Credit Twist

I don't think I really need to talk too much about the possibility of the US Fed increasing interest rates earlier than everyone thinks. I've stipulated many, many times the end of near-zero interest rates and QE3 will cause some serious disruptions. Especially since the world has been so used to it for the last 5 years and so many little bubbles have been popping up all over (e.g., bitcoin, Asian housing prices, social media).

What I want to talk about today is 'credit' - a relatively simple and boring concept that will be the key driver to understanding this year's stock market. A smooth credit system is what allows individuals and institutions to live and prosper above their means. It allows economies to prosper, and equally to wither when it is disrupted.

The current market is in an interesting flux with credit as a vague idea being withdrawn from the market, ie. the withdrawal of QE3 which isn't directly a hike in interest rates or precise withdrawal of credit/lending. The US economy continues to grow steadily despite weather disruptions (see the Feb jobs number) and QE3 tapering continues. While this isn't exactly credit tightening, the withdrawal of money from the market will have intriguing consequences. For the forward-looking stock markets, even the expectation of withdrawal of money will be influential.

We've already seen early signs of this distress and disruption from more heavily debtor/deficit nations like India, Indonesia, Kazakhstan, Ukraine, Argentina, South Africa, being forced to hike their own interest rates to try to stem too much capital flows from leaving their countries. On the other hand, New Zealand became the first developed market to hike their interest rates by 25 basis points for completely different reasons (because they are doing well, too well for their central banker). All in all, credit is leaving this world and flying back into the world central banks.

In fact, the largest risk to the US stock market is an improving economy, in an indirect way. This is counter-intuitive logic. To the normal layman, a stronger US economy economy should result in stronger orders/demand for products/services for the rest of the world, pulling global growth upwards. But what will more likely happen as a twist will come back to the concept of 'credit'. As the US economy grows, QE3 continues to be pulled away, interest rate hikes start coming, and bonds/treasuries start selling off in expectation of higher inflation, the borrowing cost for the rest of the world will increase. Credit starts to get withdrawn from countries/institutions that shouldn't have received so much of it previously. Analogous to the sub-prime crisis in 2008, you can think of countries like Argentina, South Africa, Indonesia as being 'sub-prime' (the culprit, rather than the fall of housing prices, will be the fall of commodity prices). And when one or a chain of these sub-prime countries start running into problem, you can be sure it will affect the US stock market which doesn't trade particularly cheaply after being in a bull market for the last 5 years.

At the beginning of the year, many pundits claimed that a rising US economy would bring up the rest of the global economy. The opposite may just happen as credit tightens around the world. Instead of the US bringing up the rest of the world, the rest of the world has the potential to bring down the US stock markets.

What to do today then? You can play a trader and go long US equities until bond yields start spiking, and then start reversing your trade. Or you could hop on the emerging market bear train - being naturally contrarian, I sure hate going with the bearish-on-emerging markets crowd, but it looks like they may just win it out this year. Pick and choose your strategy wisely and don't forget to keep some cash, a great multi-year long/buying investment opportunity is coming full steam ahead!

Could Selloff Cause Fed to Slow Taper?

(see my last post "Rally On, Bull" for my talk on this diagram)

I watched an interview with Art Cashin of UBS (see link) who believes there's a possibility that the recent emerging market sell-off could prompt the Fed to slow down their 'tapering' of QE3. In my opinion, in recent years the Fed hasn't given a hoot! about emerging markets and they won't veer off course in their meeting next week. They didn't care that they indirectly caused easy money to go to countries and assets that shouldn't have attracted money the way they have, which is a long list. And next week, they will just look at domestic economic indicators and base their decision to cut QE3 on them. Other than a weak unemployment number in December, other indicators like ISM looked positively fine.

In any case, if they do cut back on QE3 as I think they will continue to, we will have gotten a lot closer to that intersection point I drew up in my post last October (and repasted above). This is an eventuality that will happen. So much for all the optimism the analysts had for the markets this year! If you paid me a penny for every report I read in December calling for a continued rally in the developed market I'd be pretty rich. Well, at least rich enough to buy myself a Big Mac at Mcdonald's.

