November 30th, 2013
Summary, Conclusions, Must-Watch Developments
by Cliff Wachtel, FX Empire
Part 4 of 4: 9 Things That Decide The Markets' Fate In The Coming Months
The following is a partial summary of the conclusions from the fxempire.com weekly analysts' meeting. We stepped back from our normal weekly focus to form our outlook for the end of 2013 - start of 2014, as part of our preparation for our full forecast for all of 2014. The US government shutdown's data delay set us back about 3 weeks.
Here's Part 4, a summary and collection of conclusions about the things we all really need to watch. If don't have time to read all 4 parts, this is the one.
To view other parts click on the following links: PART 1, PART 2, PART 3. If your pressed for time, PART 1 and this article (PART 4) provide the overview, summary and conclusions. PART 2 provides details on what's needed to keep markets trending higher, and PART 3 reveals what will send markets plunging.
While the timing of the Fed taper and accompanying rate shock risks remain the key concern, there are others, and some are being mostly ignored.
For example, the EU bank stabilization plan negotiations and related ECB banks stress test issues present a huge potential risk, yet they've been mostly ignored as a major consideration for 2013-14. See below for more on that.
- Mother Of All Liquidity Rallies, Or, Don't Fight The Fed
- Growth And Earnings: Good Enough To Defuse Bubble Fears?
- Stocks Considered Expensive But Not A Bubble, Especially While #1 And #2 Persist
- Year End Data Positive But Doesn't Raise Early Taper Fears, Holiday Shopping Results In Focus
- Technical Picture: Entrenched Long Term Uptrends Keep Bullish Momentum While Above Fundamentals Hold
See PART 2 for full detail, below is a summary.
As long as the long-term bullish drivers of the 2013 rally all year remain in place, the odds favor more gains. These include:
Stimulus Continues & Continues To Work
An accommodative Fed that not only keeps cash flowing into the system, but also keeps rates so low that bonds and other safe-haven assets continue to offer meagre returns that don't even keep pace with real inflation.
Growth And Earnings: Good Enough To Defuse Bubble Fears?
If these can continue and keep P/E multiples steady at their 16.5x earnings level (not cheap but far from the 25x levels that unambiguously signal bubbles), that would go a long way to easing bubble fears. If not, then the rally becomes much less stable as trailing 12 month PE multiples move much higher.
Stocks Considered Expensive But Not A Bubble, Especially While #1 And #2 Persist
The valuation debate remains ambiguous and unresolved: The consensus is that stocks are neither cheap not outrageously expensive, especially when one considers the returns on other assets for those seeking yield. US Stocks are at record highs but not so far from the prior highs of 2000 and 2007. Each week seems to bring out another long term bear that continues to distrust the rally, but who has become reluctantly bullish. They recognize that the above listed conditions, combined with an absence of trouble from the EU or elsewhere, could keep stocks steady or climbing for years. See here for just one example of the latest reluctant bull.
Year End Data Positive But Doesn't Raise Early Taper Fears, Holiday Shopping Results In Focus
Top tier reports on growth and inflation, as well as Q4 earning reports in early 2014, are either mediocre enough to bolster delayed taper hopes , OR, are so positive that markets believe recovery can continue with the taper. Holiday shopping results could be key, as this determines much of the annual results for consumer spending, which comprises nearly 70% of US GDP. It's also key that 10 year treasury note rates keep well below 3% level that Bernanke warned could put a QE taper back on the menu out of inflation fears, as noted in the below summary of bearish forces.
Technical Picture: Entrenched Uptrends Maintain Investors' Bullish Bias
If the above fundamental drivers remain in place and so keep the uptrends remain healthy, then in times of doubt, tie goes to the bulls. That means dips continue to be bought barring very bad news that strengthens one of the bearish forces mentioned below such as:
- Rising QE taper anxiety AND rising bond rates out of proportion to the taper, thus threatening confidence in the recovery
- EU crisis or other tail risks hit.
See PART 2 for monthly charts from a sample of the leading US, European, and Asian stock indexes.
- Taper: Interest Rate Shock, Fears or Actual, Undermine Rally, Recovery
- Stock Valuations: Bubble Fears Rise If Growth, Earnings Data Doesn't
- Higher Risks Exacerbate Valuation Concerns
- Tail Risks From The US, EU, Japan, China, and Emerging Markets
See PART 3 for full detail, below is a summary.
