Prepare for volatility

Last week, I wrote to expect a short-term rally, which was a tactical trading call (see The "Merde" rally?) but I wasn't convinced that any rally would be the start of an intermediate term move upward for stocks:

My inner trader wants to buy risk in anticipation of an oversold rally. My inner investor tells me to watch the market action in likely ensuing rally to gauge the strength of the bulls as this is just another phase in the choppy up-and-down market action that we have been witnessing in the past few weeks.

The market action on Thursday and Friday makes me more unconvinced that this is the start of either a sustained bull or bear move. We have a lot of macro cross-currents between now and year-end and navigating them will be a challenge for any investor. In some cases, we have economies that appear to be outperforming but likely to start to underperform later in the year. In other cases, you have the reverse - economies burdened with negative news but whose headlines are likely to improve later. The difficulty is that the timing of all these twists and turns will be highly uncertain. Moreover, it is unclear which headline the markets will focus on during this period of uncertainty.

To summarize my outlook, I use my framework of the Three Axis of Growth, namely Europe, China and the United States. I preface my analysis with the comment that, as an investor, I am agnostic on the question of whether an economic policy is the correct one or not. Rather, I focus on the likely effects of that policy on the markets:

• Europe: News flow and headlines are negative and likely to get more negative. However, investors shouldn't discount the effect of a political response, which would serve to kick the can down the road yet one more time and the markets would rally in relief.
• China: Uncertainty reigns, but the market perception of the likelihood of a hard landing is receding, at least for now. The change in leadership later this year is likely to usher in a period of stimulus, which would provide a bullish impetus to the markets.
• US: American equities remain the global leadership, for now, but economic momentum is faltering and the Fed may not have the political capital to act between now and the November elections. Moreover, the US faces a fiscal cliff in 2013. Markets typically look ahead six months or more. When does the markets start to discount the negative effects of that fiscal cliff?

Another European summer of discontent
After the positive news about a "fiscal compact" and LTRO, which saved the eurozone from disaster late last year, the headlines from Europe is starting a negative cycle. The equity markets are reflecting that heightened anxiety as a glance at the DJ Euro STOXX 50 shows that it is in a well-defined downtrend. The bad news for investors is that the negative news isn't so bad that we are poised for a rebound. I would wait until the index declined into the support zone before nibbling away at positions.

Across the English Channel, the FTSE 100 is declined and is now testing the 200-day moving average. I interpret this as another sign of market stress over the eurozone.

Jeff Miller of A Dash of Insight put some perspective on why you shouldn't blindly react to the headlines and panic over Europe [emphasis added]:

Most of the commentary we see has three steps:

1. Some problem in Europe
2. Cockroach/contagion/domino
3. Disaster for the world

This type of commentary ignores any policy reaction, and also often insults the leadership of European nations, the IMF, and the ECB.

[snip]
I suggest that investors read very critically when a story suggests causal relationships that lack specificity or quantification. Be even more suspicious when the story ignores policy responses. And finally, how about some quantification concerning Europe's impact on the US economy?

My own conclusion -- familiar to regular readers -- is that the European story is an ongoing process of bargaining and compromise. US observers are far too ready to impose their own value judgments on other countries and cultures. The exact trade off of austerity, bank recapitalization, central bank intervention, and rescue funds is a work in progress. The exact nature will change and I still expect new entrants.

Marc Chandler at Brown Brothers Harriman wrote an excellent piece entitled 10 points on the comity of Europe that made a similar point. The article is well worth reading in its entirety, but here are some highlights:

1. EMU itself is a culmination of two trends: 1) the integration of western Europe since the 1950s and 2) efforts to keep Germany wedded to the fortunes of Europe. The elite, and it is an elite project, knows no alternative strategy.


2. Because there is no Plan B, there is no mechanism to formally eject Greece or any other member. Polls indicate a majority of Greeks want to stay in EMU.

5. EMU is an institutional expression of the comity of Europe. These nation states have lived with each other for longer than the US has been around. It is very much like a family, even if dysfunctional (what family isn’t?). They did not get to chose each other. Their histories are intertwined. There is a great desire for peace and prosperity. It is difficult to prove that integration has made peace on the continent, but is sure looks that way.

Miller and Chandler make the point that the European elites will find a way to defuse the crisis, because of the long history of Europe and the political commitment involved. Already, the consensus is starting to shift:

6. The ECB’s Draghi and EC’s Rehn came out in favor of a growth/investment pact prior to this past weekend’s election results. This changed the political discussion. German officials recognize the shift and have sought to get ahead of the curve. Some suggest that this is always what was intended. Austerity was phase 1 and growth/investment was phase 2. The debate is now really over the content of a growth/investment pact, not whether one will be forthcoming.

While European stocks are reflecting the anxiety about another eurozone crisis, the bond market isn't overly concerned. Consider, for example, the yield on the Italian 5-year note. Yields are below the crisis levels of last October and November and below the heightened anxiety levels of last summer, indicating that the bond market is not worried about contagion from Greece and Spain.

The yield on 5-year Irish paper shows a similar picture. No anxiety at all.

The yield on Spanish paper has risen, but they are at levels below the high anxiety days of last October and November.

Trust the bond market over the stock market. The bond market has to finance the European sovereigns and their banks and signs of stress will show up there first. Don't extrapolate the effects of the dire headlines in a straight line. The bears should be aware of policy reactions. That's why I believe that while the headlines are headed south, they will reverse course in a few months and start to go north again. For investors, timing that turn will be a challenge.


