Oil prices have rallied at the start of the year picking up note from media and market analysts. This rally looks great coinciding with the start of the year, but at these levels the fundamentals will be responsible for significant moves in any direction. Starting the year from an extreme sell-off helped pull the commodity up from the pre Christmas low, back to levels seen at the start of December. This level is an good example of dislocations in the markets temporarily creating opportunities to purchase assets at a fair price. We can look at this historical example to spot future opportunities.
The end of 2018 saw a lot of volatility enter markets and, looking back, created opportunities for entering into some positions. Spotting these trends and executing on them requires prior planning and building a case. Oil was in a decline from the start of October as too much supply started to pressure prices and fears about the global economy came to the forefront. As the markets came to the end of the year we saw an extended sell-off in risk assets and commodities when trade tensions between China and the US started to increase. But there were trends that weren't all bad that came from these extremes.
In the beginning of December, OPEC and Russia agreed to curb production as the US was hitting record production numbers. This news came after the majority of the swings in the price of oil and temporarily put a stop on fall in oil. Then, among light trading and trade fears the price started to drop dramatically despite fundamental news not coming out every day.
Making the assumption that you were looking to get into oil or oil commodities and determined that the news from OPEC and sanctions on Iran were good catalysts for an entry point (with some security knowing that the lack of high yield bond issuance was a good sign there wasn't aggressive expansion in the Fracking sector) you would now be watching this space. The relentless drop in the oil price would prompt you to look for data supporting that movement, inventories? flat to down in the US. Production? cuts from OPEC were to take effect in 2019. Downside risks include trade wars heating up and an economic slowdown.
Forecasts for a slowdown are present but not extreme, and the Fed came out more dovish on rate increases, providing some security that they will be willing to hold rates if conditions worsened. The US and China gave a 90 day extension to trade tariffs at the G20 in the start of December, providing some opportunity to reconcile before that time. This left oil in a good position to be bought in the violent downswing at the end of December. This doesn't mean it is a bottom, or that there is significant upside in the near term. Rather it was a good entry point with a margin of safety compared to the fundamentals at this time.
So how can you use this hindsight to look ahead? Looking at what opportunities may lie ahead and building a story is the first part. Is volatility coming back into the markets and now is a good time to buy protection in the form of puts because of low volatility? Are retails stocks looking cheap after Macy's caused an industry-wide selloff yesterday? Now is the time to start looking into these answers and waiting for a shorter term dislocation in the market to start building a longer term position.
It has been a good start to the year in equity market terms. Stocks were rallying off their lows in December and the Vix has come back down to around 20. There is a lot of talk around what happens in January spells out the year. In reality the longer term prospects will determine how 2019 will end. This week we have seen growth prospects for countries downgraded in the EU, where even Germany is not spared. The World Bank has came out downgrading global growth, with the decline led by the advanced economies. The causes of these lower estimates are not new (slowing trade, less commodity demand, removal of central bank stimulus) but they were something the market seemed to ignore, at least in the US last year. The declines we have seen in the markets have caused participants to take these changes into account in finding the right balance of long term economic prospects and market levels.
Over the past 2 months there are many people who no doubt questioned being in the markets during such a violent downturn, and are not questioning why they are not more invested into the markets now. Small gains do make for longer term returns but trying to time the markets in such an extreme fashion is difficult. Creating a longer term outlook and using that as a guiding principal of when to add or take away from exposures in the market is where the individual gains an advantage. Looking at the data it is a good time to build a story around different asset classes, sectors, and regions to invest in. Find the conditions that make sense to buy into (or sell out of) a position in the longer term, and execute.
Sometimes the market seems to be dislocated from the theory that you laid out. This is a great way to know where you need more research and testing. Perhaps change the amount allocated. This could help avoid mistakes in the long run, or find great opportunities where the market is thinking too short term.
Yesterday we saw global markets shocked by the news of a slowdown in Apple sales in China. This potentially caused the flash crash in Yen currency pairs, markets to sell off globally, yields to drop, and Fed expectations to start pricing in a rate cut in 2019. This is a culmination of all the bad news of last year coming to a head. Bad times are still ahead for us.
Today, job numbers came out in the US way above the estimates that the markets expected. The Fed said that they would be more patient with monetary policy as they assess data. Market soared back today as the good data seems to negate the moves we have seen yesterday, along with the fears that a global slowdown is increasingly likely.
