Weekend Update June 12

ABSTRACT: Both U.S. stock indices and global bonds swung back into positive territory after a recent bearish hangover set the scene for a rocky start to the week. Though the case remains strong for an eventual correction in equities, not only in North America but in Asia as well, it appears the precious metals have more room to absorb hedging against this risk.

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GOVERNMENT & POLICY

News & Notes

~President Obama supposedly expresses concern over the weakening dollar at the meeting of G7 leaders this week. The White House later denies these claims–probably after getting a ring from someone at the Fed–but the sentiment still helped drive the dollar further down against its peer currencies, as both the euro and yen saw renewed strength this week.

~The recent volatility in bonds, especially the Treasury market, appears to many as a game of chicken between investors and the Fed. The latter are finding that safe places to park their money are becoming fewer and farther between, leaving them vulnerable to imminently rising borrowing costs (a rate hike from the Fed). Sovereign bonds in developed countries around the world have lost 3.7% since the end of April, and it doesn’t help that stocks and bonds have been tracking together, negating the hedge potential of sovereign debt.

~Goldman Sachs calls this stock market “boring,” as low trading volumes have resulted in a fairly flat performance for equities. Compared to stock alternatives like the volatile bond market, and even the summer fluctuations in energy prices, investing on external economic trends around the globe promises (if nothing else) far more excitement on both ends of the spectrum: China’s stock market continues its massive bull run, while the German DAX index has entered a 10% correction amid a sell-off of Bunds.

~Ted Cruz invokes President John F. Kennedy in a speech this week in an attempt to absorb the Democratic president’s legacy into the sphere of Republicanism and Conservatism. While president, Ronald Reagan also famously referenced how JFK would have been a Republican in the political landscape of the time. Cruz’s speech is a clear statement about the stance of the Democratic Party on raising taxes.

~Nicola Sturgeon, the First Minister of Scotland and the head of the Scottish National Party (SNP), embarks on a media tour of the United States this week. Sturgeon’s popularity has exploded since the referendum on Scotland’s independence from the U.K. was held last year. Many political analysts expect that if Britain puts its EU membership up to a national vote in 2017, it will subsequently trigger another independence referendum in Scotland.

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MARKETS

Markets Largely Steady Despite Worrisome Signs

Spot gold opened at an 11-week low on Monday, so some slight recovery was expected this week. Although there were no dramatic moves in either direction, the metals were divided in Monday’s trading session, with gold and platinum posting slight gains while silver and palladium slid back near support levels at $16/oz and $750/oz, respectively.

Meantime, stocks and bonds fell in tandem, while the dollar dropped sharply. Even though U.S. small business confidence grew to a 5-month high in May, the Dow Industrials were off 0.45% Monday, while the S&P 500 lost 0.65%, and the Nasdaq was down 0.9%. European markets remained shaky ahead of the Greek negotiations, while the rest of the global markets were in the red across the board–except for Shanghai, which jumped by more than 2%.

After falling by more than 3.5% last week, crude oil was down again on Monday, falling partly on the announcement that OPEC will not be cutting its production quotas. On Tuesday, the two major world benchmarks each spiked about 4% on Tuesday morning, pushing WTI crude and Brent crude back to $60.50/bbl and $65/bbl, respectively. These price levels held steady by week’s end even after crude lost about 1% on Friday.

Tuesday morning also saw the dollar poke into positive territory before slipping into the negative for the day. World markets were again red across the board, excepting the fledgling Turkish and Brazilian indices, which may again become attractive as the global bond sell-off spreads into the sovereign debt of emerging markets, as well. U.S. stock indices avoided their 4th straight day of retreat, closing flat after opening sharply lower. The precious metals held onto modest gains for the day, while the dollar again lost ground on its international peers.