Is China stabilizing?
Moving eastward, there seems to be some degree of stabilization in China. The Shanghai Composite staged a brief but unconfirmed breakout from a wedge, which would be bullish. Although the latest trade figures were highly disappointing, the market reaction, which saw the Shanghai Composite close flat and marginally up on the day, was gratifying for the bulls.

Next door in Hong Kong, the picture looks less bright. The Hang Seng Index has violated an important technical support level Friday. I would wait for signs of follow through before turning overly bearish, however.

To understand China, you also have to understand the concept of how important "face" is to the Chinese. China's political leadership is scheduled for the change that occurs every 10 years late this year. The new leaders will loathe to step into a situation where the political and economic outlook are rapidly deteriorating - they will lose face. Expect a substantial stimulus package later this year to boost the economy. Already, the authorities are taking steps in that direction as the reserve requirement was cut by 0.50%.

As with Europe, timing that turn will be a challenge.


When will Americans realize they face a fiscal cliff?
Moving the spotlight across the Pacific to America, US equities today remain the global leaders. The chart below of the SPX against ACWI (MSCI All-Country World Index) shows that US equities continue to outperform other global bourses.

Not all is well in America. I wrote about the prospect of a short-term bounce last week here and here but the rally has been rather weak. JPM's problems notwithstanding, I believe that the rally will still materialize. The two things I will watch for in US equities are the ability of the SPX to hold support in the current support zone and for the index to rally above its 50-day moving average.

Moreover, the US faces a fiscal cliff. There have been many warnings, such as this one from The Economist. Here is some analysis from Pragmatic Capital on the reasons behind the fiscal cliff:

1. The Alternative Minimum Tax (AMT), currently at 28% for those filing jointly with incomes of $74K or greater, will drop down to $45K. That means that middle class families making over $45K will not be able to use deductions (medical, etc.) to pay less than 28% in taxes – a substantial tax increase on the middle class.

2. The so-called “doc fix” provision, which is currently keeping the government from implementing a 25% cut on physician payments by Medicare, will expire unless Congress acts.
3. The Payroll tax cut will expire at the end of 2012, increasing from 4.2% back to 6.2%.
4. The Super Committee’s inability to reach a decision last year will force mandatory cuts (sequester) in the US government’s discretionary spending. A great deal of that will hit the defense industry.
5. Unemployment benefits for workers who have exhausted the standard 26 weeks of benefits will be phased out.
6. Numerous temporary research and development tax benefits to corporations will expire.
7. The 2001 and 2003 tax cuts are set to expire. This includes tax rates on those making over $250K as well as qualified dividends and in particular the 15% rate on long term capital gains. People are wondering why we are having a string of large IPOs this year (including may private equity backed IPOs), even in a less than friendly IPO environment. Part of the reason is that the current cap gains tax rate may be the lowest that the owners will be paying in the foreseeable future.
8. At the end of the year the infamous debt limit will hit again, potentially forcing further cuts. 

To give you some sense of how steep the the fiscal cliff is, it could amount to as much as $600 billion, or 4% of GDP:

According to Goldman Sachs, the total of amount of dollars the US government will be taking out of the economy is about $600 billion. Clearly some of these provisions may be modified or extended. But given the sharply divided Congress and the contentious election year, the political impasse is likely to continue. A large portion of these tax increases and austerity measures may take effect. These changes will potentially be a positive for the US budget deficit, but for an economy that is still fragile and somewhat dependent on government stimulus, it will certainly generate a material drag on the GDP growth.

A 1-2% GDP contraction amounts to a run-of-the-mill recession. A 4% contraction puts the economy into economic depression territory. When does the stock market start to discount these risks?



Can the Fed ride to the rescue?
Moreover, high frequency economic data is going south, as exemplified by the last two disappointing NFP releases. Take a look at the Citigroup Economic Surprise Index, which charts the degree that economic data come in at above or below expectations. The index peaked in January and February and has been falling ever since and has fallen below the zero line, which is the level where economic releases come in at expectations. Moreover, ECRI has reiterated their recession call.

If the economy is deteriorating. What about QE3? Don't forget that this is an election year. The Fed will hesitate to intervene unless there is unequivocal evidence that the economy is falling apart, e.g. the stock market craters by 20%. So don't count on the Fed to be proactive and ride to the rescue.

Yes, the Bernanke Put still lives, but this insurance policy has a rather high deductible at the moment.

In short, while the US market is still the leadership right now and global investors should give their US allocations the benefit of the doubt, the outlook will deteriorate into year-end. Timing that turn will be another challenge.


Prepare for volatility ahead
So where does that leave us for the rest of 2012? In one word: Volatility.

I wrote last week that I expected a short-term rally. This was a tactical trading call for a rally that was likely to last 2-4 days. Today, the relative performance of SPY (equities) against TLT (US long Treasury bonds) show that stocks have violated a relative support level against bonds, but look highly oversold.

The relative performance of the defensively oriented Utilities sector against the market shows a similar bearish picture, but the sector appears to be extended on a short-term basis and ripe for a consolidation/pullback.

Longer term, we are faced with huge cross-currents from around the world. Investors have to contend with the following questions going forward:

1. When do some of these trends reverse and turn around?
2. Given all these cross-currents, which headline will the financial markets focus on?

These are the challenges we face. Be prepared for greater volatility and more choppiness in the markets.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.