Even acknowledging that economic growth is a poor guide to market performance, the rally in the US following a downgraded GDP forecast has commentators scratching their heads
With macro-sensitive markets, you might expect bad economic news to send jitters through the investment community. Yet last week the US saw a significant downgrade to its first quarter growth estimate and the country’s leading share index…rallied.
So how do we explain this phenomenon?
It has long been argued that economic growth is a poor guide to market performance (and vice versa), at least in the short term. Indeed the two can frequently diverge – as investors in China have learned to their cost in recent years.
Yet markets should, at least in theory, reflect the health of the corporate sector or at least sentiment towards it. And here the latest moves are something of a puzzle for conventional theory.
The third estimate of US first quarter GDP was revised down from 2.4 per cent to 1.8 per cent. This marked a 70 basis point reduction from the initial 2.5 per cent estimate that had commentators cooing over the apparent lack of impact from the sequester cuts on output. Unfortunately, the good news did not last.
So perhaps the picture for US companies was rosier than the broader economic picture suggested. However, here too the news was disappointing. Over the quarter corporate profits posted a surprise decline of 1.1 per cent, the first fall since the first quarter of 2012, with economists having predicted a modest 0.2 per cent rise.
Of course, overall corporate profitability encompasses a much wider universe than just the S&P 500. Nevertheless, it is of note that after the release all three major US stock indices rallied with all industrial sectors seeing gains. The gains may suggest that bad news is now being interpreted as a buy signal.
’We have got the perverse situation that the markets seem to like poor economic data as it could delay QE tapering’
One explanation for this is that we are seeing a relief rally as poor economic news calms nerves over the possibility of the Federal Reserve beginning to taper its quantitative easing programme.
Speaking after a Federal Open Market Committee meeting Ben Bernanke, the Fed chairman, indicated that if the central bank’s economic forecasts were met then it could begin scaling down its asset purchases as early as September:
“The committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
This prompted an immediate market response with the S&P 500 and Dow Jones falling sharply. As such it is possible that some of the recent rally reflects an unwinding of some of the taper talk panic. If that is the case, however, then it suggests there is a great deal of speculative activity relating to central bank policy.
“The US obviously faces some headwinds from the sequester cuts,” says Graham Toone, the head of investment research at AFH Wealth Management and FE AFI panellist. “We have got the perverse situation at the moment where the markets seem to like poor economic data as it could delay QE tapering.”
For the US at least the spectre of a stagnating economy could therefore be a positive for asset prices – not least if you accept the argument that the Fed’s purchases of mortgage-backed securities is helping to drive the US housing recovery. Signs of sustained economic growth might not only threaten to withdraw the monetary policy crutch for stock prices but ironically could also undermine the housing market.
So what does this mean for the UK?
Well the UK suffered its own embarrassing round of revisions last week. Although the latest Office for National Statistics figures show the country avoided a double-dip recession, the economy remains 3.9 per cent below its pre-crisis peak.
Moreover, while the ONS maintained their 0.3 per cent growth figure for the first quarter of this year, real household incomes continued their slide falling 1.7 per cent over the quarter.
Unfortunately while the UK’s economic woes appear to justify continued monetary easing the fact the FTSE 100 fell in line with US markets on fears of a QE taper is indicative of the fact the Bank of England, which has held fire on addition QE purchases since October 2012, is only a minor player in this drama. All eyes, it seems, are solely on the Fed.
And there lies the problem. While the markets are panicked over talk of a taper, the reality is the Fed has made its conditions for scaling back asset purchases quite clear. Under the Evans rule that it adopted in December, the central bank has committed to remaining accommodative while unemployment remains above 6.5 per cent and the inflation it expects in one to two years is no higher than 2.5 per cent.
Another way of looking at this is that in order for the Fed to want to taper, the US economy would have to be achieving a self-sustaining recovery. This would surely be good news for US markets, as well as for global economic prospects so markets falling in response to a taper would seem utterly perverse.
Here, I am inclined to agree with Binyamin Appelbaum, the New York Times’ Washington correspondent who mused on Twitter:
“Not sure the Fed’s problem is that markets don’t understand its message. Seems more likely the problem is a lack of trust.”