Rally On, Bull

As soon as the Fed tapering talks died down a U.S. government shutdown comes. This year has definitely not been short of excitement! 

The confusion in the markets is quite surreal - the equity markets rallied and treasuries sold-off post-government shutdown, which is initially counter-intuitive, because, shouldn't people be scared of a world where Americans can't visit their national parks and see pandas live on the internet? Some are arguing that the cause of the equity market rally is that this shutdown will prolong easy money from the Fed, helping the markets extend their rally:

"We do not know how long this impasse in the U.S. will last. If it persists, there is a chance it will hurt economic growth and affect chances of Fed tapering," said Daragh Maher, strategist at HSBC. Source: Reuters 

I have to biased-ly agree on this (see my previous post on delayed Fed tapering). This is definitely going to hurt the economy, and the damage will extend beyond the humorous shut down of the panda live cam. Easy money will continue.

In terms of implications for the markets, this turn of events is extremely confusing and even more ambiguous. On the one hand you have expansionary monetary policy with the Fed continuing QE3 and low interest rates, and on the other hand you have a contractionary fiscal 'policy' (or rather, 'failure'!) where the two parties are jockeying for political position at the expense of the citizens' livelihoods. So in the end the status quo continues: easy money in the market, higher equity valuations, but an economy that continues to stumble along. At some point these two trajectories will change directions and that's when I foresee a turn in the equity markets. Below is a simple picture of how I imagine this will all end up in the next 2 years.

At the point where the two lines intersect is the situation where the equity markets will have far outrun the growth in the economy, and become irrational just as easy money gets taken out of the money by the Fed. The most likely scenario at that point will be a market crash.

In the near term, I think easy money will prevail and it's most likely that the equity markets will continue on their upward trajectory this year. Some kind of market pullback is warranted as the economy remains tepid due to the fiscal budget while market valuations have run since last year. However, judging from all that I read I just don't feel that we are at the euphoric phase of the bull stock market just quite yet; the Fed has continued to distort and fuel the markets. Get ready for the next bull leg of the markets, it may just be the last one!

To Taper or Not To Taper That is The Question

I'm re-focusing today's topic on something I only talked about briefly last post, the US Fed's next move. The market consensus today is that the Fed will start tapering (i.e. slow down QE3 / long dated bond purchases) in September. This has been the case shaping since May of this year when Bernanke did a fumble and made the mistake of saying out loud that tapering could happen as soon as September. He quickly tried to make a U-turn subsequently by going to media to say that no, they were only going to taper if the economic data showed significant improvement.

The market has not cared about Bernanke's frail attempt to calm market fears. As shown in the chart below, US 10 year treasuries have sold off quite drastically relative to the stock market (shown as the S&P 500). This is a normalized chart and not a very typical chart to show, but I thought it neatly showed the relative underperformance of US Treasuries.

Source: Bloomberg














People have been pulling money out of bond funds relentlessly. It's pretty easy to guess where most bond funds have been allocating their money based on how quickly the US treasuries have sold off.

The question going into September is definitely if the Fed will start tapering or not in September. Most people have already factored in at least a $10bn reduction in QE3.

I really don't know why they think this!

In the last FOMC statement in July they revised down their vague Fed language on US economic growth from "moderate" to "modest", the first time in a few years. Only one person dissented from this statement and this was long time dissident Esther George. Everyone agreed on continuing the $85bn in monthly QE3. First quarter GDP growth was revised down from 2.4% to 1.8%. People have all of a sudden forgotten about sequestration (the word we all just learned in 2012) and the negative effect on people's income and employment. For example, an indication of this is Walmart earnings and their negative outlook for the 2nd half of the year. The market gets fixated over every little economic data and the accelerated sell-off in US treasuries is irrational. Why would the Fed pull-back so drastically? They are not stupid. They know a spike in mortgage rates will hinder the housing recovery. They know a spike in borrowing costs will hinder the economic recovery.

Now don't get me wrong: I too am a long term bear on US treasuries as I've said in my previous posts. But let's not get ahead of ourselves please.