What needs to be looked at through this chop is where the longer term trends are and how 'sticky' each data point is. The news by Apple (and other companies) about lower than estimated earnings in 2019 will not be a transitory event. Companies do not put out bad news of this sort if they feel the markets will turn around quickly and result in better earnings. As far as the Fed coming out to reassure markets they will be patient with the data, while it is taken as good news in the market (the Fed put trades are being reinforced) the Fed would only act towards easing as the data comes out confirming what companies like Apple are warning, a material slowdown in growth. The Fed put is great for longer term buys, knowing there is some support as the economy slows, but still would come on a backdrop of lower US growth. The high jobs numbers are great for the economy and point to the US continuing to buck the trend of the rest of the world, however the stickiness of these numbers are not as reliable over longer term horizons. Companies hire cautiously and close positions hastily as the economy sours.
For your portfolio these times still present opportunities as a decisive direction is still unclear. Knowing there is a backstop of the Fed softening its stance on rate increases, the dollar should not see as intense of a rally this year as we did in 2018. This helps in the Emerging market space as well as commodities (trade wars will still determine the majority of movement near term). The severe sell-off in the developed markets are providing attractive yields for longer term value plays and aligning valuations where we have seen stocks get expensive.
The start of the new year has many analysts discussing what the year ahead might bring and how to positions portfolios for them. I can fully appreciate the start of the year as a new beginning to the investment process but the last quarter of the year has provided most of the insight we need to assess how the markets will fare this year.
Markets started lower from bad manufacturing data coming out of China, this is a continuation of the concerns that the engine of global growth is slowing down. There will be no easing of these concerns without the Chinese government taking action to stimulate the economy. Concerns over the debt loads of companies are also a concern and will be looked at closely.
UK Manufacturing PMI came in better than expected but was attributed to large inventory build ups in preparation to Brexit disruptions that could come about in March from a disorderly withdraw from the EU. This will be a very important, and news dominating, event that will dictate currency and market movements for the first quarter. European parliamentary elections will have a large effect on the unity of Europe and further integration (or dis-integration) but will not get the same market attention as Brexit I fear.
In the US the markets open 2019 with the government shutdown still in effect. As the newly elected leaders are sworn in, you can expect more headlines (hopefully for the better) coming out this week to dictate market sentiment. The points of contention are the same as we have seen last year, deficit spending, campaign promises and partisan politics generating uncertainty in the markets.
None of these problems started in 2019 but will definitely shape the outcome of the new year. As the predictions for 2019 market performance come in, their accuracy is dependent on a lot more political outcomes than cyclical and economic trends. The only accurate prediction at this stage is that 2019 will bring uncertainty and opportunity.
The IMF forecasts that the changes in the global economy will not spare the US market in 2019 as it did this year. While growth in the global economy has been showing signs of slowing down, the US has been immune to much of the malaise.
Despite slowing growth in Europe and Asia and the US raising rates 75 basis points this year (and still expecting another increase to round out to a full 1% increase for 2018), the markets have performed relatively well, until October. With the headwinds of the tax cuts dying down and markets are starting to look at 2019 projections and the likelihood that the US can go against the global trends another year.
The cancellation of the Brexit vote today shows ow sensitive the markets are to data at this juncture. On edge markets are keeping volatility high, probably into the next year. The Fed meeting coming up on the 19th of this month will be exceptionally important. Markets will be hanging onto the language that comes out of the meeting to see how the FOMC will respond to this mix of data, and adjust their 2019 outlooks accordingly.
October jobs numbers were higher than expected coming in at 250k vs an estimates of under 200k. This will keep the data dependent side of the US equation going strong into next week. Data had a larger influence in October as yields and trade wars rocked markets. As we have seen in just the past week, lackluster PMI numbers and the fear of bad jobs numbers took the dollar rally in reverse. Now with better than expected numbers coming out today it will be interesting to see if the decline continues. If all remains constant we should see a stabilization in the Dollar and the equity markets to a degree. An increase of volatility will have to come from another source in the near term (earnings for stocks and perhaps geopolitics for the Dollar) to see volatility tick back up.
