MarketView for Febuary 3

 

 

Summary

 

OK, there is no sugar coating it, the markets slumped on Monday and it was not a pretty picture. At the same time, it certainly was not the end of the world. Yes, the S&P 500 index did manage to suffer its worst decline since last June, after weaker-than-expected data on the factory sector encouraged those who became twitchy over the day’s negative numbers to merely liquidate a portion of their holdings.

 

While much of the nervousness came as a result of distress within the emerging markets, it is also true that the manufacturing sector of the economy grew at a slower pace in January as new order growth fell by the most in 33 years, while spending on construction projects barely rose in December.

 

Investor sentiment also soured sharply after the factory data, driving the cost of protection against a drop on the S&P to its highest level in nearly four months. The CBOE volatility index chalked up a gain of 16.5 percent to 21.44, its highest level since December 2012.

 

S&P e-mini futures showed 2.999 million contracts traded for the session, the largest volume since February 25, 2013.

 

Just as distressing to those who watch the charts, the Dow Jones Industrial Average closed below its 200-day moving average for the first time since December 28, 2012, a technical breakdown which in theory could indicate further declines.

 

Selling was broad-based, with only nine components in the S&P 500 trading in positive territory. Telecoms were down 3.7 percent, while the consumer discretionary sector was down 2.7 percent, placing them among the worst performing sectors of the day.

 

Stocks have been pressured as the Federal Reserve confirmed its commitment to withdrawing its market-friendly stimulus and by concern about growth in China. China's service-sector growth slowed to a five-year low, another indicator of slowing momentum in the world's second-largest economy.

 

More importantly, investors have become leery with regard to the outlook for emerging markets, where a recent rout in currencies spurred some central banks to raise interest rates or intervene in markets to limit the swings. That, in turn, has pressured bond and stock holdings and forced investors to exit in favor of assets perceived as relatively safe, such as the dollar.

 

With earnings season halfway over, Thomson Reuters data shows that of the 250 companies in the S&P 500 index that have reported earnings, 69.7 percent have topped expectations, above both the 63 percent beat rate since 1994 and the 67 percent rate for the past four quarters.

 

Telecoms were weaker on speculation AT&T's plan to cut prices on its large shared data plans could prompt other carriers, particularly larger rival Verizon Wireless to offer new discounts. AT&T lost 4.1 percent to end the day at $31.95 and Verizon lost 3.4 percent, closing at $46.41.

 

Rumors on the Street are that Charter Communications is considering raising its bid for Time Warner Cable, a move that could pressure its reluctant rival ahead of a proxy deadline.

 

Britain's Smith & Nephew will acquire ArthroCare for $1.7 billion in cash to strengthen its treatments for sports injuries, an area growing faster than its main replacement hips and knees business. ArthroCare shares ended the day up 8.2 percent to $49.12.

 

Pfizer moved up 0.7 percent to $30.60, the only Dow stock to close higher. Pfizer's experimental breast cancer drug significantly delayed progression of symptoms in a mid-stage trial, meeting the study's primary goal.

 

Trading volume was heavy on Monday, with about 9.46 billion shares changing hands on the three major equity exchanges, a number that was well above the 6.94 billion share average in January, according to data from BATS Global Markets.

 

Economic Data Indicates a Bit of a Slowdown

 

Manufacturing activity slowed sharply in January, coming on the heels of the largest decline new orders during the past 33 years, while construction spending barely rose in December, pointing to some loss of steam in the economy.

 

Economists largely blamed frigid temperatures for the chill in economic activity and said they expected a rebound in the months ahead. However, they also cautioned that the economy was receiving some payback after a strong performance in the second half of 2013.

 

The Institute for Supply Management (ISM) reported that its index of factory activity fell to 51.3 last month, its lowest level since May 2013, from 56.5 in December.

 

Bad weather also appeared to hurt auto sales in January, with Ford, General Motors, and Toyota all reporting lower sales for the month of January.

 

January's ISM figure made it the second straight month of slowing growth from November's recent peak reading of 57, which had been the highest since April 2011, and indicated manufacturing was slowing after output grew at its fastest pace in nearly two years in the fourth quarter.

 

Underscoring the weather impact, delivery delays increased a bit last month, but the biggest red flag was the huge drop in the forward-looking new orders index, which fell to 51.2 from 64.4 in December. That 13.2-point drop was the largest monthly decline in the key component since December 1980.

 

In a separate report, the Commerce Department said construction spending rose 0.1 percent in December, slowing from the prior month's 0.8 percent increase. While private construction spending hit a five year high, outlays on public construction projects recorded their largest drop in a year, reflecting the drag from weak state and local government spending.

