Market Outlook | May 22, 2017

“Confidence is a very fragile thing.” (Joe Montana)

Visible Trends

Since March 1 2017, a few big picture items have become a little clearer. 1) The US Dollar weakness continues  2) The odds of a US rate hike seem low and even lower 3) The Real economy is not quite as vibrant, as witnessed by low 10-year yields 4) Record stock market highs and low volatility continue to persist with mild and non-lasting blips. Of course, the rising stock market and low volatility are nothing new, regardless of the DC power shift. Yet, the collective US markets appear eager for an excuse to sell while feeling a bit unsettled about the DC political gridlock that’s mind-numbing, deflating and, at times, quite shocking. Being bullish in anticipation of policy changes is not looking too promising. However, as long as interest rates are low and the collective narrative remains more or less the same, then change is hard to visualize.

The lethargic stock market action is enticing for bears who want to throw the towel and uneventful for bulls riding the trend. But the trends mentioned above are signaling what’s been brewing in the undercurrent of Western societies. The lack of lift and ignition of the real economy is a real issue. It’s not a populist message or fear-mongering tactics as some would like to outline. Again, Trump’s victory and the eventual Brexit outcome have redefined the post 2008 crisis.  The intellectual class is slowly coming to terms with depleted growth rates, but the record high stocks somehow overshadow the more brutal and unpleasant side of current conditions. The intersection between artificially induced interest rates (higher stock prices) and a not so rosy real economy is slowly approaching.

 Re-Emergence

Since the start of the year, as the US dollar weakened along with commodities, and on a broader level, emerging markets have done well.  From India to South Korea, EM has been on a solid run in 2017, mainly since investors were looking to rotate out of a stretched US. Plus, EM currencies have outperformed the Dollar in the first part of the year. Of course, last week’s sudden downturn in Brazilian stocks and currency leads investors to briefly reassess risk and ask further questions. Interestingly, jumping on EM quickly for better returns might not be an easy answer:

“Investors are earning less and less extra yield to own emerging-markets debt… These nations have been adding leverage. They're more susceptible to unpleasant surprises out of China or other large economies. And some, like Brazil, have some serious political and fiscal challenges that can easily erupt in ways that could impede the functioning of their capital markets.” (Bloomberg, May 18, 2017)

With China remaining such a wild card, the real risk of EM isn’t understood. It’s quite clear that low yields in developed countries have triggered rotation into riskier EM in the ongoing search for higher yields. Perhaps, the low interest rate environment in the developed world, from Germany to the UK to the US, reignites demand for EM debt and other risker assets. Yet, like all critical questions, is the risk in EM worth the reward? So far lots of bullets have been dodged. Perhaps, this is more of a country by country risk rather than a broad conclusion regarding developing markets. That said, Chinese debt is the most watched and is potentially highly vulnerable, and the discovery of bad or large debt can spark a meaningful and inter-connected reaction. The[HM1]  recent EM ease among investors and the smooth sailing run should be taken lightly without any skepticism.

Radical Shifts

From retail to financials, there’s a growing concern that’s been impacting traditional companies and jobs. The boom of artificial intelligence, self-driving cars, Amazon’s logistic driven empire, disruptive technologies across multiple sectors, increasing shift towards on-line retailers and more efficiency has led to further pressure on the job market. Surely, new skills are needed for the general population, while efficiencies lead to less job creations. The changing landscape of new skills, mixed with aging population begs the question of this transition impact on labor markets. (See below in Article quotes). Ultimately, if broad based job creation fails to materialize then consumer spending might be impacted. Yet, the new economy is being understood, and it is no accident that Nasdaq’s big winners are Amazon, Netflix and Google, which pave the way for the new economy. However, without broad participation, and encouraging polices in DC, it’s harder and harder to visualize a robust real economy.

Article Quotes:

“China is attempting cure itself of an addiction to debt. The problem is, that could just stoke yet more demand. Take local-government debt, one of the biggest contributors to the overall growth in debt in recent years. A major concern has been off-balance-sheet ‘local-government financing vehicles,’ whose debt now represents around 10% of China’s $8 trillion bond market. The money raised is supposed to finance infrastructure projects and the like. But much of it—around half, according to Wind Info—has been put to unproductive uses like paying down old debt and keeping moribund local companies alive. The debt is often issued in the guise of corporate bonds, and can be bought by banks. Beijing is now trying to rein in the financing vehicles’ voracious debt appetite. Though the debt isn’t recorded on local governments’ books, there’s little doubt they will be on the hook if defaults start growing. As of 2016, local-government debt totaled 33 trillion yuan ($4.782 trillion), of which UBS analysts estimate a third is implicit or hidden liabilities.” (Wall Street Journal, May 15, 2017)

“During his presentation, Bullard explained that U.S. macroeconomic data since the March 2017 meeting of the Federal Open Market Committee (FOMC) have been relatively weak, on balance. For instance, he noted that U.S. inflation and inflation expectations have surprised to the downside in recent months. In discussing the FOMC’s March increase in the policy rate (i.e., the federal funds rate target), he noted that the financial market reaction has been the opposite of what would typically be expected. ‘This may suggest that the FOMC’s contemplated policy rate path is overly aggressive relative to actual incoming data on U.S. macroeconomic performance,’ he said. In discussing the FOMC’s March increase in the policy rate (i.e., the federal funds rate target), he noted that the financial market reaction has been the opposite of what would typically be expected. ‘This may suggest that the FOMC’s contemplated policy rate path is overly aggressive relative to actual incoming data on U.S. macroeconomic performance,’ he said.” (Federal Reserve Bank of St. Louis, May 19, 2017)

Key Levels: (Prices as of Close: May 19, 2017)

S&P 500 Index [2,381.73] – The March 1^st highs of 2,400 are on the radar for many observers since that was a tangible and historical peak point. Interestingly, last week’s record highs of 2,405.77 triggered a reaction of fading enthusiasm.

Crude (Spot) [$50.33] – Once again, there is a mild sign of staying above $48. January highs of $55.24 can be the next target for bulls.

Gold [$1252.00] –   For over four years, the commodity has hovered around $1,200. Gold desperately lacks positive momentum and sideways action remains in place.

DXY – US Dollar Index [97.14] – Dollar weakness continues with annual lows being made, yet again, on Friday. The post-Trump rally has not witnessed a stronger dollar and that’s becoming quite a macro theme.

US 10 Year Treasury Yields [2.23%] – Since Trump was elected, 10-year has stayed above 2.20% but peaked at 2.62% in mid-March. Despite the economic improvement chatters, yields remain closer to 2.20%, showing lack of trust by bond markets on the economic conditions.

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