Friday, February 7, 2014

Stocks Must Rebuild the Wall of Worry

Print FriendlyYou may know the old expression about how bull markets climb a “wall of worry.” But once all of the old worries seemingly disappear, markets then become vulnerable to new ones.

At the end of 2013, there was a growing consensus that the world was entering a phase of synchronized growth. But during January, that optimism gave way to new worries that stocks will have to overcome. Or fail in the attempt.

It didn’t take long for the much-anticipated “pause that refreshes” in many of the world’s equity markets to turn into fear of a global contagion. Will this week’s rebound reduce those fears or merely provide temporary relief?

As the year started, markets fell around the world. For the US and Europe and Japan, it was an understandable pullback after a robust, some would say exuberant, 2013. But for emerging markets, the declines were an acceleration of previous weakness.

A clear reason for the broad-based decline was the Federal Reserve’s start of the gradual tapering of its quantitative-easing program. At the margin, this should reduce the flow of investor money into so-called risk assets.

Then some specific problems started to pop up four weeks ago today, with last month’s surprisingly weak US jobs report for December. This was followed since then by Argentina’s currency devaluation; an unexpectedly soft manufacturing report in China, the world’s second-largest economy after the US; sharp interest-rate increases in Turkey, India and South Africa; a continuing inflation decline in the euro zone; and this week’s dramatic drop in Japan’s stock market.

Then today, Friday, brought the eagerly awaited jobs report for January. With the addition of only 113,000 jobs, it proved to be weaker than expected for the second consecutive month. Strangely, the unemployment rate ticked down to 6.6 percent even as the labor pa! rticipation rate ticked up to a still-dismal 63 percent. Bad weather, the worst in 35 years by some measures, may or may not have been a factor.

But this time, stocks were up as we completed this letter to you, in sharp contrast to last month’s negative reaction to the poor jobs report. Time will tell whether this reaction means a new climb up the wall of worry (slow growth) for stocks.

World stocks’ weakness in January and early February weren’t the only reasons to question whether global growth will measure up to recent optimistic expectations. Yields on 10-year US Treasury issues dropped to as low as 2.6 percent this week from 3 percent at the beginning of the year. Bond yields tend to drop (with rising prices) when growth and inflation soften.

The bond rally has been all the more impressive or disturbing, depending on your point of view, because it occurred despite reduced buying of US Treasury and mortgage securities by the Fed. Yields on Japanese government bonds, German Bunds and British gilts are also down.

In the US, an increasing body of opinion was that economic growth was poised to finally break out of its slow 2 percent or so rate to 3 percent or more in 2014. The US economy grew at a brisk annual rate of 3.7 percent in the second half of 2013.

But the jobs reports plus disappointing reports on US car sales, manufacturing and home sales have created doubts about whether faster growth is actually achievable this year.

It’s debatable the extent to which turbulence and problems in various emerging markets can affect the US economy and corporate profits and therefore stock prices. But we’re all linked, as the financial crisis of 2008 proved.

Just one example: Slower growth in the emerging markets would dampen profits of US multinationals, not only in the more economically sensitive industries but also in consumer staples, which generally are considered a relative safe haven in a volatile stock market.

Plus, we! ’re! talking not just about economic growth and corporate earnings. Credit and money flows are a key factor.

Valuations of risk assets are directly related to the amount of available credit and the level of interest rates. Collectively, the world’s monetary policy has tightened in 2014. The Fed is tapering. China is cracking down on its shadow banking system. Europe’s banks are deleveraging. And emerging markets are fighting currency weakness with interest-rate increases.

In the US, credit used to grow at 8–10 percent a year. But the growth was just 3.5 percent over the past 12 months.

Interest rates likely will remain very low for some time to come. Will that benefit help propel stocks higher on a new wall of worry, namely sluggish growth in 2014? Stay tuned.

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