 

The soft construction spending data will probably not have much effect on the government's advance fourth-quarter gross domestic product estimate as it was broadly in line with assumptions.

 

The government reported last week that the economy grew at a 3.2 percent annual pace, supported by consumer spending, exports and inventory accumulation, after logging a 4.1 percent rate in the prior quarter.

 

It expanded at a brisk 3.7 percent pace in the second half of the year, up sharply from 1.8 percent in the first six months of the year. It was the biggest half-year gain since the second half of 2003.

 

Exports are not expected to match their strong growth and businesses are expected to step back from restocking. When added to the impact of cold weather, it portends a slowdown in first quarter growth. Indeed, the ISM survey showed a pullback in new export orders and a contraction in inventories.

 

The prices index hit an 11 month high, due mostly to an energy-related increase after the cold snap caused a shortage of propane and pushed up prices for electricity and heating oil in some parts of the country.

 

An indicator of employment fell to its lowest level since June, again pointing to a possible downside risk to expectations of a rebound in employment in January after a surprise slowdown in December.

 

January's employment report will be released on Friday and is expected to show nonfarm payrolls rebounded to 185,000 new jobs created during January, up from 74,000 jobs in December, according to a Reuter’s survey.

 

Outlook for Emerging Markets Cloudy at Best

 

Emerging markets are facing headwinds going into 2014, but January's rout surprised even the most diehard among the believers who faced large declines in stocks, bonds, and currencies.

 

Political turmoil and terrorism threats across market capitals from Ankara to Kiev, along with growing concern about bad debt in China's shadow banking system, caused a full-scale pullback across all risk assets.

 

As a result, some investors are starting to see attractive values in these markets. Sentiment remains weak, however, so the actions of emerging market policymakers will determine whether investors take advantage of low valuations or opt to preserve capital, strategists say.

 

In just a month, the broad MSCI Emerging Markets stock index is down 7.5 percent versus a decline of 5 percent for all of 2013, a year when developed markets surged by 30 percent. The benchmark S&P 500 index is down 3.8 percent year-to-date.

 

Yield spreads between emerging market sovereign debt and comparable U.S. Treasuries widened by nearly 50 basis points, according to JPMorgan's benchmark indices, the largest one month increase since June of last year when the Fed's first hint at reducing its monetary stimulus rattled global markets.

 

Turkey, India and South Africa have recently surprised markets with aggressive defenses of their currencies. Their actions come as the Fed moves toward more normal monetary policy that will cause less money to move abroad in search of higher returns.

 

Emerging market currencies have lost ground against the dollar and the euro. Bank of America Merrill Lynch (BAML) research said that in aggregate, emerging market currencies are now undervalued by about 2 percent, a sharp swing from 2010-2013 when they were considered overvalued. The bank sees cheap medium-term bonds in South Africa and Brazil. Mexico, Poland, Hungary and Malaysia look to be fairly priced, they said.

 

The aggressive rate hikes from central banks in troubled countries could stabilize those currencies, but it comes at a cost. Higher rates could slow growth in certain countries that are already struggling, and the weak demand from China means it will be more difficult for countries to export their way out of trade imbalances.

 

As fundamentals have not improved, emerging market countries with negative balance of payments metrics are in danger of more underperformance in their currencies.

 

The Institute of International Finance wrote in its latest capital flows report on emerging markets that the asset class now has a price-to-earnings ratio for the coming 12 months, which gives a clue as to future corporate earnings, at about 9 times, below the decade average of 11 times. By comparison, developed markets are trading at a forward P/E of 15, above the long-run average of about 13 times earnings.

 

To be sure, the IIF cautions that not every market is going to rebound. Many emerging markets - such as the now-famous 'fragile five' - face challenges in implementing structural reforms. These five - Brazil, India, Indonesia, South Africa and Turkey - are considered the emerging nations with the weakest balance of payment positions and most monetary policy uncertainty.

 

"The broad weakness in expected earnings over the next 12 months (with only China expected to see much pickup) is another warning that 'cheap' may not translate to 'rally' any time soon," the IIF, an association representing big banks, wrote.

 

Those countries have responded, to a point. After Turkey's central bank hiked its benchmark interest rate by 425 basis points, BAML said it is time do some "serious bottom fishing in Turkey."

 

In addition to Turkey, central bankers in India and South Africa have taken aggressive action. Mexico has also undertaken major reforms across multiple sectors. In the long-run reforms are positive, while for the near-term the challenge could be a negative for the bottom line of many firms.