6/26/13 – Economic and Market Normalization Continues

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 26, 2013 9:29:32 AM

and tagged Yesterday's News

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Seems like the central banks’ soothing is working. U.S. markets were up yesterday, and international markets are up broadly today. Even the narrative has changed, with neither of the major papers dealing with the central banks or the markets on the front pages, and the only real discussion in the Wall Street Journal being “A Hawkish Signal Bernanke Didn’t Send.” Got that? Nothing to see here. Move along.

I don’t usually focus on short-term market movements, but one of the things I found interesting yesterday was that, even as rates ratcheted up through most of the day, U.S. stock markets rallied. Although one day is far too short a time to draw conclusions, at least at that scale we have demonstrated that equity markets can do well while rates increase. We also have historical evidence that this is the case, over much longer time periods.

I noted the other day that interest rates not only will go up, they have to go up as markets normalize. The normal reason rates rise is that, with an improving economy, demand for capital grows faster than supply, forcing the cost of such capital up. This is actually a good thing, a side effect of growth. The other reason rates increase, of course, is Fed action—but, as the central banks have emphasized, we’re far from that. Watching rates increase is a sign that the markets may see growth in the real economy, a position with which I agree.

There were a couple of pieces of real economic news today. The first is that economic growth in the first quarter was revised downward, from 2.4 percent to 1.8 percent, largely due to a 4.8-percent drop in government spending—the sequester, to a large extent—which offset nearly 3-percent growth in private consumption. That’s the bad news. The good news is that the sequester should peak either this quarter or next, reducing the drag from the government sector. At the same time, personal spending should increase, allowing for faster growth in the next quarter or two.

All of this represents a normalization of the economy. Consumers are beginning to cut back on paying off debt, as they have largely delevered, freeing more money for current spending. Home equity levels are being rebuilt. Financial markets have come at least partially back to earth. The housing market appears poised to continue its recent growth in prices and sales, as supplies remain low and demand high. Even if higher mortgage rates hit demand, that should only slow growth, not reverse it.

Normal means no panic. Stock markets are up this morning, and interest rates have ticked down. The Fed’s intention to taper off its intervention, someday, appears to have been digested.

There are two things we should take away from this. First, the Fed has now explicitly stated that tapering is on the table. Even if the reaction was much more than it had expected, the conversation has been started. Hopefully, the discussion in the markets will now center on when and how the taper will start, so that it doesn’t come as a surprise. I think the Fed accomplished the shot across the bow that was one of its goals.

The second takeaway is that, even at current levels, the equity markets retain a considerable amount of stimulus built into current pricing. When the Fed actually does start to dial back, they remain vulnerable to reduced expectations.

So now everyone can go back to watching the Fed and trying to determine when it will make its next move. Let the countdown begin.

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