Busch: Q2 Market View Update
There are numerous articles around focused on the resurgent U.S. economy and the potential for a positive, self-reinforcing cycle of growth, employment and more growth. As we will receive the latest on the US employment situation on Friday, the pulse check will be interesting to see if the heart of the economy beats as strongly as these optimistic articles portend.
My view remains that the goal of the US Federal Reserve is to achieve economic growth via extraordinary soft monetary policy and they will continue this policy until they truly believe the crux of the aforementioned articles.
This is supported by many of the comments by Federal Reserve officials including today’s views expressed by FOMC voting member and Cleveland Federal Reserve President Pianalto.
She said that the moderate economic recovery in the U.S. is becoming more "self-sustaining" despite continuing headwinds and described recent labor market trend as "promising" but left her outlook for recovery and inflation unchanged despite rising gas prices according to Dow Jones. Yet last week, FOMC Chairman Ben Bernanke expressing more caution stated that labor market conditions are “far from normal” and “we cannot yet be sure that the recent pace of improvement in the labor market will be sustained.” Bernanke’s comments generated a rally in equities and bonds as his remarks were interpreted to mean that monetary policy would remain highly stimulative.
My simple interpretation remains that the U.S. central bank policy is to drive investors out the risk curve as far as they can to aid the economy. This is accomplished via massive quantitative easing programs that make risk free assets (U.S. Treasury securities) expensive and forces down the yields of all securities including mortgages, high yield, and leveraged loans. In turn, this should reduce borrowing costs for not only consumers, but also corporations.
This process should lead to consumers repairing their balance sheets via lower consumer debt loads and costs which aids consumer spending. For corporations, the reduced borrowing costs allow them to reduce their funding costs for projects and capital expenditures (along with tax incentives). If we toss in the Federal Reserve’s regulatory stimulus in the form of passed stress tests and allowing financial institutions to issue dividends and buy-back shares, then we get a large boost to one of the most underperforming sectors of the stock market since 2008. Remember, FOMC policy also drives demand for investments that can provide a return such as high dividend paying stocks and covered call strategies.
All of this translates into a well-supported equity market rally that has shallow pullbacks and a strong upward trend. At the beginning of the year, I underestimated how far US equities would rally as I believed the S&P would see gains for the entire year would be 7.5%. Currently, the index is up 12.8%.
From these levels, I am circumspect that we will be able to sustain a rally beyond 15% for the year. At the minimum, we’ll likely see disappointment on either growth or earnings from these lofty expectation levels especially at this time of year where seasonal equity flows typically slow after Q1. As we get into the summer, we’ll see more uncertainty generated from the US via the US Supreme Court ruling on health care to US elections to newsflow surrounding the US fiscal cliff that looms at the end of the year.
As a parting visual, take a look at the VIX index chartover the last 3 years and note the spikes that have transpired after the index hit 15.0. The low on March 16th, 2012 was 13.66. To me, this indicates the rally in equities is near a short term peak.
Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.