Market Outlook | May 16, 2016

“Organization can never be a substitute for initiative and for judgment.” (Louis D. Brandeis)

Warning Clues

Momentum is fading among equity holders, as witnessed by action in broad US stock indexes. Sentiment is shifting towards bearishness and cheery attitudes are calming down. The list of prior neglected worries is slowly being confronted. Interestingly, the bond markets are not buying the strong economy story, yet again. Simply, the economic strength that the Fed over-promised is not to be seen. To be fair, the US 10 year yield has showcased for a long-while that economic strength lacks substance and confirmation. The passive approach by the average investors will be tested. Collectively, investors, by accepting the status-quo and doubling down on the Fed’s script, are now facing the risk of reality. In other words, the financial markets have glued all worries into a mostly smooth-sailing upside move.

The August 2015 sell-offs and early 2016 sharp downside moves were noteworthy, by all means. On April 20^th, the Nasdaq peaked and the VIX (Volatility Index) slightly bottomed. Nasdaq, as the face of innovative areas with limited exposure to commodities, began to show fragility on April 20^th, as well (led by Apple's weakness a few days before). Central Banks of all kinds are dealing with a reality that’s been long deferred. But timing the ultimate “judgment” day is the frustrating challenge for participants. The status-quo that’s been prolonged is still favored even though alarm bells are mildly and loudly ringing.  One notable theme is how EM and Commodities are digging themselves out of the grave after being battered during the last few years. Rotation into “beaten-up” names reflects how developed markets are a bit saturated. (i.e Japan, Germany etc).

Liquidity Concerns

At the height of any crisis, there is one issue that comes-up: Liquidity. At this stage, investors have heard enough warnings to re-balance portfolios and make adjustments to current risk exposure. Earnings have been weak, “Brexit” is an ultimate unknown risk, the US election is still a wild card , China is hardly stable and EM tied to commodities are still licking their wounds. That’s the big picture and common concern. By digging a step or two into the mechanics of financial markets, one will find ongoing liquidity concerns. Even in areas that appear “liquid” such as bonds, the liquidity risk is severely misunderstood. The post 2008 era brought tons of regulatory changes along with Banks reshuffling their business models. Both factors present less liquidity, which creates further risk than previously imagined. Here is one example:

“Dealers are cutting back while the junk bond market swells. There are $2.2 trillion of high yield bonds outstanding, up from $741 billion 10 years ago, the Bank of America Merrill Lynch Global High Yield Index shows. Even if banks were holding the same inventories they had before, they would still own a smaller percentage of the market. With revenue from bond trading having plunged, banks including Morgan Stanley, Credit Suisse Group AG and Nomura Holdings have been shrinking trading staff.” (Bloomberg, May 12, 2016)

Beyond Drama

As most Hedge Funds struggle to make money, investors must wonder about the market dynamics and concept of risk-taking. There is this disturbing feeling of over-reliance on the Fed, which has lost credibility. Globalization is being challenged in Europe and in other circles. And policymakers have failed to uplift the business spirit for the most part, as global growth is anemic. Thus, investors have enough reasons to be reluctant and seek shelter or tax related strategies at this junction. Suppressed and very low yields have forced further risk-taking into risky assets (as stated above i.e. junk bonds).  A reset is desperately needed, and, at this stage, the atmosphere is not overly optimistic.  Perhaps, more downside moves will turn the sentiment toward panic as things remain mostly calm.

Article Quotes:

Regarding China: “After March data suggested that economic activity was finally picking up after a long slowdown, April figures released at the weekend suggested otherwise. Overall investment, factory output and retail sales all grew more slowly than expected. Private-sector investment for January to April grew just 5.2 percent, its weakest pace since the National Bureau of Statistics (NBS) started recording the data in 2012. More worrying, private-sector investment is decelerating sharply from rates near 25 percent in 2013, to just 10 percent last year and now just over 5 percent.

The reason policymakers are so concerned is that private-sector fixed-asset investment, which includes land, equipment and buildings, accounted for more than 60 percent of overall investment in January to April. The sector provides a third of all jobs in China and creates 90 percent of new urban jobs, state media have reported.” (Reuters, May 15, 2016)

“The history of the German economy since its labour market reforms of the early 2000s demonstrates that “structural reform” is most unlikely to solve this problem. The most important macroeconomic fact about the country is that it is unable to absorb almost a third of its domestic savings at home, despite ultra-low interest rates. In 2000, before the reforms — which cut labour costs and workers’ incomes — German corporations invested substantially more than their retained earnings. The opposite is now true. With households in surplus and the government in balance, a vast external surplus has duly emerged.  Why should others be able to make productive use of savings Germans cannot apparently use? Why should structural reforms elsewhere, as advocated by Germany, generate the investment surge lacking at home? Why, not least, should one expect indebtedness to have fallen when demand and overall growth is so weak in the eurozone as a whole? ‎What has happened, instead, is the conversion of the eurozone into a weaker Germany. (Financial Times, May 10, 2016)

Key Levels: (Prices as of Close: May 13, 2016)

S&P 500 Index [2,057.14] – Failed yet again to move above 2,100. Again, that signals fading buyers’ momentum. Interestingly, the index fell below 2,050, which sets the stage for a critical period in weeks ahead. Massive pressure is building on the downside.

Crude (Spot) [$44.66] – Visible signs of stability arise between $40-46. Staying above 

$42 will confirm the validity of the recent rally.

Gold [$1,271.00] – Peaked at $1,295.00 on January 2015 and, again, stalled at $1,294.00 on May 6^th. This signals fading momentum.

DXY – US Dollar Index [93.88] –  After dollar weakness for several months, there are signs of a very mild revival.  Perhaps, a re-strengthening of the dollar is setting-up at this stage.

US 10 Year Treasury Yields [1.70%] – Since the April 26, 2016 (1.93%) peak and until last Friday, there has been a significant turn around in yields, which coincides with the lack of economic confidence. 

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