The negative market reaction to signs that the Federal Reserve is unlikely to take part in more quantitative easing soon has led to worries that the market rally will fade.
Markets have rallied this year after the Fed’s Operation Twist and two rounds of liquidity injections from the European Central Bank. Some had expected a third round of quantitative easing from the Fed later this year, but these hopes were dampened by the news that only two of the Fed’s 10 board members backed further easing at its most recent meeting.
“Markets are only going up because of central banks’ extraordinary measures and the underlining economy is struggling with severe headwinds,” Stewart Richardson, partner at RMG Wealth Management, told CNBC Wednesday.
“If we don’t get any more QE from the Fedor LTRO from the ECB , markets will take a step back and reassess why they’re going up.”
He warned that recent U.S. economic data has been buoyed by the weather and seasonal variations, and data in coming months may show “stall speed”.
Others argue that recent U.S. data suggests that the massive amount of cheap money pumped into the economy has revived it enough.
Russ Koesterich, chief investment strategist for BlackRock's iShares ETF business is optimistic that the US economy is stabilizing, based on recent news on the labor market and the manufacturing sector – and thinks markets are already pricing in slow gross domestic product growth of around 2 percent for this year. He added that the recovery was “subpar.”
Profit margins will be key to maintaining the market recovery, Koesterich argues. Many corporates have improved their margins by relatively low wage growth and cheap borrowing costs.
“Gains will be predicated on margins staying high and marginal GDP growth, rather than the type of monetary expansion seen in the last six months,” he told CNBC Wednesday.
He predicted that margins will stay high for the next six months to a year.
“Margins probably will revert in the long term, but in the near term the cost of wages and the cost of rates are likely to stay low,” he said.
“Corporate margins will be key for several quarters. If we revert back to mean or below, the valuation of equity markets doesn’t look so good. It’s going to be a struggle,” Richardson said.
Key risks to margins include high energy costs and faster-than-expected wage growth – which could particularly affect companies such as Foxconn, which have large workforces in developing economies.
High energy costs are more likely to affect margins by reducing consumer spending in the US than by raising companies’ cost bases, according to Koesterich.