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Stocks have rallied sharply in the U.S., Europe and Japan this year, mainly on the record levels of “Quantitative Easing”, or “QE.” (read as low interest rates and massive purchases of government bonds by central banks). The S&P500 Index, shown below, has surprised the skeptics this year and rallied right through the old highs last seen in 2007. While the technical condition of the market show it as somewhat extended at the top end of the trading range, every minor pullback has been met with fresh buying. Clearly there is still money on the sidelines that has missed the rally over the last year. We also have to consider the possibility that money will eventually move over from bonds to stocks once investors realize that interest rates will be heading higher. While we will still see corrections along the way, the recent trend has clearly been up.
Given that markets have risen so far on ‘QE’ though, investors are constantly faced with the question of ‘what happens to markets once this monetary stimulus starts to be removed?’ We had a glimpse into that potential situation last week when the Minutes of the last U.S. Federal Reserve (Fed) meeting were released. While nothing new was really said, it did show that some members were in favour of moving away from their ‘easy money’ policy as early as the July Fed meeting. That news shook markets but it was interesting to see which were impacted the most. The U.S. and China fell less than 1% the following day while the European markets dropped between 2-3%. Japan, the biggest winner over the past year, lost 7% that night! So the ‘sugar high’ from an easy money policy seems to be most at risk in the ‘Land of the Rising Sun.’
One day of trading never tells the entire story but stock market will clearly be at risk once QE begins to get wound down. The million dollar question of course is when that will occur and, on that count, the Fed continues to advocate that timing of the removal of QE is ‘data dependent.’ While everyone tries to read between the lines on what the Fed means and when they will remove the stimulus, the simple answer at this point seems to be that even the Fed doesn’t know right now. Data dependent clearly means that they will watch the economic data until they feel that the U.S. economy is on a sound footing and then they will slowly start to remove the stimulus. If the economic data deteriorates before or during that process, then they will stop removing the stimulus, or even add to the QE program. So investors will now be paying even more attention to every bit of economic data to help them ascertain what the Fed’s next move might be and when that might occur. It also put stock markets into that odd syndrome where ‘good news is bad news’ (i.e. good economic news means better chance of recovery, which means a better chance that QE will end which, in turn, removes one of the strongest sources of the stock market’s strength over the past year). This should make the next U.S. payroll report on June 7th a very interesting trading day; would the stock market sell-off on strong employment numbers?
Now that we’re all comfortably confused, we can ask the question of what has been happening to the economic data lately? It has actually been pretty good in the U.S. As shown in the chart below, the Economic Surprise Index shows that numbers have been coming in ahead of expectations for the past year, with recent gains being supported by the recovery in the housing and auto industries. Even more impressive is the fact that this is taking place while government spending is being curtailed by the ‘Sequester’ initiative. While we did see a ‘spring swoon’ in each of the prior 3 years, the data has continued to stay relatively solid into the 2nd quarter this year.
