Sent: 26-06-2013 15:04:03
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Markets Get Wobbles as Training Wheels are Removed
Ben Bernanke's public refinement of Fed policy last Wednesday contained some of the best news investment markets had received in many months. What a pity market traders got the wobbles as their training wheels were removed.
Last week's ATC email, crafted in the lead up to the two day Federal Open Market Committee meeting which finished on Wednesday, anticipated everyone being better informed about the direction of markets once Fed Chairman Ben Bernanke had spoken at his scheduled post-meeting press conference.
The ATC article observed that markets would have to start making their own judgements about whether growth is strong enough to sustain market appreciation. They would have to give up taking their lead from the US central bank.
On Wednesday, the Fed chairman did try to remove the one way bet market traders had been counting on for higher asset prices. Bernanke was forcing his followers to begin making some independent judgements about the trajectory of the US economy and, more broadly, global economic outcomes.
The market reaction to the Bernanke statements - a two day drop in the S&P 500 of 3.9% and a 35 basis point spike in 10 year US bond yields - made it look like the withdrawal of asset purchases was unexpected or coming faster than had been anticipated when the Fed's positioning is almost identical to the expectations depicted previously in surveys of market analysts.
Bernanke's commentary about the Fed's intentions, in any event, was tempered by his remarks about the flow of data. If the Fed's optimism about the state of the US economy was misplaced, Bernanke committed it to stay in the market longer. It would not be cutting back on its asset purchase program irrespective of the economic outcomes. The magnitude of the program would be data dependent.
Despite the reaction, at least at one level Bernanke proffered good news. He said the US economy would expand at a faster pace in the year ahead. Growth would accelerate from 2.2% in 2012 to an anticipated 2.3-2.6% this year and a higher 3.0-3.5% next year.
From an Australian perspective, acceleration in growth suggests a boost to the growth rate for raw materials in global markets. The commencement of upward revisions to global growth forecasts is a vital step in stabilising resource sector markets (both physical commodities and equities) and attracting new investment funds to those companies that can demonstrate a meaningful investment proposition.
More broadly, the Bernanke outlook implied materially better conditions for corporate profitability. Combined with a higher real growth rate was an expected tick up in inflation to around 1.5-1.8% in 2014. That implies future nominal GDP growth of slightly over 5%, an improvement of two percentage points on recent outcomes.
Nominal GDP growth is the starting point for an assessment of corporate profitability. The Bernanke forecast is saying, in effect, that the top line growth potential of US companies is improving. This is a vital step if investor anxiety about company profitability, increasingly driven by cost cutting, is to be allayed.
Part of the reaction by the market was similar to the response of the child having the training wheels of his bike removed. He knew all along it was coming but the immediate reaction is some wobbling and anxiety about being left on his own before confidence begins to grow.
Another part of the reaction probably reflected the uncertainty about the growth prospects themselves. The Fed is now ahead of the pack in its view about the state of the US economy. Despite its eminence among central banks, its judgements about the economy have been wrong before. It has withdrawn support prematurely before being forced to return with more aggressive action later. This would be playing on the minds of traders.
A third part of the reaction was a continuing anxiety about how far the US market had risen (having returned a positive outcome every month since October 2012) and how low bond yields had fallen. Bond yields had already started to rise. Stronger growth would be likely to take them higher.
The effect of higher yields is ambiguous. To the extent they reflect stronger economic activity, they are offset by stronger corporate and personal income growth. If cash rates remain near zero through 2014, the widening spread between short and long term interest rates should encourage lending, helping to stimulate private sector employment growth. The effect of higher interest rates on the nascent housing recovery, however, and the effect of that on household confidence, remains the greatest fear in the shorter term.
Yet another part of the market reaction last week came via China. Chinese economic statistics are suggesting easing in the pace of growth there. Perhaps more troubling for some, the Chinese central government appears happy for this to happen. Stability in growth is a higher priority than a return to anything even slightly reminiscent of the breakneck speed evident through most of the 2000s. Ministers have said as much, making even 8% annual GDP growth an unlikely stretch in the foreseeable future.
One of the benefits of Bernanke's comments is that Fed watchers will not have to hang on his every word as much as they did in the past. He has stated his guideposts for adjusting policy. The target data points have been made explicit.
Data flow is always important in the US but never more so than in the coming few months. Weekly jobless claims, monthly payroll numbers and household survey unemployment rates will loom large. Statistical sampling techniques alone will have meant these numbers would never flow evenly. Expect volatility in markets from this source alone.
Further than that, a clear improvement in labour market conditions might take several months to emerge leaving potential for several months of directionless but highly volatile trading conditions before clarity emerges that the Fed is right (and markets move higher) or the Fed is wrong and has to pick up its asset buying (in which case markets might still move higher).
(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).
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