Central Bank 'Put' Leads to Sweet Spot for Stocks

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Tragic week for the world
Last week was yet another tumultuous and tragic one. America mourned five brave Dallas police officers senselessly slain in the line of duty while France sustained another horrific terror attack, with ISIS claiming responsibility. And at week's end, Turkey's President Recep Tayyip Erdogan fought and defeated an attempted coup.

And yet the US stock market appears undaunted, with the Dow rising an impressive 2% in one week. This gives the Dow a respectable return (capital appreciation only) of 6.26% for the year thus far. Perhaps even more surprising last week was the fact that Treasuries finally sold off and yields moved higher, with the 10-year Treasury yield finishing the week at 1.547%.

US economy shows improvement
So what is pushing stocks higher and bonds lower? Well, one likely reason is that US economic data is improving. Retail sales and industrial production were both strong, exceeding expectations. And the Beige Book, also released last week, revealed that 11 of 12 Fed districts are reporting growth of a “modest to moderate” nature. Even inflation appears to be firming, with the June Producer Price Index in particular indicating a solid increase in prices. While consumer price inflation on a headline measure appears low at 1.0% (y/y) as of June, with food and energy weighing prices down, at the core level it's a different story as service price inflation is now running at 3.2% (y/y).

Another likely reason is the 'central bank put'—i.e., the belief that stocks can only go down so much without central banks becoming more accommodative and therefore providing a floor for stock prices. The European Central Bank (ECB) is expected to become more accommodative in coming months. And there is the expectation that the Bank of Japan will loosen monetary policy now that Abe's party fared well in the country's most recent elections. Although the US economy is doing better, most assume that the Fed will keep rates lower for longer.

The CME Group, which manages one of the world's largest options and futures exchanges, places the odds of a July rate hike at 1.2% and of a September rate hike at 12.9% based on fed funds futures. In summary, equity markets are in something of a “sweet spot,” whereby growth is judged to be adequate but not yet strong enough to justify a tightening in monetary policy.

Wary of monetary policy exhaustion
This environment seems to have benefited a variety of different risk assets, including emerging market stocks and dividend-paying stocks. This makes sense given that dividend-paying stocks look attractive to income-starved investors, while emerging market assets typically perform well when monetary policy is getting looser. However, we need to be wary of the impact monetary policy exhaustion will have on asset classes, which means earnings will become more important. It's hard to see a scenario where stocks move up much further without improved earnings underpinning them. After all, exhaustion may not be far off.

For the past few weeks, ECB President Mario Draghi has been calling on governments to increase fiscal spending, as his central bank is running out of policy tools. The UK may be the first to put words into practice, as the new Chancellor of the Exchequer has already suggested that the austerity targets of the previous incumbent would not be adhered to. With so little room to maneuver on monetary policy, fiscal policy may be the only viable solution to offset the risk of a technical recession in the UK post BREXIT.

Given the current environment, investors should benefit from being more active. The winds of change are moving fast these days, bringing with them changes in fortune to a variety of asset classes. While investors need to take risk, they must be both selective and agile.

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About the Author
Kristina Hooper is the US Investment Strategist and Head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law, a master's degree from Cornell University and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

Important Information
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.

A Word About Risk
Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.

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