Thursday, June 20, 2013
The market doesn’t seem to like the level of clarity provided by the Fed on Wednesday. The Fed sees the economy doing just fine and if it continues on this pace, then the QE program would end by the middle of 2014.
I have been talking about this issue along those lines in this space for month now, but investors are surprisingly ‘surprised’ by this, causing turmoil in the stock, bond, and currency markets all over the world. The overnight weak factory sector reading from China amid persistent questions about that country’s banking sector doesn’t help matters in today’s session either.
The outlook for China remains problematic, indicating that the growth pace has likely stalled, if not reversed, in the current quarter. The HSBC Bank’s preliminary PMI reading slipped further into contractionary territory in June at 48.3 from May’s 49.2 level. This indicates that second quarter GDP growth could come in below the first quarter’s level. The growth worries have weighed on capital flows into the country, which has resulted in unusually tighter liquidity situation in the inter-bank funding market. What this means is that the country's growth picture doesn't look that promising, unless the monetary and fiscal authorities directly intervene.
But it’s not about China or the jump in initial Jobless Claims in the U.S. this morning – it’s all about the Fed today. As I have said here many times before, ‘taper’ doesn’t necessarily mean tightening. But markets are forward looking beasts and they try to look ahead to the time when QE will end and the countdown to interest rate increases will begin. Looked at this way, the taper becomes the first shot in a drawn-out normalization process that does look like tightening. But even if taper was no tightening, it is nevertheless the first sign of monetary policy change since 2007. And changes in monetary policy always have a direct bearing on asset prices, including stocks.
Why is that? Because asset prices are, in the end, the present values of all expected cash flows from the asset, discounted at an appropriate discount rate. One could argue about what this discount rate should be, but everybody agrees that it has to be in some way related to long-term risk-free rates, like the yield on the 10-year Treasury bond. And just as an example, if investors were willing to pay 15X next year’s earnings for stocks when the 10-year Treasury was yielding 1.6%, the they will completely be justified in demanding a lower multiple when the yield goes higher - say to 2.6% or even 3.6%.
I am not suggesting that the stock market bull run that started in March 2009 has come to an end. But it does mean that the market needs to find a new level of equilibrium – at a lower level. Hard to tell how low the market’s new equilibrium point will be, but I would expect it to be at least 10% to 15% below the May peak. Get ready for a rough summer in the market.
Director of Research
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