The Global Financial Markets are a real-time barometer by which the health of the economy can be assessed and even predicted. Just as high volatility tells you that something is very wrong, in the same way low volatility and rising or stable equity prices with broad market participation tell you that things are robust no matter what the gloom-and-doomers may be saying, or that seemingly stable prices but with narrow market participation tell you that the tide may be ripening for a turn. Macroeconomic data of course is crucial even though it can be lagging, to inform and re-inforce the story derived from the markets.
Many economists and watchers would probably agree that the high market volatility since August is a reflection of the following major problems
- A significant strengthening of the US Dollar from late 2014 through 2015 against most currencies, especially against Emerging Market Commodity producers along with additional deflationary impacts of US, Japanese, and European Central Bank Quantitative Easing (QE) Policies, have crashed Commodity prices. This has in turn fractured the credit worthiness of commodity producers, increasing their borrowing costs, and has forced them to keep pumping out the commodity to stay solvent, which exacerbates the supply glut further pressuring the price of the commodity, and keeping commodities in a vicious downwards cycle. The very tight correlation between the global equity markets and the price of Crude Oil is telling us how important this problem has become.
- China’s growth and export slowdown, growing non-performing investments, and resulting Capital Outflows have created a tremendous amount of instability in China’s domestic financial markets and pressure on the Renminbi. China’s massive foreign currency reserves have dropped by 20% in the last 15 months as their Central Bank uses them to minimize the slide in the RMB. The term thrown around by the media has been “China sneezes and the world catches a cold”, to explain the roiling of the US and global equity markets since the problems with China came front-and-center.
What adds to the bearish sentiment is the divergent path the US Central Bank has taken by beginning to increase short-term interest rates in this very uncertain global growth environment relative to the easing policy stance of Japanese and European Central Banks. This threatens to worsen two of the above drivers of instability … i.e. to further strengthen the US Dollar and in turn to further drop Crude Oil/Commodity Prices. The tightening stance of the Federal Reserve also makes China’s job, of stabilizing its growth decline and of setting it on a sustainable longer term trend, more difficult. To do so, China must find a balance between making their exports more competitive with their trading partners to support its own middle class, while encouraging domestic consumption to wean it off of its dependence on exports, and in the process of both make a smooth transition to becoming a major international currency.
In addition, market volatility itself adds to bearish sentiment which can breed additional volatility by seeping into consumer and businesses spending decisions.
So will things continue getting worse, start to get better, or stay the same?
We believe each of the underlying issues above have actually started to stabilize.
Our summary prognosis for equities is as follows.
- The US Equity markets have bottomed, though the problems in the global economy have not yet stabilized
- We expect the US Equity Markets to continue moving sideways (i.e. up and down) in a broad price band until the healing process is further along
- China’s equity market has also likely bottomed
- We should see a broader bottoming of other Commodity exporting Emerging Markets as the year progresses
The clarity and conviction in our view comes first and foremost from our proprietary predictive models of the markets. These models have been refined, improved, and tested meaningfully through real-time use during the 2007-2009 Recession and over the course of the subsequent Bull market, including the correction from last August. But there are three other lenses which we use, that are easier to communicate, and that are also indicating these “green shoots”.
#1 The Markets’ Tale
- US Equity Markets have demonstrated a very strong support level around 15,000 for the Dow since 2013 when the level first acted as resistance for the post-“fiscal cliff” rally, and then as very strong support repelling 5 different declines from causes ranging from the “Taper tantrum” in 2013, and the Ebola Virus in 2014, to the Chinese currency devaluation/growth slowdown related decline last August. The two recent tests on Jan 20th and Feb 11th that correlated with the crash in Oil prices into the mid-$20/barrel range, and the increasing strength of the two subsequent bounces from this support level, indicate how formidable the support is. What we can conclude is that whatever the reasons, the macro problems described in the paragraphs above have not yet been substantial enough to break the back of the markets (by breaking this support) and the underlying economy.
- We have found Gold to be an excellent indicator for market liquidity and fear. Gold’s very strong rally in February could initially have been attributed to the high levels of fear in the markets back in February, however the continuation of the rally late last week, even after the equity markets had stabilized somewhat, indicates there now could be enough liquidity in the markets to support a broader based stabilization in “risk-on” markets like US and Emerging Market Equities, and Commodities at least for the near future. Again, I am not saying there is a new uptrend that would start here, but that there are signs of stabilization.
