U.S. and global equities were under pressure last week, with all major U.S. indices lower for only the fourth time this year. With discussion of the Fed tapering its stimulus, market uncertainty gained momentum. The S&P 500 was down 1.0% for the week.1 We consider the market pullback technical in nature since the mention of a Fed quantitative easing exit likely created a natural point to take profits after the recent rally.
Timing is Everything
Although the markets declined in response to Fed signals, this does not change our view of the fundamentals for growth, inflation, earnings and policy. Tapering and eventually stopping quantitative easing (QE) is not a tightening of monetary policy; it is just a reduction in (and end to) the pace of easing. Markets are highly sensitive to changes in the Fed’s QE and zero interest rate policy. This is not because those changes are the main driver of global growth and inflation but because they would reverse the easy money environment that has driven asset reflation over the last several years. Easy money has boosted asset prices and helped to pull the global economy out of recession. Once the world economy reaches a level of escape velocity, monetary stimulus can be taken away, and the economy can take over as the driver of asset prices. If things go as planned, the handoff should be relatively smooth.
We do not think the Fed’s message is as controversial as it has been made out to be. Economic conditions have improved, and if the present path continues, tapering would probably be appropriate later this year. But the Fed wants to ensure the improvement is sustainable through the summer and fall. In addition, the Fed is cognizant of the U.S. fiscal tightening and wants to ensure the economy can withstand this headwind. Quantitative easing isn’t going to zero soon, and it may be months before Fed purchases dwindle. Also, the potency of QE could actually expand (even if the $85 billion per month declines) because of the lower federal budget deficit.
We believe investors are anxious about an end to Fed assistance because they lack economic confidence. Since 2009, the Fed has been clear about open-ended policy, supported by the recent message from key FOMC leaders. There is no pressure on policy from the perspective of the Fed’s two mandates: 1) Inflation is below target and 2) unemployment is still too high to warrant taking economic risk. The Fed is unlikely to cause a U.S. inflation problem in the next two years, but the consequence of its policy has been inflationary around the world, primarily in the form of asset inflation. The Fed will only pass the baton to the private sector when it believes confidence has been restored, and growth is self-reinforcing to weather the market turbulence associated with moving from hyper-accommodative to accommodative policy. Earnings will then become more critical to drive equity prices. This transition to a neutral policy will be historically slow. Bottom line: we believe the Fed is not ready to scale back the degree of accommodation and will wait for more data to confirm a sustainable recovery.Calm Interrupted
On Thursday, the Japanese stock market declined 7% and other markets sold off significantly. Theories about the cause include: 1) U.S. Fed Chairman Ben Bernanke’s comments, 2) a disappointing China Purchasing Managers’ Index (PMI) or 3) the Japanese 10-year government bond yield touched 1%. Selling in Japan was aggressive because of an overbought condition. A steady, grind-higher environment for all equity markets had lulled investors into a false sense of calm, setting the stage for a reversal.
As far as U.S. economic activity, consumer spending has held up in spite of the payroll tax increase. However, weak government spending and soft demand abroad have offset this positive surprise. In our opinion, the likelihood of renewed sharp fiscal shocks has declined with the federal budget deficit decrease. Inflation is falling in many countries, with U.S. core inflation at 1.1%,2 a lower level than the past three times in 11 years when the Fed has justified easing programs.
In conclusion, a short-term cautious stance might be advisable given negative headlines and potential market volatility. Yet the U.S. equity bull market retains its key tenets. We believe that growth potential for the U.S is supported by a revival in manufacturing competitiveness, a rebound in housing and the trend toward energy independence.
1 Source: Morningstar Direct, as of 5/24/13. 2 Source: Bureau of Labor Statistics, “Consumer Price Index – April 2013,” May 16, 2013, http://www.bls.gov/news.release/cpi.nr0.htm..
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Euro STOXX 50 Index is Europe’s leading Blue-chip index for the Eurozone and covers 50 stocks from 12 Eurozone countries. FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock
Exchange. Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. FTSE MIB Index is an index of the 40 most liquid and capitalized stocks listed on the Borsa Italiana. Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Hong Kong Hang Seng Index is a free-float capitalization-weighted index of selection of companies from the Stock Exchange of Hong Kong. Shanghai Stock Exchange Composite is a capitalization-weighted index that tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The MSCI World Index ex-U.S. is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets minus the United States. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
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The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-investment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results.
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