Bernanke's $10 Billion Baby Step—Weekly Market Review
Investors’ sanguine reaction to the Fed’s announcement last week that it would begin “tapering” large-scale asset purchases was reassuring. Given the incoming U.S. economic data, however, it shouldn’t be surprising. As I wrote in a blog post after the announcement, investors should remember that the Fed is reducing the pace of asset purchases expressly due to a strengthening economy. Markets apparently get that now, whereas last May, when the Fed first indicated it was preparing to taper, the reaction was broadly negative at first, though growth-oriented asset classes and subcategories rebounded fairly quickly.
Much has changed since then. The budget deal Congress passed last week represents an important step towards sanity after a long spell of government-by-self-inflicted-crisis. Moreover, it reduces uncertainty over important spending and taxation policies for the next couple of years. The U.S. economic data, while not as strong as anyone would like to see, have proven fairly robust as the year comes to a close. The economy had added about 2 million jobs in 2013 through the end of November, the most since the first 11 months of 2005. Over the past four months, payroll gains have averaged a decent 204,000. And the latest estimate of third-quarter GDP growth, released last week, showed the economy expanding at a fairly robust 4.1% annualized rate, the strongest rate since the beginning of 2011. Importantly, improving demand was a key source of strength, with final sales of domestic product and final sales to domestic purchasers both revised higher. Inflation, meanwhile, remains all but absent.
Time Was Ripe for a Taper
In short, as the Fed has considered over the past few months whether the economy was becoming strong enough to warrant weaning from quantitative easing, all the pieces started to fit together, from employment, lending and purchasing managers’ surveys to interest rates and stock market performance. Even the opposite ends of Pennsylvania Avenue somewhat cooperated. The economic data released last week (beyond the GDP revisions) were mostly positive, with four out of five reports on manufacturing (the latest Empire State Manufacturing Survey, the PMI (purchasing managers’ index) Manufacturing Index flash estimate, industrial production, and the Philadelphia Fed Index) showing improvement. (The outlier was the Kansas City Fed Manufacturing Index.)
Quarter-over-quarter nonfarm productivity growth improved to a 3.0% annualized rate in Q3 as the labor cost of producing a unit of output fell at a faster rate, suggesting that companies continue to squeeze value out of employees. With demand apparently improving and many companies already running lean, I would expect to see continued improvement in hiring activity next year.
Housing data last week were mixed. Housing starts reached nearly 1.1 million on an annualized basis in November, a 29.6% gain over year-ago levels, and the National Association of Home Builders’ Housing Market Index hit a recovery high. While housing continues to contribute to growth, existing home sales fell sharply in November. According to the National Association of Realtors (NAR), all-cash buyers of existing homes made up 32% of November’s sales; without them, the NAR claims, sales would have essentially fallen off a cliff. With mortgage rates rising and low inventories pushing up prices, the pace of the housing market recovery will bear watching as we head into the New Year.
The majority of the economic data we’re now seeing is, however, consistent with a steadily, if slowly, recovering and expanding economy. Perhaps the process has been slower than in past episodes, but that’s usually the case after a major financial crisis. Otherwise, the pattern looks relatively normal, its cycles of ups and downs included.
Deleveraging has largely run its course, and there are few signs of excesses in the economy. I expect continued modest growth and muted inflation in 2014, even as the Fed continues to wind down its asset purchases. The Fed Funds rate, Chairman Bernanke took pains to reiterate, is highly likely to remain low for a long period, as the Fed waits for unemployment to fall “well past” 6.5%, especially if inflation stays low.
With tapering now finally a reality, we can expect some of the asset classes that thrived amid last summer’s “taper tantrum” to perform relatively well, including industrial stocks, U.S. dividend growth stocks, global equities and senior loans. Core bonds, emerging market debt and high yielding dividend stocks, on the other hand, may once again face headwinds.
Given 2013’s strong run for many asset classes, many investors wonder whether the gains can continue. We cover this question at length in our 2014 outlook, and while the U.S. is unlikely to repeat the exceptional results of this past year, I do not believe the secular bull market is at an end. In fact, when I recently sat down with colleagues to discuss the state of the markets, discussion immediately turned to what could go wrong. Should we be worried about weakening purchasing managers’ surveys in France? Upcoming elections or political unrest in India, South Africa, Indonesia, Brazil, Ukraine, Turkey or Thailand—to say nothing of Syria, Egypt and elsewhere in the Middle East? The point is not that many things can go wrong, it’s that many investors are still thinking this way; we’re still climbing the proverbial “wall of worry.” That kind of skepticism, while not sufficient, is certainly necessary for markets to keep rising.
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