FINANCIAL REVIEW

At Least it Wasn’t a 100 Point Drop

Sinclair Noe — December 15, 2014

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW -99.99 = 17,180
SPX – 12 = 1989
NAS – 48 = 4605
10 YR YLD + .01 = 2.11%
OIL – 2.53 = 55.28
GOLD – 28.30 = 1194.50
SILV – .85 = 16.29

The S&P 500 index traded below its 50 day moving average for the first time since the end of October. At its session low, the S&P 500 was down about 5 percent from its record intraday high hit earlier this month but up more than 8 percent from a low hit in October. Oil continues to be a drag on the stock market, and West Texas Intermediate hit a 5 ½ year low; now down right at 50% from the highs of June. OPEC’s Secretary General reiterated the oil producing organization will not cut production despite the current low prices and glut of supply coming out of the US and elsewhere. That’s leaving supply plentiful and prices low even as demand has been waning.

We have seen the lower prices at the pump and that basically means everybody gets a break, a few extra dollars in your pocket. That’s a good thing. So, why is the stock market reacting badly to lower oil prices? Quite simply there are a lot of companies involved in the energy sector, and that is where we get the drag. Also, the decline in oil prices alongside other economically sensitive commodities, including copper, might signal trouble in the global economy. A sputtering recovery in Europe and concerns about Asia have undercut oil demand even as robust production adds to a global oil glut. The fear is that the drop in oil prices might be a warning of something more sinister in the global economy. And if there are really global economic problems, it could spell trouble for the debt accumulated by energy companies, especially in the high yield market.

In economic news today, the National Association of Home Builders/Wells Fargo released the homebuilders’ confidence index today; it dropped one point to 57. A reading above 50 indicates optimism about new home sales trends. December marks the sixth consecutive month of above-50 readings.

Industrial production rose a seasonally adjusted 1.3% in November. This is the biggest increase since May 2010. The Federal Reserve also made upward revisions to output in the past three months. In November, manufacturing output rose 1.1% with broad-based gains. Output of consumer goods rose 2.5%, the largest increase since August 1998. Utilities output jumped 5.1% on cold weather in the month. Mining output dropped 0.1%.

The Great Recession is officially over, but Americans are still 40% poorer today than they were in 2007, the year before the global financial crisis. According to a new report by the nonprofit think-tank Pew Research Center, the net worth of American families — the difference between the values of their assets, including homes and investments, and liabilities — fell to $81,400 in 2013, down slightly from $82,300 in 2010, but a long way off the $135,700 in 2007. There is also a dramatic disparity in net worth between races. The median net worth of white households was $141,900 in 2013, down 26% since 2007. It declined by 42% to $13,700 over the same period for Hispanic households and fell by 43% to $11,000 for African-American households. One theory for the wealth gap: White households are more likely than other ethnicities to own stocks directly or indirectly through retirement accounts.

The wealth of most Americans has stood still. According to the Bureau of Labor Statistics, in November 2014, the average weekly wage was $853 versus $833 for November 2013. But things are improving somewhat when it comes to housing. According to Black Knight Financial Services, which tracks mortgage performance, nationwide, only 8% of borrowers have homes that are underwater as of October 2014, down from a peak of 35%, or 18 million homes, in February 2011; but 8% still impacts 4 million homes.

Bigger economic news this week will come from Europe, where there will be a presidential election in Greece, which will likely lead to snap elections, which will likely lead to talk of Greece defaulting or making a general commotion in the Eurozone.

Greek Prime Minister Antonis Samaras has brought forward the presidential election to this Wednesday, two months earlier than initially planned. Center-right Samaras needs to get two-thirds of the 300 members of parliament to back his party in either the Wednesday vote or a second round, which is expected just before Christmas. Should he fail, the threshold drops to 180 votes in the third round, possibly held on Dec. 29. If Samaras fails to secure enough support in the third round, parliament must be dissolved, meaning a possible snap election in late January; which seems very possible. And in a snap election, the far-left, anti-austerity Syriza Party is leading the polls. They don’t necessarily want to exit the Euro Union, but the Euro Union might want to kick them out. We’ll see. But the whole thing has really messed with the Greek stock market and threatens the Euro financial theater.