The precious metals got a boost when the dollar fell further on Wednesday. Gold added about $15 per ounce to return to the $1,190 mark after the DXY index sank to 94.7. The other metals also managed marginal gains. Meanwhile, stocks saw renewed strength, with all three major indices advancing more than 1.2% on the day. Investor funds may have been briefly flowing into equities after their recent downturn because of their comparative attractiveness to major government bonds: the yields on benchmark 10-year U.S. Treasury notes and 10-year German Bunds both hit 9-month highs this week. The T-note yield has jumped from 1.86% to 2.48% (before returning to 2.34% on Friday) in a span of just 2 months, while the Bund has risen from a floor of 0.05% yield to about 1% during that same period.

Not coincidentally, funds have overcrowded into the corporate bond markets. The three traditional largest buyers of these securities (insurers, mutual funds, and foreign investors) have been concentrating ownership, with these three groups holding two-thirds of all corporate debt. They snapped up a large portion of the $9 trillion in corporate bonds offered after 2009 in the wake of the financial crisis. In the last decade, these “big three” types of investors have accumulated an additional $3 trillion in bonds, meaning any downturn in these assets could be highly correlated in their huge institutional portfolios.

Even analysts at Wells Fargo have been warning that a simultaneous drop for the dollar and bonds could prompt the mutual funds and foreign investors to dump their shares en masse. The big players in the bond markets (BlackRock, PIMCO, Vanguard) have issued similar advice in their investor reports. Median corporate bond yields are at a 17-month high of 3.36%.

Seemingly ignoring that the U.S. is seeing the weakest productivity for an economy in expansion since WWII, stock indices rallied on Thursday thanks to jobless claims holding steady below 300,000 for the 14th consecutive week and retail sales rising 1.2% in May. Indeed, there were a record high number of job vacancies in April, marking the first time on record that job openings were outstripping new hiring. This should indicate that the labor market has some space to grow. Wholesale (producer) prices also saw their biggest gains in May in over 2 years. Yet, it’s abundantly clear the stock markets don’t particularly follow fundamentals, instead responding more to trends, prevailing sentiment, and optics.

The bounceback in U.S. and Chinese stocks is therefore more about momentum than underlying strength. After a pullback begins, trader behavior on the buy side can often succeed in keeping the indices propped up. Before Thursday’s bump, both the Dow Jones and the S&P 500 were on the cusp of relinquishing all of their gains for 2015; in terms of market breadth, approximately 60% of shares listed on the S&P closed above their 200-day moving average at the end of last week, the lowest proportion in 8 months. Even as the market continues to top, plenty internal indicators such as this have been going sideways.

Here are two more telling reasons to believe that stock values are expensive relative to the issuing firm’s actual strength: According to the AP, 72% (360) of the companies listed on the S&P reported adjusted profits for Q1 that exceeded net income, and the proportions are rising. Moreover, more than a fifth of those companies (105) had adjusted profits that were at least 50% above their reported net income. This trend of inflating corporate performance has likewise been on the rise.

Due to some profit-taking, the precious metals slid back on both Thursday and Friday, posting modest losses across the board. By Friday, gold held around $1,185/oz, silver halted near $15.95/oz, while the Platinum Group metals were nearly flat at $1,100/oz (Pt) and $745/oz (Pd). Stock indices across the U.S. and Europe did end the week on a sour note, though their counterparts in Japan and mainland China were still in the green on Friday. In forex, with the dollar moving back above 95.0 on the DXY index, the euro held just above $1.12 and the yen fell to about 123.5 per USD.

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GEOPOLITICS & WORLD EVENTS

Europe Searches for Firm Footing on Slick Greece

Greece remains deadlocked in its negotiations with creditors in Brussels, Belgium this week. Although fiery finance minister Varoufakis made conciliatory comments about European Commission President Jean-Claude Juncker, Prime Minister Tsipras has seemingly burned his bridge with the Luxembourgian after mischaracterizing the institutions’ efforts to strike a deal to his parliament. Not only is time running out on Greece’s original bailouts, but Athens’ benchmark stock index has also lost 26% over the last 6 months. Expectations of an imminent deal were quashed when the IMF contingency walked out of discussions in Brussels and flew to Washington.

