At its December 18 Fed meeting, the US Central Bank announced its plans to start tapering back its policy of purchasing treasuries and mortgage backed bonds commonly known and referred to as quantitative easing or QE. Starting in January the Central Bank will reduce its purchases of these securities to $75 billion a month, a reduction of $10 billion. Based upon a slowly recovering economy the Fed's intent is to announce a further $10 billion reduction at each of its eight meetings in 2014 which would result in eliminating the program altogether. As markets have relied on the stimulus program to support asset prices, potential withdrawal of the program was greeted with a certain amount of apprehension creating an environment where bad news was received positively by markets and good news was not so well received. A fair question is: As Fed policy normalizes in 2014 will the markets reaction to good and bad news do the same?
Good News is Bad for Asset Prices
Financial markets can be unpredictable and fickle things. One of the great conundrums of the last five years has been the notion of markets responding counterintuitively to economic data. The market participants that performed the best during the financial recovery were those who embraced the notion that weaker data would encourage an accommodative Fed which would provide more and more stimulus. This position required an iron constitution to accept and anticipate counterintuitive market behavior to varied economic data. And market behavior proved to be very unpredictable. In addition to being an "unloved" bull market by most investors, the equity market's rise was widely resisted as retail investors avoided equities while professional money managers resisted as well as shorted equities, which was a truly losing cause. The most disastrous results were from those managers who could not adapt to the idea that bad was good or good was bad. For tenured managers this shift was too overwhelming to acknowledge. Headlines of failed hedge funds littered the financial press each and every week for years. Predicting market behavior became first anticipating the data and then forecasting the market's response to that data, which is not a new concept but now it had a new twist. The only thing more bizarre than the market's response to data was the media's portrayal of how the market would react to data. End of month labor reports became circus-like with the multitude of analysts and professionals that CNBC and other financial programs would trot out and interview. All of the analysis and pontificating was based on a notion that weak data would keep the Fed on hold from removing liquidity from the market and helping maintain the bull market. The biggest fear became a large and positive labor report.
With the Fed's Decision to Announce the Taper, is it Time to Shift the Thinking Again?
Will the most successful money managers in 2014 be the ones that can go back to the old school way of interpreting economic data? If so, how and when will we know how the market is responding to the data? How many data points will we need to spot a trend? Based upon the equity market's reaction to the Fed's statement, it seems the market is ready to embrace good economic data again and reward the markets accordingly. To be sure, the reference to markets is equities, not all asset classes. Commodities such as gold have already weakened significantly and fixed income have suffered as yields have started to climb again after falling briefly. There was much revelry when yields did not skyrocket with the Fed's announcement. I think much is being made about this, when in reality, why should we be so confident that rates won't take their good old time to start to rise? One reason investors might point to a subdued yield environment is the fact that the Fed seemed very concerned about inflation, and more specifically, the lack thereof. The one thing that may scare the Fed more than good old fashioned inflation is not so good old fashioned deflation. As few outside of an economics classroom appreciate, deflation is truly a worrisome concept. In a nut shell, consumers stop consuming in anticipation of lower prices and the mechanics and benefits of debt break down with deflation. For a culture and society that lives for debt, this is debilitating. Japan in the 90s is the case study of deflation. Trust me, it's worse than inflation.
The Fed Soothed Markets By Assuring Them of Low Short Term Rates Forever (Hyperbole)
One of the things the Fed would like to accomplish is an ability to soothe markets more through guidance and commentary than through actual action. If the Fed is successful, it can accomplish its intended goals of assisting markets without the fear of unintended consequences of increasing its balance sheet. If the market accepts this approach and acknowledges the Fed's accommodative position, then good economic data can be interpreted as good for markets and vice versa. This can happen perhaps because without the market actually performing quantitative easing, the market can move away from the fear of losing stimulus and accept good news for what it is, an improving economy which should lead to improving financial markets: higher equity values and normalized interest rates.
Ironically, As Equity Markets Are a Discounting Mechanism, is There Remaining Upside?
As money managers are wont to do, equity forecasts for 2014 are naturally upbeat. Most range from modest, if any, growth, to the sublime of an additional 20% on top of 2013 gains. However, given the growth in equity values to date versus the modest GDP growth in the real economy, is good economic data just doing "catch up" leaving the equity markets flat in 2014? With most managers at the least acknowledging a fairly priced equity market, what room is there left for further short and intermediate term asset value growth? If equity markets continue to function as they always have, the improving economy has been long since priced in to todays values. Maybe what the markets are left with is that good news is just a sigh of relief and not an exultation or catastrophe.
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