It’s been a very interesting couple of days for the economy and the markets. I’ve pointed out before that, in fact, the economy and the stock market are only loosely connected; good news for one isn’t necessarily good news for the other, and that is now being illustrated very well.
The other key point that we’re getting a much closer look at is the conflict between a recovering economy and the likelihood of continued Federal Reserve support. There is an implicit assumption in current market valuations, in my opinion, that we will get both revenue and EPS growth (which to some extent requires economic growth) and continued Fed support of lower interest rates (which to some extent requires economic weakness). You see the problem here.
When I’ve made this point, to investors or reporters, the very reasonable question has been whether the economic growth, and consequent revenue and earnings growth, would offset the effects of any rise in rates. It’s a good question, and one we may be starting to find the answer to.
Statistics released this morning show that third-quarter growth was revised up to 3.6 percent from the initial 2.8 percent. That’s a big upward jump from what was already a surprisingly strong initial figure. And the details were just as strong as the headline. Although most of the additional growth came from inventory accumulation, that extra inventory was actually needed to respond to higher sales—that is, the inventory-to-sales ratio remained unchanged.
Other stats were equally positive. Both personal income and the savings rate were revised higher, again from already respectable levels. Initial jobless claims dropped to 298,000 for the week, well below expectations and below 300,000 for only the second time since 2008.
Given that employment and growth are two of the Fed’s key watch items, the unexpectedly strong data suggests the Fed might start pulling back sooner than expected. Other positive data points over the past week include improving consumer confidence, an increase in car sales, a very large increase in new home sales, and a very positive ADP employment report.
All of this implies that the improving economy part of the stock market expectations is playing out. With interest rates on the rise over the past week with the good news, however, it’s growing less likely that the Fed will continue its support, and the market has reacted poorly. There is increasing talk in the press about a December taper, and quotes from Fed members who are known as doves saying that it may well be time for the Fed to start to pull back. The market’s decline, even in the face of improvement in the real economy, suggests that the current rally has been based more on the Fed. The reaction also shows that, at least on very short-term data, the idea that an improving economy can override the effects of lessened Fed stimulus is, shall we say, not proven.
When the Fed declined to taper in September, the argument was twofold: that The economy was weaker than commonly understood, and the pending political risk of the debt ceiling confrontation was too great. With the economy strengthening, and a deal looking possible on the 2014 budget, a taper seems ever closer—maybe not in December, but shortly thereafter. The signs at the moment are that the markets might react in a negative way when the taper does finally hit.