Market Outlook | July 19, 2016

“The English never draw a line without blurring it.” (1874-1965)

Blurred Reactions

As US stocks hit all-time highs, some may view this as a signal of massive improvement and vibrant real economy. Others might see this as large corporations with exposure to multiple countries having a relative appeal. Meanwhile, for some this is a result of very low interest rates that limit the option of “attractive”, liquid investments, which ends up benefiting the US equity markets. Whichever theory is more right is not  relevant, but looking at the headline number only may send a misleading message about the market dynamics and potential risk ahead.

On July 6, 2016 following the Brexit reactions and some overreactions, the US 10 year Treasury Yield hit a low of 1.31% while Gold reached its annual highs of $1366.25. Low yields and higher Gold prices are the classic result of participants rotating to “safer” assets.  Both are critical inflection points that may be revisited if flight to safety turns  rampant, or they will be a reference point until the next unease and notable unrest. Have investors felt less nervy since early July? Are investors even clear what to worry and what not to worry about? 

Surely, Gold’s gains this year are driven by several factors. Commodities were cheap at the end of last year following a multi-year downturn.  Central Banks are running out of monetary tools / solutions, which makes Gold the anti-Central Bank bet.  In a world of too many negative yielding bonds, the urge to move to other asset classes (i.e Gold)  is an incentive that helps Gold prices. 

The initial Brexit response drove the Volatility Index (VIX) to 26 on June 27^th. Since then a complete collapse of the volatility index fell to below 15. This showcased the perceived risk of Brexit was very short-term oriented.  A complete lack of fear led to S&P 500 index hitting all-time highs despite so many tangible concerns. Through most of July, fear has been losing value and now trading “cheap”, while the status-quo (higher stocks) has been in favor again. Brexit risks on US markets are not quite understood. The market  overreacted, but then marched on to a very familiar beat. Interestingly, the impact on London Real Estate and funds that have links to the UK are feeling some pain, with investors feeling a bit panicked. Yet, that hasn’t caused a widespread global reaction as of yet. Plus, more Brexit deliberation will provide some color, but Europeans' woes will be discovered as well.

Fuzziness Persists

Financial markets may not be reflecting the precipitating concerns related to weaker growth, increasingly negative global yields, an aging population, dynamic political risks, policy risks in Europe and the Central Bank’s shaky credibility. All these factors are on the table  because they cause mild anxiety, but the consequences are either greater than expected or not fully realized. Much of day to day economist and political strategist discussions circle on the issues above, but the markets are not responding to this.

In some cases, the political and economic worries are brewing and playing out viciously. However, the lack of meaningful reaction to Brexit and lack of volatility towards the wishy-washy Central Bank attitude confirms three things: 1) Liquid markets are very efficient in digesting information 2) Liquid markets are very short-term oriented and not overly bothered with long-term implications 3) Lack of desirable yields make US equities and other developed world equities attractive even if the fundamentals are hardy stellar. 

Amazingly, all-time highs in stocks via S&P 500 index  fail to match the political and economic anger that’s brewing on the ground-level. This disconnect causes confusion for some, rage for others, but is out of sync for the general population. This fuzzy set-up is tricky in managing risk as illusionary perspectives cause further uncertainties.

Long-term Shifts

Anti-West leaders from Turkey to Iran to Russia and China are beginning to shape the future of Asia and Europe. At this moment, the markets are inundated with short-term matters, such as possible rate hikes (or rate cuts) and relatively appealing investments in a very low interest rate environment.  But as anti-west regimes such as Erdogan and Assad continue to stay in power, the ambitions of Putin and the communist Chinese government is the wild card for those looking at their business interest. Many “worrisome” matters have been shrugged off by public financial markets.  From Ukraine to Syria, to Brexit a spark in volatility or massive sell-offs have been measured. We’ll see if the failed Turkish coup causes any meaningful panic-like response. 

In a period where globalization is being challenged by Western political leaders, the not-so-friendly partners of the West are re-visiting their personal ambitions. Operators need to remake their business models, attempt to find growing areas and cut losses in unstable areas. At this stage, the myopic nature of liquid markets is where the desperation for yield is bigger than the fundamental nuances.

Article Quotes:

“Asian investment-grade dollar bonds offer a premium of 347 basis points to 10-year German bunds, 190 basis points more than similar-maturity U.S. Treasuries and of 58 basis points to similar-rated debt of American companies, based on indexes from JP Morgan Chase & Co. and Bank of America Merrill Lynch. While the return on the region’s corporate notes has trailed their U.S. and global peers this year, they’ve outperformed both since 2014, the indexes show. The amount of sovereign and corporate bonds with zero or negative yields has doubled to $10.1 trillion since Britain’s June 23 vote to exit the European Union. A shrinking supply of debt from Asian issuers is enhancing their allure, especially for those who can fund investments by borrowing money at negative interest rates, according to Credit Suisse. The European Central Bank’s purchases of investment-grade corporate bonds since June is also starving investors of opportunities in that continent.” (Bloomberg, July 14, 2016)

“According to China International Capital Corp., the country's pension funds may invest about 100 billion yuan ($15 billion) in domestic stocks this year as they hand over some of their money to the National Council for Social Security Fund. This could inject a good deal of institutional chutzpah into a market plagued by excessive participation of individual investors and perhaps start a virtuous cycle of allowing professionals to manage retirement savings. Statistics on the make-up of trade in Chinese markets are scant, but the general understanding is that about 80 percent is your average Joe, or Zhang, rather than portfolio managers who are paid to analyze companies and trends. Even last year's crash wasn't enough to abate the common man's growing love of A-shares: Stock-trading accounts increased 51 percent in 2015.” (Bloomberg, July 11, 2016)

Key Levels: (Prices as of Close: July 15, 2016)

S&P 500 Index [2,161.74] – All-time highs appear again.  The breakout above 2,100 was sharp and mainly driven by a near 9% rally following the Brexit lows. Sustaining above 2,100 for an extended period remains the near-term challenge.

Crude (Spot) [$45.95] –   Stabilization mainly defines recent action. The last few years showcased oversupply of Crude, which is well known and reflected in prices. Since the last 7 trading sessions, Crude is attempting to stay above $44 as maintaining $50 proved to be short-term.

Gold [$1,327.00] – Major acceleration since the May 31, 2016 lows of $1,212.10. Topping July 6^th  highs of $1,366 is a key challenge for Gold bulls. Most of the year has been favorable for Gold, since the market has been in a period of unstable central banks and political climates.

DXY – US Dollar Index [96.58] – May and June have witnessed strength in the US dollar. A recently reversal after a slow start to the year where the Dollar weakened a bit. Growing unease of other currencies will determine much of the dollar strength in the near-term.

US 10 Year Treasury Yields [1.55%] –   Although yields closed a bit higher than annual lows of 1.31%, clearly yields are much lower than most expected at the start of the year. The rush to safety and lack of anticipation of rate hikes continue to drive yields much lower.

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