The S&P 500 responded positively to fairly negative data overnight. Is there a better recent example of irrational exuberance?
Unfortunately for investors, the party is nearly over, with the Fed likely to begin tapering as soon as March next year.
There was a range of disappointing data released last night for the United States. Retail sales declined slightly in September, contrary to market expectations, which reinforced the slowdown in consumer spending throughout the September quarter. Excluding automobile sales, core retail sales were up by 0.4 per cent in September.
The Conference Board Consumer Confidence survey fell sharply in October – much more than the market expected – following the 16-day government shutdown. Expectations for economic activity for the next six months also declined significantly.
Producer prices fell modestly in September, contrary to market expectations of a small rise, and inflation expectations remain low. Core producer prices, which excludes food and energy, rose by 0.1 per cent in September.
Despite the disappointing data, the US S&P500 rose overnight to a new all-time nominal high. Market analysts attributed the rise to the poor data increasing the likelihood that the Federal Reserve will delay the taper of its asset repurchasing program when the Fed meets tomorrow.
There are two problems with this:
1. The data released last night had no impact on the likelihood that the Fed would delay tapering.
2. The market now prefers poor data.
With regards to the first point, the driving force behind the Fed decision to maintain its repurchasing program was political uncertainty.
Data had softened but the decision was made on the precipice of the debt ceiling negotiations. The eventual shutdown is estimated to have removed $24 billion from the US economy, although the real effect will be larger when you consider the flow-on impact of political uncertainly on consumption and investment decisions.
The Fed will not have a good read on the economic effects of the government shutdown until at least December. But they are likely to remain cautious given the US federal government begins re-negotiation on the debt ceiling and budget in January. On balance, it seems unlikely that the Fed would be swayed by data released overnight, which makes it unusual that markets were swayed by it.
On the second point, market participants reacted positively to poor US data because it reduced the probability of tapering. Is this not the very definition of ‘irrational exuberance’? Provided you have confidence in the Fed’s decision making, positive data should always be preferable. Surely a recovering economy and greater economic prospects is preferable to a continuation of the gravy train?
A bit of research suggests that the US stockmarket is not as strong as the headlines indicate. If adjusted for inflation, the S&P 500 is still almost 12 per cent below its peak in August 2000. Prices are overvalued but perhaps not as overvalued as you might think. But even with the adjusted data the fundamentals do not justify the market optimism. Unfortunately for investors the party will be over soon.
I expect the Fed to begin tapering in around March as long as two criteria are met. First, the US economy does not soften further in the first quarter of 2014. Second, the budget and debt ceiling negotiations are completed without too much drama or a repeat of the government shutdown. Markets will then cool, as we saw when both QE1 and QE2 were wound back. Hopefully it will prove to be a soft landing.
Domestically, we have not seen the rise in share prices experienced by our US counterparts. This puts us in a much better position to weather the post-QE adjustment. In fact, there is a good possibility that the Australian economy will be left better off due to an appreciation of the US dollar, and a rebound in tourism, manufacturing and exports.
As RBA governor Glenn Stevens said yesterday, investors should make sure they have realistic expectations. Right now investors are racing to make money, while hoping they are not the one left holding the baby.