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Yellen But Not Screamin'—Weekly Market Review

Jerry Webman, Ph.D., CFA

Chief Economist

Temperatures may be dropping, but equities remain hot, with developed and emerging market stock indices posting broad gains last week. Investors liked what they heard from Fed Chair nominee Janet Yellen’s confirmation hearing and from the Chinese government, which released some limited details about objectives agreed to at a major policy meeting, the Third Plenary.

As stocks continue to rise amid ambiguous economic signals, investors appear torn between the fear of missing the rally (hence continued large inflows into equities) and worries that the rally has gone beyond what fundamentals justify. While it’s true that we haven’t seen a dramatic pullback in U.S. equities since 2011, valuations do not appear unduly high; there are certainly few signs of a bubble. Earnings have been relatively robust, as well. With 463 members of the S&P 500 Index having reported, 76% have beaten earnings expectations, more than usual. Repeating a familiar trend, however, revenue surprises have been below their long term average levels.

When considering how much longer the rally can last, it’s important to remember that markets are forward-looking and they respond to perceptions not of how things are today, but of whether conditions are likely to improve or deteriorate in the months ahead. Looking toward 2014, I expect a modest improvement in growth, driven by increasing housing demand, a moderate uptick in capital spending, improved credit conditions and a continuation of surging domestic energy production. Combined with low inflation, easy Fed policy, less fiscal drag and (probably) no more government shutdowns or debt ceiling fiascos, conditions do favor improved growth.

I would note that while we’re unlikely to have to endure the uncertainty that comes with government shutdowns and debt ceiling showdowns this winter, the botched rollout of the Affordable Care Act (ACA) means that some degree of uncertainty emanating from Washington is likely to persist. Whether you love the law or hate it, its messy implementation does raise important concerns for many businesses and consumers, who simply can’t tell what’s going on and plan accordingly. Most big legislative changes in the U.S. come incrementally, usually amid much fussing and fighting in the halls of government. As unsatisfying as such a process can seem, it does usually make social and economic adjustments smoother. With lawmakers and the President considering various proposals to ease the implementation of the ACA, the introduction of the new healthcare law could turn out to be more incremental and actually more effective than expected, after all.

Not-so-lonesome Dove

While the market seems to be shrugging off the drama surrounding the ACA, investors were closely following Janet Yellen’s confirmation hearings this week. Overall, markets liked what they saw and heard. Yellen’s nomination and highly likely confirmation offer a sense of continuity; she was, after all, Ben Bernanke’s second-in-charge. In her hearings, she offered a generally dovish stance, which reassured markets that the Fed would not tighten prematurely. Tapering decisions will remain data-dependent, and interest rates should remain low for a long, long time. There’s speculation that with Yellen at the helm, the Fed might lower the unemployment threshold at which the central bank might consider a rate hike. The target is currently 6.5% (vs. an actual unemployment rate of 7.3% in October), but some observers feel that the rate overstates the strength of the labor market. Many potential workers have given up their job search until economic conditions improve. The Fed could decide to reduce the threshold to, say, 6%—even as it begins to taper its monthly asset purchases. The tone of its guidance will be critical. Framed correctly, such a move ideally would signal that even as the economy gradually improves and renders massive asset purchases less necessary, the Fed will continue to keep rates low to help support investment and spending.

China Moves Toward Major Reforms

Halfway around the world, the Chinese government was doing some messaging of its own. Following the completion this week of the Third Plenary Session of the Communist Party’s Central Committee—a big pow-wow of Party officials focusing on the direction of national reforms—markets cheered an array of announced reforms aimed at reinforcing the reorientation of the Chinese economy toward domestic consumption and away from massive, export-oriented investment. These reforms include an easing of China’s one-child rule for certain couples; a relaxation of the household registration (“hukou”) system in towns and smaller cities, which incentivizes rural migrants to move there rather than the big cities; increased rights for farmers over rural lands and the establishment of a rural property market;  an increase in the dividends state-owned enterprises (SOEs) pay to public finances; accelerated convertibility of the yuan; establishment of a deposit insurance scheme; strengthened anti-corruption measures; and more.

Taken as a whole, the announced reforms are squarely aimed at giving market forces a more “decisive” role in the Chinese economy, and forestalling the so-called Lewis Turning Point. This is the point at which supplies of cheap labor diminish, growth slows and further development becomes increasingly difficult—a phenomenon that the aging and eventual shrinking of China’s one-child-policy-constrained workforce does nothing to alleviate. Of course, the implementation of such wide-ranging reforms will be difficult and probably slow, but the government’s commitment to them and its decade-long hold on power does inspire confidence that China’s leadership understands many of its key structural challenges and seeks to overcome them.

Sluggish Eurozone Not Ready to Blossom

As China wrestles with its biggest challenges, Europe continues to face headwinds in overcoming its own. Despite some signs of “green shoots” emerging, Eurozone GDP grew just 0.1% in the third quarter, compared with the previous quarter. German growth slowed from 0.7% to 0.3%, while France’s GDP turned negative once again, after having briefly turned positive last quarter. Italy remains mired in recession (although its GDP is contracting at a steadily milder pace), while the recession ended in Spain and the Netherlands. Though in the European Union but not in the Eurozone, the United Kingdom has been faring relatively well, with its economy growing 0.8% in the third quarter. Europe’s weak growth and worryingly low levels of inflation prompted a recent interest rate cut by the European Central Bank, but if there’s a silver lining, it’s that the single currency has weakened somewhat, making European exports more competitively priced on the global market—a positive development for a range of companies headquartered on the Continent, many of which still trade at attractive valuations.


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