Policy

Markets at an Inflection Point

February 27th, 2013 | By Nick Sargen

Highlights

  • Following a strong showing in January, equity markets pulled back this past week amid talk the Federal Reserve may curtail quantitative easing before year's end.
  • We do not buy the story about the Fed, especially considering that fiscal drag from expiration of payroll tax cuts and pending sequestration along with higher gasoline prices will likely delay an acceleration of the U.S. economy.
  • If so, the most likely outcome is that stock and bond markets will settle into trading ranges until there is a clearer reading on the economy. Long-term, we expect bond yields to rise once the economy regains momentum, and we are overweighting stocks relative to bonds in balanced portfolios.

A Surprising Start to the Year

Our view at the start of this year was that the U.S. economy would accelerate in the second half from the current pace of about 2% growth, which could set the stage for the stock market to test its all time high set in October 2007. This outlook reflected our belief that the private sector of the economy – consumers and businesses – had made considerable progress adjusting to the housing bubble and financial crisis. We are encouraged by the rebound in auto sales and in residential housing – two sectors that typically lead expansions. At the same time, we acknowledged that the economy would probably get off to a sluggish start owing to fiscal drag from a 2% increase in the payroll tax and higher taxes on the wealthy.

To our surprise, the market came within a few percentage points of its all time high in the first month and a half, even though news on the U.S. and global economy was mixed. In the United States, retail spending appears to be off to a sluggish start as households have to contend not only with the impact of higher taxes, but also with a surge in gasoline prices of about 45 cents a gallon. At the same time, data from Europe confirm that recession there has spread from the periphery to the core countries including Germany. Consequently, global GDP growth in the fourth quarter was the softest since the onset of recovery in mid-2009.

Why, then, has the stock market done so well? We believe the principal reason is that investors today are less fearful of a global recession or financial crisis than before. While Europe is mired in recession, fears of a break-up in the euro-zone have diminished as a result of strong actions by Mario Draghi, head of the European Central Bank. In Asia, there is now relief that China's economy is expanding at a healthy pace of 7%-8%, lessening worries about a "hard landing." Moreover, there is new-found hope that Japan's new government will act decisively to end two decades of deflation.

Finally, in the United States investors appear to be ignoring developments in Washington, D.C., as rumblings about the 2013 fiscal cliff turned out to be over-blown. This premise is about to be tested, however, as it is unlikely the two political parties will reach an agreement that would avert sequestration, which is set to begin on March 1. To be sure, the media is replete with horror stories about the impact that the scheduled cutbacks in government spending will have on the economy. However, most economists believe the impact will be manageable, as the outlay reductions in 2013 are expected to total only about $44 billion, or roughly half of the $85 billion in cuts that are budgeted. The consensus view among economists is that this will lower projected GDP growth by about three-tenths of one percent.


Enter the Fed into the Equation

The main factor that caught the market's attention last week was the minutes from the December FOMC meeting. They indicated there was debate about whether the Fed's quantitative easing program was distorting capital markets, and, if so, whether the program should be phased down before year's end.

My reaction to this story is to discount the possibility of the Fed ending quantitative easing later this year. I would hope that as part of meaningful discussion of monetary policy there is debate within the FOMC about this issue. However, debate does not necessarily translate into action.

My view of the Fed is that monetary policy is being driven largely by the troika of Chairman Bernanke, Vice Chairman Janet Yellen and New York Fed President Bill Dudley. They are the most powerful members of the Fed, and none of them has waivered from the view that unemployment is unacceptably high at 7.8% while inflation is well under control. In fact, Janet Yellen recently gave a speech in which she indicated the Fed should not be in a hurry to tighten policy even if unemployment fell to 6.5% — the level the Fed had previously indicated as being a target. While this does not mean that all FOMC members subscribe to the troika's view, it is unlikely that the skeptics of quantitative easing will carry the day.


Implications for Financial Markets

My reading of the current situation is that the stock market has had a phenomenal run since the second half of 2012, but it is now likely to settle into a broad trading range until investors get a clearer picture of the U.S. and global economy. In my view, the rally reflects diminished fears of a global recession or a major policy blunder.

To sustain new record highs, I think investors will want to see clearer evidence that economic conditions in the United States are normalizing – meaning real GDP growth is approaching 3% per annum while monthly nonfarm payrolls are expanding by 200,000-250,000. I do not foresee this happening in the first half of this year, and think the transition to higher growth will not be apparent until the second half, when the impact of fiscal drag should lessen.

Meanwhile, we anticipate that the stock and bond markets will settle into trading ranges. Longer term, as the economy gains momentum, we look for the stock market to set new highs while bond yields will trend higher. Accordingly, we are over-weighting stocks relative to bonds in balanced portfolios.