Market Outlook | July 25, 2016

“The art of simplicity is a puzzle of complexity.” (Doug Horton)

Order Restoration

The rampant stock market acceleration continues as the S&P 500 index hit another all-time high. In an environment with mounting macro and political risks, the theme of rising equity prices is hardly as shocking as before. Basically, that’s the status-quo move since the participants are quite conditioned from this pattern. This is a testament to Central Banks imposing their will by driving the overall sentiment and capitalizing on their well-devised messaging.

At this point, the sensational reactions to a “disconnected” market are not surprising but rather simply numbing to observers and clue-seekers. In other words, the real economy does not appear strong enough to raise rates, and global growth is too sluggish, yet, shares of large US corporations continue to appreciate. Of course, with so much capital seeking returns, it is understandable that investors flock into the more liquid and well-recognized US equities. Not to mention, capital is desperate for yield, so risk-taking is not only an optional luxury but a necessity for more and more investors.  Here is one example of inflow into EM bonds:

“Net inflows to funds that buy emerging-market bonds reached an all-time high in the week through July 20, according to Bank of America Corp. — $4.9 billion, to be precise.” (Bloomberg, July 22, 2016)

Interestingly, asset appreciation is taking place in an environment of muted volatility. Potential market turbulence is valued “cheap” and Brexit effects have been modest, except for the decline in the British Pound. Perhaps, the slow summer months are not an ideal inflection point, but here is a reminder regarding the volatility index development:

“The last time spot VIX Volatility Index closed under 13 for four consecutive sessions was in early August last year.  In fact, the VIX back then stayed sub-13 for four straight sessions ended August 3rd, and registered three more sub-13 readings by August 14th. By the 17th, the S&P 500 Index peaked, dropping north of 11 percent in the next six sessions. History seldom repeats itself, but it may rhyme.” (See It Market, July 20, 2016)

Risk Chasing

The massive chase towards winning ideas comes with its own set of risks, but with so many headlines about worrisome issues failing to topple the stock market, euphoria is in full gear, again. Occasionally, there are actual breakdowns, like Netflix, as one of the tech horses (in FANG stocks), witnessing a sharp drop. There are moments where specific names or business models end up falling out of favor. Yet, the broader indexes are hovering much higher and creating a feeling of a roaring bull market. Part of this is driven by more Merger & Acquisitions and buybacks.  

At this stage, investors, who missed the rally or were roused by recent headline cheers, face the inevitable risk of overpaying at the late end of the cycle. Like usual, latecomers have a price to pay, but this comes at a time where valuations and central bank objectives are not fully understood. There is an additional risk that looms from rate hikes, currencies and political destabilization.  For now, risk is still misunderstood and the Fed-led market can attract more flow and push higher until new sets of data confront ugly realities. Yet, when volatility is very low and stocks are at all-time highs – one needs to reexamine their expectations. What’s the upside? What’s the practical expectation from now to year-end?

Inflection Point

The run in commodities from the first half of 2016,is now facing a major test. Some signs of stalling in commodity pricing are visible by technical indicators as momentum is slowing a bit. The inverse relationship between Commodities and the Dollar is worth watching again. The dollar is stabilizing and has the potential to go higher, which might inversely impact commodities.  Currency factors go hand in hand with commodities.   

 In terms of Crude, there are signs of rolling over, which begs some questions about supply glut and global demand. Clearly, the supply glut was a critical driver that drove Crude much lower in recent years. Plus, the unstable climate in Middle East (i.e Syria, Turkey, Iraq etc.), political fragility in Europe and unclear growth in China make the commodity outlook even more unpredictable.  That said, commodity bulls are eagerly awaiting confirmation in strength and the suspense of the next few weeks await. 

Article Quotes:

Currency Factors:

“If People’s Bank yen purchases couldn’t force up Japanese investment, by necessity Japanese savings had to decline in line with its current account surplus. There are only two ways the inflows could cause Japanese savings to decline. First, a domestic consumption boom could cause the Japanese debt burden to rise, which Tokyo clearly didn’t want. Second, Japanese unemployment could rise, which Tokyo even more clearly didn’t want. There is, in short, no way Japan could have benefited from People’s Bank purchases of its yen bonds. Only the United States permits unlimited purchases of government bonds by foreign central banks — not because, however, it is immune to the problems Japan and other advanced countries face. Like them, the United States can easily fund productive domestic investments without foreign capital, and so rather than cause productive investment to rise, foreign investment causes domestic savings to fall, which can only happen with a rising debt burden or rising unemployment.” (Foreign Policy, July 22, 2016)

Lower Expectations:

“Respondents to the ECB’s Survey of Professional Forecasters (SPF) for the third quarter of 2016 have revised downwards their expectations for growth in euro area economic activity for both next year and the following one. The average point forecast now stands at 1.4% for 2017 (revised down by 0.2 percentage point) and at 1.6% for 2018 (revised down by 0.1 percentage point). Based on the information provided by the respondents, these revisions largely reflect an expected negative impact on the euro area from the UK referendum result. The Q3 2016 SPF average point forecasts for inflation in 2016, 2017 and 2018 stand at 0.3%, 1.2% and 1.5% respectively. This implies that forecasts for 2016 are unchanged, while those for 2017 and 2018 have been revised slightly downwards, by 0.1 percentage point, compared with the survey round from the second quarter of 2016. Average longer-term inflation expectations (for 2021) remain unchanged at 1.8%. The balance of risks around this forecast is assessed as remaining on the downside.” (ECB, July 22, 2016)

Key Levels: (Prices as of Close: July 22, 2016)

S&P 500 Index [2,175.03] – Another all-time high. The index is up over 20% since the lowest point on February 11^th.  A resounding response to recent lows.

Crude (Spot) [$44.19] –   Since June 9, 2016 highs of $51.67, the commodity has declined and has attempted to maintain around $45.

Gold [$1,320.75] – From December 2015 to July 2016, Gold has rallied about 30% from the lows. However, it is potentially stalling at current levels. In the past, heavy resistance at $1,400 was visible both in 2013 and 2014.  Breaking above the $1,400 can mark additional positive momentum.

DXY – US Dollar Index [97.46] – Range bound since March 2015. A well-defined range between 94-100 seems to be the trend. March 2015 and December 2015 marked a top around 100. Interestingly, the lowest point was reached in early May 2016 (91.91).

US 10 Year Treasury Yields [1.56%] –  Some signs of stabilization have appeared; although, July 6^th  lows of 1.31% occurred earlier this month, so it is too early to tell. A minor hurdle at 1.60% and major hurdle at 1.80% have created a slight stall; a breakout above these points can signal a more convincing rising rate environment.

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