#2 The Macro View
The two most likely mechanisms in the current environment that could actually cause liquidity to increase in the system are
- The underlying problems that were drying up the liquidity in the first place, and hence creating the market volatility (i.e. the problems listed in previous paragraphs), have hit an inflexion and have started to moderate. Two examples here -
- For the problems related to Commodity/Commodity Producing Emerging Markets, the most important indicators to look at are the spreads between High Yield Bonds of different risk tranches versus the 10-Year Treasury Note. There has been a remarkable shrinking in these spreads over the last 2.5 weeks with a technical strength that has not been seen since early 2015.
- For China, its M2 Money Supply YoY % growth is a leading indicator of inflation, which we believe has to begin to increase if China’s growth slow-down is to stabilize. The M2 growth rate has been clawing its way back from its low in April 2015 which has coincided with an acceleration of the Chinese Central Bank efforts to turn the growth situation around. The YoY growth in M2 hit 14%, its highest level since July 2014. This has been the only positive surprise this year among a host of negative growth related indicators for China. The probability that China has successfully arrested and is turning around its export and growth doldrums increases significantly If this growth rate keeps giving upside surprises over the next few months.
- The Fed is kick-starting “Carry Trades” again to support Commodity Prices and solve the China growth issue in one fell swoop. Given negative Interest Rates in Europe and Japan, such a “Risk-on” trade could be quite profitable. The mechanics could be for the entity to borrow money (and get paid to borrow money) from Japan or the Eurozone due to Negative Interest Rates, and then park the money in a higher interest yielding currency like the Australian Dollar (currently offering a 3 month interest rate of 2.25%) or in the future in the USD (after the Fed raises rates a few times) and/or purchases commodities, High Yield Bonds, or Equities, i.e. “Risk-on” financial instruments with the USD or AUD obtained from the borrowed money. However, given the downside risk from the declining end-markets, it takes someone with very deep pockets (like the Fed) to try and actually turn the tide (so to speak) and then hopefully attract other market participants to this trade once the new trend is established. We can hypothesize that this party is actually the Fed if, from here on, subsequent rises in US equities are accompanied by a declining USD, at least for the remainder of the current rally. In other words, if this mechanism was actually happening in conjunction with Chinese Central Bank activities, we would see a declining USD co-incident with 3 things … rising US equities, rising Commodity prices including Oil, and a dropping RMB against its (China’s) trading Partners. More on this in our next letter if this hypothesis can actually be backed by a month’s (versus just a week’s) worth of data.
The Infrastructure sector is the first derivative of the economy, i.e. if the pace of the global economic growth decline is indeed slowing, the infrastructure spending decline would be arrested first and will be one of the first sectors to recover. Since High Tech is pretty healthy and one of the least impacted by the problems causing the current slump, we would expect Tech Infrastructure to be one of the first sectors to reflect a turn-around. Two bellwether companies in the High Tech infrastructure space are Cisco Systems and Applied Materials. Both companies blew away analyst estimates in their last earnings calls on Feb 9th and Feb 18th respectively and their stocks rose by ~10% each, overnight after their earnings calls.
Our Medium-Term Forecast
Like I forecasted in an interim update to my Linked-in connections on Feb 12th, the day after the Dow hit 15,412, “The US Equity markets decline from December (originally from last July) may have been arrested for good at the 1800 level for the S&P500 and 15,400 level for the Dow. However we don't think a new uptrend is on the cards until all the negativity has been absorbed, i.e. the markets should continue to bounce and go sideways for the next many months. In other words, this is no time for panic selling”, the US equity markets have bounced substantially from that low with the Dow closing on Friday above 17,000. We think there is more life left in this bounce for the reasons described above, maybe all the way up to the 18,000 level. However, the problems have not gone away, only faded, and more healing is needed before there is an end to the correction from last July. We think another strong bout of pessimism and volatility with an accompanying test of the Feb 2016 lows is likely as a result, before we finally enter the next phase of the rally from 2009.
That phase should have a very different, inflationary nature, and hence provide a very different profile of returns compared to the dis-inflationary nature of the previous phases of this astounding and historic rally. But that again like most of this letter is a contrarian view, though I would like to think, a rational one.