The dollar is nearing the highs for the year once again. Rising interest rates in the US have bolstered the dollar this year as other major central banks are not near the same part of the cycle as the US. The BOJ came out last night lowering inflation forecasts in a sign that rates and asset purchases will still be a part of the picture in Japan. The Euro and Pound outlooks for rate increases look murky from the threat of a hard Brexit and political and fiscal divisions across Euro member countries.
The only shorter term catalysts that could substantially move the Dollar lower would be heightened trade war rhetoric or signs that the language is starting to affect the overall economy (through corporate earnings or otherwise). These factors seem to be longer term trends that will take time to develop which means in the mean time, expect the dollar to remain strong going into the 4th quarter.
Stocks are making a comeback this morning after Italy concerns wane, but the initial shock of the announcement that Angela Merkel will not seek reelection in 2020 pulled down the Euro. Since the announcement that too has recovered to trade about flat. This change in the Christian Democrats chair could be good for the country, where taking a stance on issues such as immigration and European integration need to be dealt with to stop the populist rise in the country. The silver lining of this transition is that Merkel will now be able to take decisive action without the need to tip toe around political sensitive issues.
Elections in Brazil were looked at approvingly by the markets too, boosting EM stocks in European trading. The country is looking at the newly elected president, Bolsonaro, as good for the economy by being pro business. These changes in themselves do not make much of an impact to the markets but will be important factors in managing the economy as markets start to wobble.
About a quarter into earnings season and the data is showing a very strong 3rd quarter. The markets took the news and dropped the S&P almost 9% this month. A lot of analysts are scratching their heads over this conundrum and why the data isn't raising as rosy of a picture as in the past. There are three major thoughts on why earnings don't matter, two of them justify the correction, while one of them leaves a lot more to worry about in the coming months.
The estimate cycle usually goes in its downward revising fashion as the estimate date comes near. This is a classic example of people overestimating near term future conditions. This year something different has happened, estimates went up as a result of the tax cuts that came into effect. This caused the markets to rally on the news and the optimistic estimates before the actual results came out. Therefore no stock prices are shocked or unprepared for these higher numbers.
In relation to the earnings story, a lot of companies forward guidance was a cause for concern. Admitting to the one time boost from these tax cuts and concerns over the tightening of the rate cycle, the markets could be pricing in modest earnings growth in the future. Companies have come out in their earnings calls mentioning the tougher climate that is ahead and headwinds to their industries, or the economy as a whole. While this is not good for companies' stock prices it is a factor that can be measured, as a result, so will the market correction.
This is the big question mark in terms of how much the market has to drop. Earnings and outlook stories will understandably see an adjustment in the markets to take into account the new realities. The big "if" factor is whether the trade wars with China escalate, sanctions on the middle east de-stabilize the region and the oil market, or Italy and the Euro countries come to a budget resolution. These issues are more frightening to the markets because there is no estimate to how bad they can get. As escalation in the trade war deepens, you can see earnings consistently erode beyond even the lowest estimates. Sharp spikes in oil prices can negate any wage growth Americans have seen, and curb spending. These are the concerns to watch in terms of how much the market may still have to go. As time goes on you will see these negative factors start to fade, or be priced into earnings forecasts. It will be in a couple quarters that the macro factors start to become an earnings story.
The Euro came off its lows after the news that Italy wanted to start discussions over their budget with the European Commission. While coming off the recent lows, many market participants are not sure this will be the end of the volatility in the Euro or any other currency in the near term. Taking a look at the bigger picture we can see that, while the headline news certainly does affect there markets, the increase in volatility is nothing new.
Since the start of the crisis, major central banks lowered their interest rates to historic lows to stem the crisis and stimulate the economy. After the initial shock of the market turmoil this brought volatility down since interest rate differentials were the only measures to use and no country looked ready to start a rate increase cycle any time soon (The ECB tried it to their detriment). With the announcement of QE across central banks, volatility increased as the balance sheets of the major central banks started to swell.
Now we are starting to see the volatility decrease as the US starts to shrink its balance sheet. Europe is expected to follow suit with the end of their QE program this year and the start of higher rates in the middle of 2019. Barring the current threats of Italy the removal of the ECB in open market operations will bring down the volatility of the Euro. At that point we will be back to pricing the Euro based on interest rate differentials and this is where the importance of the Eurozone unity will come in. The level at which the euro is set will be dependent on several interest rates as opposed to just the ECB rate. It will be at this time the that spreads concerning the markets today will truly have an impact on the currency.