Is the Market Over-Reacting?

Zacks

Thursday, May 23, 2013

The overnight weak economic news out of China adds to the market uncertainty created by Fed related developments from Wednesday. Hard to tell at this stage whether the global market turmoil is a justified response to what we learnt on Wednesday or the typical over-reaction. But it nevertheless proves beyond any doubt the primary role that the Fed’s monetary policy has been playing in pushing the market into record territory.     

Let’s put the China news out of the way first. A highly watched reading of activity levels in China’s manufacturing sector came in weaker than expected. The HSBC preliminary purchasing managers’ index (PPMIQ) for May came in at 49.6 from 50.4 in April. A combination of factors, ranging from weak demand domestically to problems in international markets and increased competition from Japanese suppliers following the sharp drop in the exchange value of Yen appear to be at play here. But the PMI weakness follows weak economic readings in recent months, including the first quarter GDP growth that came in below expectations. Given China’s outsized influence in the basic materials and commodity sectors, this is a net negative for companies in those sectors.

China is no doubt important, but the bigger story for the markets today is the U.S. Federal Reserve. The signals coming out of the Fed’s two reports on Wednesday – Bernanke’s Congressional testimony and minutes of the last FOMC meeting – may be confusing, but they both indicate that the central bank is seriously thinking about tapering the monthly level of bond purchases. In fact, the announcement could come as soon as the Fed’s June meeting. This will be a major shift in monetary policy when it comes as it would be indicative of the central bank’s confidence in the U.S. economy’s ability to start moving on its own.

But this is no easy move for Bernanke & Co. The tricky part will be in convincing the markets that the tapering decision was not the start of a full-blown unwind of the last few year’s extraordinarily loose monetary policy. They certainly don’t want the tapering decision to spark a major rise in bond yields. But that may actually be inevitable. Rates have to rise to reflect the economy’s ground realities; they can’t forever stay at rock-bottom levels. And this represents the major threat to the stock market; it would no longer be the only game in the investment town.

Keep in mind, however, that markets almost always over-react in the short term. It is very likely that the turmoil in global markets today is just such an over-reaction. We may not know when the Fed will start tapering, but we know for a fact that they don’t want to rock the boat.

Sheraz Mian

Director of Research
    
 

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