Tsipras has now taken the approach of warning about the risks of a “Grexit,” implying that any anti-establishment spillover into Spain and Italy would be on the conscience of the Troika. The tense nature of the negotiations has widened the rift between hawkish German Finance Minister Wolfgang Schaüble and more moderate Chancellor Angela Merkel. Though a potential Grexit could have a devastating ripple effect across the continent, derailing Europe’s recovery from recession, it does appear that each fresh Greek proposal is simply a rehashing of previous sticking points. If one follows the logic, Tsipras may not be negotiating in earnest because his party expects the creditors to cave at the final moment and accept a more attractive deal for Greece.

Chinese Markets Froth as Economy Slows

While the Chinese economy will likely fall short of the government’s target of 7% growth for 2015, the establishment can still pat itself on the back for the fantastic performance of its equities market.

The government indeed deserves credit for the unbelievable 6-month rally that has nearly doubled the value of the Shanghai stock index. By liberalizing its policies on buying and trading shares, the Chinese government ostensibly unleashed the massive potential of its stock market. Yet, the financial index provider MSCI will still delay adding blue-chip Shanghai stocks into its emerging markets index until the Chinese equity market gains better access to large institutional investors and capital markets. Nonetheless, it seems a foregone conclusion that yuan-denominated stocks will eventually be included in the MSCI index.

In only 12 months, the Chinese stock market has ballooned in value by $6.5 trillion. Despite the apparent success of this rally in stocks, there are plenty of worrisome signs that point toward the unsustainable character of the bull run. Chinese exports fell for the third consecutive month in May, while imports sunk by 17.6% to their lowest levels in three months. Overall, the Chinese economy is slated for its weakest year of expansion since 1990. Moreover, price-to-earnings ratios for companies listed on major exchanges are at 5-year highs, indicating that many firms are overvalued–and perhaps grossly so.

Much of the pouring of funds into stocks has been fueled by margin trading: Investors (read: speculators) on the mainland have accumulated nearly $350 billion in trades on margin, pushing margin debt to a new all-time high this week. Thus far, such speculation has been largely endorsed by the establishment and the state-owned media, encouraging citizens to buy into the stock market by any means necessary. This lends credence to the axiom that so long as the Communist Party supports a rally in stocks, it will happen. As Chinese equities edge closer to a fresh 7-year high, one wonders how long investors can willfully suspend their disbelief and continue buying.

Deutsche Bank Desperately Reorganizes

In a surprise move, the two co-CEOs of Deutsche Bank (Anshu Jain and Jürgen Fitschen) announce their resignation. Their replacement, John Cryan, is touted as a “turnaround specialist” thanks to his work as the CFO of UBS. He will have his work cut out for him, as the world’s biggest investment bank based outside of the U.S. is under investigation for concurrent tax evasion and fraud probes.

Similarly, HSBC is preparing to revamp its organizational structure in order to counter a downturn in the bank’s profitability. HSBC plans to cut 50,000 jobs, ceasing their operations in the once-attractive growth markets of Brazil and Turkey.

News & Notes

Turkey’s benchmark stock index, the BIST 100, drops 6% following elections that eroded the ruling party’s hold on the country’s legislature. Like many emerging markets hit hard by the global downturn, Turkey’s central bank has been trying desperately to protect the lira’s free fall. Along with Brazil, Turkey is another emerging market that has seen its economy go to shambles since the 2008 financial crisis. The median growth of emerging market stocks is at 4%–the lowest since 1999–and would be worse if not for China’s surge and Russia outperforming its regional partners.

India’s army strikes against insurgents across the border in Myanmar (formerly Burma) to avenge terror attacks conducted by these groups against Indian servicemen on June 4. The Manipur ambush killed 18 Indian soldiers, the most deadly attack of its kind in India in three decades. India’s military has taken a hardline stance against the terrorist group, perhaps sending a strong signal to similar factions elsewhere.

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A LOOK AHEAD: Monday promises to be rather busy with news: the Empire State Manufacturing index and industrial production data will be released in U.S.; manufacturing sales come out in Canada; adjusted retail sales and the producer/import price index will be announced in Switzerland; Italy releases its most recent CPI reading; and the meeting minutes from the last gathering of the Reserve Bank of Australia will be released.

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