Weekly Market Commentary - Fall Forward

The past two years indicate that major policy actions must take place in the coming weeks in the United States and Europe to emerge from the soft spot and push the economy forward in the fall. The coming weeks hold the potential for policy events that echo those of 2010 and 2011.

However, this year, the stock and bond markets are leading the policy actions—the rebound in stocks relative to bonds on the announcement of a third round of quantitative easing (QE3) and European policy actions has largely already happened.

 

 

 

Fall Forward

Several weeks ago, we noted that the stock market was turning up while bonds were beginning to sell off and that meant the global economic surprise index was likely on the cusp of turning up or the rally would be short. Fortunately, the economic surprise index has started to move higher, supporting the stock market over bonds [Figure 1].

The G10 economic surprise index measures whether data reports come in better or worse than economists’ estimates for the world’s largest 10 economies. There are two stages to a rebound in the economic surprise index. At first, when the economic surprise index turns up, this is because economists’ expectations finally got too low after being too optimistic for some time. Then, after partially rebounding, a further rise is driven by the data not just being better than feared, but actually showing strength. So far, we are experiencing the early, rather than the later, stage of the rise in the surprise index. The economic data may no longer be worse than feared, but it remains weak in most areas including job growth and manufacturing activity.

Back in March, we published our Spring Slide indicators that forecast an economic soft spot would soon emerge along with a stock market slide as spring got underway, similar to what happened in 2010 and 2011. Now that the economy is fully entrenched in this year’s soft spot, it may be helpful once again to look at 2010 and 2011, to see what drivers emerged in the fall of those years to push the economy forward again.

The past two years indicate that major policy actions must take place in the coming weeks in the United States and Europe for the economy to fully emerge from the soft spot in the fall:

  •  • In 2010, the Federal Reserve (Fed) pre-announced the second round of unconventional stimulus called quantitative easing (QE2) at their annual conference in Jackson Hole, WY on August 27. This followed the July passage of a trillion dollar bailout package in Europe.
  • • In 2011, the Fed announced the current stimulus program, Operation Twist, on September 21. This was followed swiftly by the German parliament ratifying the expansion of the European Financial Stability Facility (EFSF) on September 30.
  • •In each year, the stock market turned sharply higher following these policy catalysts and economic data subsequently began to improve.

Here in 2012, the coming weeks are full of the potential for policy events that echo those of 2010 and 2011:

  • • The Fed may preannounce QE3 at the Jackson Hole, WY conference at the end of this month or at their upcoming September 13 meeting.
  • • The German constitutional court may rule favorably on the European Stability Mechanism (ESM) on September 12, with bond purchases by the European Central Bank (ECB) then conditional on a formal request from Spain or Italy.
  • • The next Troika, so-called because it is made up of the European Commission, International Monetary Fund, and ECB, review of Greece is on September 14. If favorable, Greece will obtain the next tranche of bailout funds.

Major policy actions are likely. In fact, just last week German Chancellor Merkel made some comments supporting the ECB’s communication on buying bonds, and rumors were circulating in Europe that Spain was preparing a request for a bailout. So there are plenty of policy drivers likely in the coming weeks to help the economy in the fall. But, unlike 2010 and 2011, this year the stock and bond markets are leading the policy actions. This sets up for a departure from the pattern of the past two years, since the rebound in stocks relative to bonds on the announcement of QE3 and European policy actions appears to have already largely taken place. In addition, investors have reversed their preference and started to favor more aggressive, cyclical stocks over defensive, yield-oriented stocks in the past few weeks, as you can see in Figure 2.

 

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

For additional information on the indexes that make up these sectors, please see page 5.

We are likely to get the policy actions the markets are now expecting. The market has quietly drifted back to this year’s high on very low trading volume and volatility. In fact, the average absolute daily percent changes in the S&P 500 Index over the past 10 trading days have only been this small one other time since 1996. However, it is likely to get louder in the coming weeks. With market participants having bought the rumor surrounding policy actions this year, they are unlikely to buy again on the news when the policy actions emerge. We do not expect a major pullback, but instead the return of volatility—especially with the U.S. elections and pending fiscal cliff adding uncertainty not present in the fall of 2010 or 2011.

 

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data. The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. "Operation Twist" describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective. Consumer Discretionary: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services. Consumer Staples: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. It also includes food and drug retailing companies. Energy: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels. Financials Sector: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs. Healthcare Sector: Companies are in two main industry groups — healthcare equipment and supplies or companies that provide healthcare-related services, including distributors of healthcare products, providers of basic healthcare services, and owners and operators of healthcare facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products. Industrials: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Also, companies that provide commercial services and supplies, including printing, employment, environmental and office services, or provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure. Manufacturing Sector: Companies engaged in chemical, mechanical, or physical transformation of materials, substances, or components into consumer or industrial goods. Materials: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel. Technology Software & Services: Includes companies that primarily develop software in various fields such as the internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products. Telecommunications Services: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network. Utilities Sector: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power. The S&P Consumer Discretionary Index is comprised of companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services. The S&P Consumer Staples index is comprised of companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. It also includes food and drug retailing companies. The S&P Energy Index is comprised of energy companies that primarily develop and produce crude oil and natural gas, and provide drilling and other energy related services. The S&P Financials Index is comprised of a wide array of diversified financial service firms are featured in this sector with business lines ranging from investment management to commercial and investment banking. The S&P Health Care Index is comprised of companies in this sector primarily include healthcare equipment and supplies, healthcare providers and services, biotechnology, and pharmaceuticals industries. The S&P Industrials index is comprised of companies whose businesses: Manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure. The S&P Information Technology Index is comprised of stocks primarily covering products developed by internet software and service companies, IT consulting services, semiconductor equipment and products, computers and peripherals, diversified telecommunication services and wireless telecommunication services are included in this Index. The S&P Materials Index is comprised of companies that engage in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel. The S&P Telecommunications Index is comprised of companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network. The S&P Utilities Index is comprised primarily of companies involved in water and electrical power and natural gas distribution industries.