So what would likely end the rally? Its obvious threats include:
Taper: Interest Rate Shock, Fears or Actual, Undermine Rally, Recovery
Taper that brings continued rising rates without corresponding growth in the economy and in earnings that would be needed to justify those rates, that would suggest the economy and earnings can handle higher rates and continue to recover.
In other words, the biggest question is, can the US taper without killing the rally, both in the US and abroad? As we discussed in Part 3, rising US rates are a problem for the rest the world too, because they make US assets in general more attractive, and the higher-yielding US bonds a better deal. Thus rising US rates force bond rates up everywhere, which is a problem for in places where they're trying to ease (Europe, Japan, Australia, etc.) or at least trying to prevent further tightening (China). For emerging markets, rising US rates mean less demand for bonds of emerging markets and the EU's GIIPS nations' bonds, and thus higher yields on them and higher borrowing costs in these nations.
We continue to believe the odds favor no taper for the rest of the year, but doubt it can be delayed much beyond March 2014 unless the US economy shows signs of deteriorating or bond rates start to spike and threaten the recovery. What could bring an early taper, perhaps even before year end? Fed Chairman Ben Bernanke explicitly told us this week that the decision to taper next month depends mostly on whether 10-year Treasury yields are at 3% or higher come December. If so, U.S. policymakers will be reluctant to reduce stimulus prematurely and risk even higher rates on the benchmark note. If rates are 2.7% or lower, then pre-Christmas tapering remains on the table. If they're between 2.7% and 3%, then we suspect the Fed errs on the side of caution and leaves taper decisions to the Janet Yellen-led fed, for all the 6 reasons we discussed here.
Stock Valuations: Bubble Fears Rise If Growth, Earnings Data Doesn't
The current consensus is that stocks aren't cheap but that they've room to run higher and are not in bubble territory. To keep the bubble argument at bay, growth and earnings data need to do one of the following
Continue their slow, steady improvement, ideally good enough to keep the bubble fears at bay
Be so good that markets believe economic and earnings growth can continue even with a taper and whatever rising bond rates come with it
Be weak enough to keep current levels of QE in place, and that combination of QE and low rates continues to keep risk assets like stocks moving up.
Higher Risks Exacerbate Valuation Concerns
Rising risks mentioned in PART 3, such as interest rate shock, QE failing to keep asset prices up, assorted tail risks in the US, EU, or elsewhere make risk assets look overvalued
Tail Risks From The US, EU, Japan, China, and Emerging Markets
As mentioned in PART 3, examples include:
- Another debt ceiling and budget battle that unlike the last one, does cause damage.
- Threats beyond US borders: Slowdowns elsewhere in the global economy that could be a material drag on US growth. As at the start of the year, the EU remains the biggest threat by far for reasons discussed in prior parts of this forecast.
Year-End Data And Events To Watch
The central banks remain the focal point of market moves, so signals they send, and the reports and data that matter most to them, will likely be the most influential in the final weeks of the year. Examples include the10 year note rates or other benchmark interest rates, monthly jobs reports, and retail sales (including updates on the holiday shopping season in the West). December meetings and rate statements, along with any other major speeches that could change market consensus about the banks' policies could also be market moving.
US Retail Sales
December's US retail sales reports for November will be unusually important. Not only are they the first read on holiday shopping, they'll also help confirm whether the spike in inventories behind the strong Q3 advanced GDP was in fact a bullish buildup in anticipation of rising sales, or a bearish buildup of leftover goods from weak prior months. In other words, it will strongly influence Q4 GDP expectations and thus overall expectations for the coming quarter.
A Clear EU Bank Stabilization Plan Done By The December 31 Deadline? The May Deadline?
The EU bank stabilization plan must meet at least three key goals:
Beat The Deadline: By December 31st the EU is supposed to finalize plans and funding for a bank stabilization mechanism that will help recapitalize or shut down banks that fail the ECB stress tests. With a clear detailed plan and funding in place that removes uncertainty about whether failed banks could raise contagion risks, the EU can proceed with the stress tests. Without a clear plan, the stress tests must wait - who wants to risk another EU crisis by finding bad banks before a safety net is in place? EU credibility would suffer a bit from the delay, but as long as they get a clear plan in place by May, no biggie. After May 2014 EU parliamentary elections could suspend progress for up to 9 months, bringing a variety of risks, which we discussed in detail here.
