US: Markets Through the Looking Glass

US: Markets Through the Looking Glass

Julia Coronado - Market Economics
US Daily Spotlight | 31 Jan 2013 01:40 |

Financial markets continued their increasingly bizarre, bullish run Wednesday, with a teensy equity selloff and little change in Treasury yields, despite a surprise negative print on Q4 GDP growth. While a number of volatile drivers of Q4 GDP weakness should be smoothed through, one truly needs to be peering through the looking glass to extract a positive spin from such a negative surprise. The FOMC also looked through the Q4 economic weakness, although the Committee drew the conclusion that not enough has changed in the economic outlook for them to alter their ongoing expansion of monetary policy, and they maintained their USD 85bn pace of securities purchases. It appears that a recent expansion in leverage on the part of hedge funds has contributed to the bull run in markets that has been impervious to weaker-than-expected economic data, and, at some point, markets could become responsive once again to economic data.

The economy declined 0.1% in Q4, well below expectations for a 1.1% gain and after a 3.1% pop in Q3. The biggest surprise was a sizable contraction in government spending and a larger-than-expected drag from inventories. A surge in federal spending was the driver of the upside surprise in Q3, fueling election year conspiracy theories, and this strength unwound in Q4. Meanwhile, consumer spending and business investment picked up, commercial and residential investment was solid, but a bit below expectations, and trade weighed on growth with both imports and exports declining at year-end.

Smoothing through the government and inventory volatility, the economy grew 1.5% saar in 2012, and in H2, suggesting a run rate below what most people think of as the US economy's growth potential. While the pickup in consumer spending is welcome, we expect consumers to pull back in H1 as they get hit with higher taxes, and our basic read on households is that their spending remains stable, but unspectacular. The pickup in investment was stronger than expected, and we think investment will be stronger in 2013, but probably grow at a somewhat more subdued pace than we saw in Q4. The ongoing drag from government consolidation at both the federal, and state and local levels offset areas of private-sector healing in 2012, and this dynamic will continue and intensify in 2013. Against a run rate of 1.5%, the economy will absorb the brunt of federal fiscal tightening in H1 through higher payroll taxes in Q1 and sequestration spending cuts in Q2.

The disconnect between data and financial market performance is highlighted in, which shows that US economic data have been consistently surprising to the downside on balance, as of late. This stands in contrast to upside surprises in Europe. Globally, markets seem to still be fuelled by fading European tail risks and, as shown in, an acceleration in leverage by hedge funds. Margin lending by broker dealers correlates quite well with the performance of risky assets over a long horizon, and picked up noticeably over the past several months.

Anecdotally, we understand that leveraged investors seized upon the combination of open-ended QE from the Fed, the backstop of the OMT in Europe and the likelihood of aggressive expansionary policies in Japan to increase their commitment to risky assets and currency moves, and position for higher Treasury yields. The question for 2013 is whether the easing in market conditions will successfully produce an economic improvement consistent with asset valuations. We expect it will to some degree, but it will take some time, and markets may be complacent about the fragile state of the underlying economy. Indeed, the further risk appetite pushes up commodity prices and bond yields, the greater the likelihood of a near-term economic soft patch.

Cognizant of the ongoing, still fragile nature of the recovery, the FOMC reaffirmed its commitment to open-ended QE at the January meeting. The statement ignored the 800-pound gorilla in the economic outlook – the drag from fiscal policy. The Committee looked through the negative GDP print saying that the economy "paused in recent months in large part because of weather-related disruptions and other transitory factors"; the latter factor was a veiled reference to the enormous drag from declining government spending. The statement also acknowledged that "global financial strains have eased somewhat", although "the Committee continues to see downside risks to the economic outlook". For 2013, these risks are mainly domestic and emanate from fiscal tightening and the uncertainty about fiscal policy.

The FOMC appears to be uncomfortable crossing the line and naming fiscal policy as the culprit weighing on the outlook in its statement. The reason for this hesitancy was highlighted Thursday afternoon when House Republican Jeb Hensarling, Chairman of the House Financial Services Committee, condemned the Fed’s decision to continue QE. Despite the political risks, the conclusion of all, but one, FOMC voters was that the economy still needs monetary support, and that "with appropriate policy accommodation, economic growth will proceed at a moderate pace". The guidelines for QE remain unchanged: "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities". With growth likely to remain subdued in H1 on the back of fiscal restraint, the hiring backdrop is not likely to pick up, and the Fed will remain committed to QE at the same pace through year-end. We expect continued purchases at a reduced pace in H1 2014, and then a balance sheet stabilization in H2.