Meanwhile, a snap election was held in Japan yesterday. Prime Minister Shinzo Abe’s Liberal Democratic Party and Komeito, its junior partner in the ruling coalition, won the Lower House election by a landslide. In an election billed as a touchstone for the LDP’s economic policies, the ruling bloc secured a two-thirds supermajority in the 475-seat House of Representatives, giving it the power to override the Upper House. Sunday’s poll was widely seen as a referendum on Abe’s economic policies, dubbed “Abenomics” — a policy mix of radical monetary easing, fiscal stimulus and structural reform vows.

Russia’s currency is plunging yet again today. Currency prices are all about supply and demand. And just about everything that’s transpired in the past year has made the world far less interested in buying Russian money. Last year, one-third of Russia’s exports came from crude oil. When the value of your exports collapse, so does your currency. Worse yet, the Russian government, ever dependent on oil revenue, needs about $100 per barrel to balance its budget. And so, in a rather surprising and dramatic move late today, the Russian Central Bank raised interest rates from 10.5% to 17%. The ruble has lost 18 percent of its value just this month and if the slide continues it might just end up as the worst performing currency of the year—even worse than the Ukrainian hryvnia. Sometimes irony can be completely delicious.

The main event in the US is the Federal Reserve rate decision, where most observers are on the lookout for any change in the central bank’s rhetoric, especially around the timing of a rate hike. No one really expects the Federal Open Market Committee to do anything to the Fed’s ultra-low interest rates when they meet on Wednesday. That’s why most traders will instead focus on any changes to the language in Fed chairwoman Janet Yellen’s statement: Will it finally drop the phrase “considerable time” when discussing when it may make its first rate hike?

One of the thing the Fed should do, if they are really serious about raising rates, is to explain how they will handle the disconnect between the US and the international bond markets, because it is a disconnect that just might lead to a big sell-off in bonds.

US central bank policy makers expect the main Fed funds rate to rise from near zero today to 1.25 per cent by the end of next year, with the first rate rise penciled in for next June. The market projects rates to end 2015 at 0.50 per cent, with the first rate rise in October.

By the end of 2016, the Fed’s policy makers forecast rates at 2.75 per cent, while the market has them at 1.50 per cent. By the end of 2017, Fed policy makers expect rates to be 3.75 per cent compared with market forecasts of 2.0 per cent.

Keep in mind that we are likely to see much more monetary easing in Japan, now that Abe has scored a victory in the snap election. Also, there is a very strong likelihood that Mario Draghi will indeed deliver full blown quantitative easing in the Eurozone early next year, which should keep Euro bond yields in the extremely low to negative range.

But in the US, there has to be risks that yields will rise sharply, should the Fed stick to its forecasts and start tightening policy aggressively in the middle of next year.

With yields on 10-year US Treasuries close to all-time lows and nearly a percentage point lower than they were when the year began, yields surely have only one direction to go — and that is up. If US yields do head north, then yields in other government bonds are likely to follow, despite benign inflationary pressures and the launch of QE by the European Central Bank and continued QE in Japan.

It means 2015 could be a tricky year for fixed income fund managers, particularly those running long-only portfolios. This might explain why absolute return funds have become more popular, as these funds can short the market and use derivatives to protect capital in the event of a blow-up in bonds.

For example, some absolute return funds have bought emerging market credit default swaps to protect portfolios against a sharp jump in yields. I don’t want to play the game of trying to predict where bond yields will be a year from now; that’s a fool’s errand, as the spectacular failure of most bond forecasts this past year proved. But it seems that something big might happen, just because there is a big disconnect between global bond markets.

The US Senate was still at work today because there are a few more pre-holiday tasks ahead. However, there will be no government shutdown as a spending bill was passed Saturday. There were some very strange provisions that were tacked onto the spending bill, but the strangest by far was allowing Citigroup to open a branch office in the cloakroom of the House of Representative. Lawmakers said it was just a matter of convenience and would make it easier to collect their payments and take there marching orders. (not confirmed, it just seems that way)