Be Clear On Key Details: Making the deadline won't help if the EU produces a plan that doesn't end uncertainty about how it will deal with banks that fail the tests. If the plan is too vague and allows failed banks to create contagion fears, then it's EU crisis Act III. The EU has made the mistake of try to fool market with vague, underfunded plans before back in the first Greek bailout, and these only served to raise fears and spark the worst selloffs since 2009 that ultimately required far larger financial commitments to calm markets. Unfortunately, the EU is already trying to keep wording vague in order to please everyone. For example, because Germany currently opposes any risk sharing among EU members (pay for your own banks, danke) it softened terms to allow Germany to dodge funding bailouts of non-German banks. See here for details.
Enough Funding: It's estimated that the stress tests will unearth about $50 bln in capital shortfalls, and that's with the polite fiction that GIIPS bonds held by EU banks are risk free! To keep markets calm, they'll need commitments for more than that to provide some cushion. If they cut funding too close, they risk raising uncertainty about how, when, and if, the EU can fix its banks.
CONCLUDING THOUGHTS: THE BIGGEST QUESTIONS
As we said at the start of 2013, the biggest questions for the coming year once again are:
- Does stimulus continue, and continue to work at propping up asset prices to record levels despite less than stellar underlying fundamentals and earnings?
- Can we continue to avoid contagion risks, most likely from the EU, even though none of the problems that caused the EU crisis have been fixed, nor have needed reforms and decisions been made?
Does Central Bank Stimulus Continue, And Continue To Work?
It's virtually assured to continue, and probably increase in the EU and Japan. But will it continue to work? The US looks set to begin to taper its QE, though the timing and pace will depend on both the health of the recovery and how well the Fed can manage to keep interest rates contained. If in fact the US is in a "liquidity trap," (relatively small QE cuts bring disproportionately large rate increases which threaten the recovery) then any meaningful taper is likely to be slow in coming and slow in implementation.
A Yellen-led Fed will err on the side of caution, and do whatever it can, including delay the taper, to keep rates low unless inflation suddenly becomes a major threat.
Can We Avoid Tail Risks?
Can The EU Continue To Avoid A New Chapter In The Debt Crisis? Specifically:
Devise a clear and funded plan to deal with banks that fail the ECB stress tests and complete these tests in a more or less timely manner, and otherwise continue to avoid a new chapter of the crisis while finally showing some real progress towards centralization of bank supervision and budgeting, and do it before May 2014, when EU parliamentary election activities will delay further progress for up to 9 months.
Arrange any additional bailouts that might be needed.
These are just the most immediate problems facing the EU. It also faces a host of difficult long term decisions that it must make to survive. See here for details.
Can The US Avoid A More Damaging Debt Ceiling Fight?
It could happen again, the atmosphere in Washington has not improved.
The Biggest Near Term Question: Can The US Taper Without A Rate Shock?
Can the US exit QE without causing US and overseas rates to spike higher, as we saw in May 2013? Whether the Fed tries to taper in December, March, or at some other point, that question remains the single biggest question and determinant of the fate of US and global markets.
The Big Common Denominator
Virtually all central banks of the largest economies are in easing mode. The Fed is moving toward a very tentative, slow tightening and telling everyone it wants to keep rates down for a long, long time. That is about as hawkish as you get as far the major central banks are concerned. The ECB and BoJ are moving towards additional easing. Australia's RBA has not ruled out further easing, especially if China struggles.
In sum, the USD, EUR, JPY and most other major currencies are all at risk of government inflicted losses of purchasing power. The USD has been fading versus most currencies and commodities for decades, as we discussed in depth here. While it may strengthen in the coming months, long term currency trends tend to persist, because changing the underlying fundamentals of entire countries takes a long time.
If most of your wealth is denominated in one of these at-risk currencies, you risk further decades of losses as your currency is debased. Virtually everyone with assets to protect and grow needs to
- Diversify their currency exposure,
- Hedge their primary currency's depreciation risk
- Build a currency-diversified income stream
Fortunately, it's not hard or time-consuming. You don't need to open accounts all over the world or engage in risky, complex day trading. In fact, please don't unless you've REALLY done your homework. This kind of get-rich-quick day trading philosophy pushed by so many forex types is strictly for those with the right training, personality, and (even then) experience.
Be Wise - Learn From A Fool: Easy Ways To Avoid A Common, Fatal Mistake
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Be wise, learn from my mistakes, and those of many I've watched and advised.
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To view other parts click on the following links: PART 1, PART 2, PART 3, PART 4. If your pressed for time, PART 1 and PART 4 provide the overview, summary and conclusions. PART 2 provides details on what's needed to keep markets trending higher, and PART 3 reveals what will send markets plunging.
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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.