodity prices do not present a convincing story for a rate hike. If a strong US economy fails to materialize then markets might respond in a nasty manner to any surprises.

Further Revelations Await

As the US approaches an election year, the odds of major policy changes are very slim. Plus, the unraveling of the energy sector is being discovered globally from Texas to the Middle East. Thus, along with the credit market implosion (i.e. junk bonds) and Emerging market weakness, one can expect further revelation of risk in riskier assets. Basically, the concept of risk-reward will be reset and adjusted to a new cycle. For now, assessing potential/pending damage is the task for investors from retail to distressed energy opportunities, which should occupy the minds of risk takers. Relying on central banks for the description of ground level economic activity is seemingly less potent these days.

Meanwhile, Chinese data points scared market participants in the summer of 2015, which served as a reminder of what was greatly feared before: Unsustainable growth rate. The Chinese slowdown has now converted to major government reforms. Yet, reforms do not occur overnight and the growth of the middle class consumer market is still being digested early-on. Markets are bound to be extra sensitive in digesting Chinese news. Good or bad news should get tons of attention and influence sentiment.
Non-commodity related themes from Germany to Japan to Nasdaq may be appealing at first sight. However, the commodity demise has created (and continues to create) appealing risk-reward set ups. Thus, 2016 will force investors to decide between going with proven winners versus searching deep value in less favorable areas. One of these two is going to win big. The answer for what will work is simply mysterious because the risk is still being understood.

Article Quotes

"In 2011, China became Russia’s largest trading partner. In 2014 alone, China’s investment in Russia grew by 80 percent—and the trend toward more investment remains strong. To get a sense of the growth in economic ties, consider that in the early 1990s, annual bilateral trade between China and Russia amounted to around $5 billion; by 2014, it came close to $100 billion. That year, Beijing and Moscow signed a landmark agreement to construct a pipeline that, by 2018, will bring as much as 38 billion cubic meters of Russian natural gas to China every year. The two countries are also planning significant deals involving nuclear power generation, aerospace manufacturing, high-speed rail, and infrastructure development. Furthermore, they are cooperating on new multinational financial institutions, such as the Asian Infrastructure Investment Bank, the New Development Bank BRICS, and the BRICS foreign exchange reserve pool. Meanwhile, security ties have improved as well. China has become one of the largest importers of Russian arms, and the two countries are discussing a number of joint arms research-and-development projects." (Foreign Affairs, January 2016 Issue)

“No country has ever devalued its way to prosperity. If it were possible to achieve economic growth by printing money, buying bonds or setting interest rates at negative rates, then many countries would be rich. The reverse is true: Weak currencies lead to slower growth, as we have observed from recent experiences in the Western world and Latin America. Negative rates disadvantage particular groups within the economy. Savers, retirees, pension funds and insurance companies are all harmed by negative and zero interest rates. Thrift, which means putting aside money today in case of a rainy day tomorrow, makes no sense with negative rates. There is no reason to delay current spending to save for tomorrow's capital stock. Negative rates drive people on fixed incomes into risky assets. Some, including senior citizens, need income from their savings. They are driven into risky assets such as equities and junk bonds in order to get the 5 percent return that they would normally receive from savings accounts. They are forced to take on more risk than they prefer.” (Manhattan Institute, December 17, 2015)

Key Levels:
(Prices as of Close: December 24, 2015)


S&P 500 Index [2,060.99] – A severe resistance has maintained at 2,100 for several months. Interestingly, the index hovered around 2,100 during the summer months, ahead of the August sell-offs. A similar pattern continues to form.

Crude (Spot) [$38.10] – An eagerly awaited bottoming shape appears to be forming, but not yet fully convincing. Staying around $40 for a sustainable period seems to be the major test. Yet, the downturn remains intact.

Gold [$1,068.25] – Previously, Gold failed at $1,180. Now, it appears to fail at $1,080. The multi-year decline remains in place despite some signs of a bottoming revival.

DXY – US Dollar Index [97.98] – Trading around familiar range. Dollar strength remains intact despite a very mild pause. Recent action suggests high probabilities of the Dollar index staying above 94, baring major shifts.

US 10 Year Treasury Yields [2.24%] – The 50-day moving average is 2.20%, which tells the story about the dull, sideways action. Basically, no major change has occurred as yields remain trading near the low end of the range.


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