Market Outlook | August 22, 2016

 “But this long run is a misleading guide to current affairs. In the long run we are all dead.”  (John Maynard Keynes 1883-1946)

Collective Revival

After a brutal January 2016, US stocks climbed back up, demonstrating strength and 

reaching record highs. Even Brexit worries did not derail the S&P 500 index, Nasdaq and developed markets. Simply, various market-related concerns mainly ended up being very short-lived and the rally marched on. For every investor the assessment of risk gets trickier by the day. Elevated markets these days are not limited to stocks, since bonds have also rallied significantly.

Interestingly, commodities and Emerging Markets have recovered from “desperate” levels, further emphasizing the ongoing tolerance for “riskier” assets.  Finding bargains is not that easy across many well-established areas, especially at mid-year. Even less than quality areas have found enough buyers either out of desperation for yield or some “perceived” fundamental improvements. The market participants are hardly shy; investors may talk as if they’re nervous, but recent actions suggest further trust in Central Banks and less panic. 

Chasing returns at the wrong part of the cycle is a deadly and dangerous game, as many cycles before have proven. Hedge Funds have tried to revive themselves after a difficult period where differentiation has lacked between thousands of managers. China is not much of a reliable story, and faces its own woes in terms of financial systems. Political uncertainty lingers in the Eurozone to other less established nations, but it is not quite a market moving matter. The US dollar remains a critical barometer for asset classes and currency moves, but the dollar has been mostly trading in a small range and not setting any alarming trends.  Investors have plenty to digest, but the art of knowing which macro trend is relevant at what specific time is highly precious. Otherwise, some of the macro noise may not be too relevant in financial markets despite the multiple brewing macro related factors.

The Credibility Game

For a long-while the bond market has not been buying the strength in the economy.  With US 10 year Treasury yields below 2%, it reconfirms that the Fed’s constant “posturing” lacks credibility. Plus, the Fed’s very limited execution on rate-hikes, besides last December, begs further questions about their trustworthiness. It is a period of calmness on the surface, but terrifying precariousness below. Amazingly, the Fed may force a rate hike because crying wolf too many times is a very damaging blow.

Recently, 3-month Libor rates have  risen, Crude has somewhat stabilized and even 10 year yields have moved up, albeit slowly. All these give the appearance of less worries and more calmness than before. In fact, the sentiment is shifting toward a more positive territory, but 

perception of the risk is all out of whack.

Regarding Junk Energy Bonds: “It seems as if traders are simply disregarding the possibility of another decline in oil prices, or another wave of bankruptcies, simply in their zeal to capture any extra yield they can find. They justify this by telling themselves that the shakeout has already happened and that the energy market is in full recovery mode… It seems investors are demanding a remarkably small premium for all those uncertainties.”  (Bloomberg, August 18, 2016)

Courageous Thinking

The bold and courageous move in this climate is to walk away from the all-time highs in stocks and elevated bond markets.  The Fed may seem untrustworthy with their messaging, assets are too pricey by several measures, and increasingly more market behaviors are driven by the desperation of yield or investors chasing returns. Regardless, the sentiment is shifting more bullish and the upside limit is the big unknown in days and weeks ahead.

Bond markets have not feared a rate-hike for most of this year. That’s been interpreted as bond markets not buying into the economic strength  painted by federal government data; this is a recurring pattern. Interestingly,  as Libor begins to rise a bit and a new round of Fed posturing regarding rate-hikes emerges, there is a growing anticipation of some Fed action.  Yet, an elevated stock market and housing prices fail to capture the struggles of the real economy’s growth potential  Several failed policies and shaky confidence in small businesses add to the stress. Disruptions in multiple sectors also create further damage to many business models on top of all this.  One example of bearish, real economy is the retail sector:

“Sluggish sales at Macy's are hurting more than just the mega-retailer itself. The department store chain recently announced that it would be closing 100 stores in a bid to shore up business. That could impact about $3.64 billion in commercial mortgage-backed securities debt, according to a report by Morningstar Credit Ratings' Steve Jellinek and his team…. These anchor tenants make up a sizeable chunk of mortgage-backed deals, and regional malls typically suffer large losses when vacancy rates surge and loans go into default.” (Business Insider, August 17,2016) 

The damage to the US retail sector goes beyond the sector, impacting other investors, which is another reminder of the weak economic status despite the posturing from the Federal Reserve.

Article Quotes:

Chinese leadership: “Since coming to power almost four years ago, Mr Xi has waged a campaign against corruption. On one reading, this is to clean up the system before he undertakes political reform. On another, it is at its heart an old-fashioned purge of his enemies. Similarly, Mr Xi has centralised power, taking jobs and responsibilities that his predecessor delegated to others. Some observers think this shows he is strong; others conclude that he has been forced to act because he feels weak. Such contradictions are the backdrop to rumours about the forthcoming leadership changes. The only certainty is that the churn will be enormous. By late next year, five of the seven members of the Politburo’s Standing Committee will have reached retirement age. One-third of its 18 other members are due to go with them. In the coming months, as the combination of promotion and retirement cascades through official China, leadership posts will be shaken up at every level of the party. Hundreds of thousands of jobs will be affected, down to the level of rural townships and state-owned enterprises.” (The Economist, August 20, 2016)

Europe struggling to find growth: “Some central bank watchers think the ECB will also ease the rules governing which bonds can be bought under the flagship QE programme. The minutes offered little clue as to how the rules could be relaxed, saying only that the lack of evidence on how the latest headwinds would affect the eurozone meant “it was widely felt among members that it was premature to discuss any possible monetary policy reaction at this stage”. Research published by S&P, a rating agency, on Thursday suggested the UK leaving the EU could limit the effectiveness of the ECB’s negative interest rate policy, by lowering the value of the pound against the euro — though policymakers are more concerned about the exchange rate to the dollar. Financial markets has weathered much of the turmoil that followed the UK’s Leave vote, but share prices for financial companies were still volatile and remained below their pre-referendum levels. This reflected concerns over banks’ low profitability in an environment of low rates and weak growth, as well as high volumes of bad loans.” (Financial Times, August 18, 2016)

Key Levels: (Prices as of Close: August 5, 2016)

S&P 500 Index [2,161.74] – Breaking above 2,100 was noteworthy this summer. Several all-time highs beg further questions. A 20%+ rally since February 2016 lows suggests a remarkable turnaround.

Crude (Spot) [$48.52] – Attempts to re-visit June 9, 2016 highs of $51.67. Interestingly, earlier this month Crude sold-off quickly to $39.19.  The lack of ebb and flow in recent trading action calls into question price stability.

Gold [$1,346.40] –   An ongoing rally continues this summer and calendar year. December 17, 2015 lows of $1,049.40 marked a new bottom.  As the dollar's  strength slows down, Gold has gained further ground.

DXY – US Dollar Index [96.19] –   After establishing strength in 2014, the dollar has traded in a narrow range for the last 18 + months.

US 10 Year Treasury Yields [1.57%] –    In the last month, yields traded in a very narrow range between 1.50-1.60%.  July lows of 1.31% stand out as a possible major low in yields (top in bonds), yet the narrow current range does not provide a clear picture of a trend.

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