Stock market supercharge waits on the sideline

The US is continuing to create jobs at a solid pace, stock prices are rising and government bond yields are starting to increase despite the almost unlimited buying from the US Federal Reserve which is designed explicitly to keep bond yields at low levels.

While it remains a problematic environment for the US economy as the hangover from the global banking and financial crisis is still being felt, the fact is the economy is on the mend, with employment up 155,000 in December and 1.84 million through the course of 2012. The unemployment rate was steady at 7.8 per cent to register a fourth straight month where it has been below 8 per cent, something not seen in the US since 2008.

Making the news on the labour market even a little more favourable was a slight acceleration in average hourly earnings to a 12-month high of 2.1 per cent, while the average weekly work hours also edged higher to give a tentative sign of improving economic activity. At the same time, the Institute of Supply Management services index jumped to 56.1 points to provide further evidence that the US economy ended 2012 with decent economic momentum.

The US in not alone in getting some better economic news. The Chinese purchasing managers indices were solid for December, which fits with a range of other hard data on retail spending, industrial production and business investment, which have also shown a move higher in recent months. In the eurozone late last week the composite PMI, which includes both the services and manufacturing sectors, rose to a nine-month high of 47.3 points, while German retail sales were stronger than expected in November.

The market response to the economic news has been powerful.

US stock prices are wonderfully buoyant. The Dow ended last week at 13,435 points while the S&P 500 closed at 1,466 points, aided by the favourable jobs news. The S&P 500 is now up 30 per cent from July 2011 and is up a whopping 110 per cent from the March 2009 lows, when it appeared that the US economy was heading for something close to a 1930s type depression. The policy action of the Fed and the US administration avoid that and now US stocks are only about 5 per cent below record highs.

In Germany, the Dax has risen 30 per cent since June 2012 and coincidently, is 110 per cent above the 2009 low point. There have been similar rises in other major European markets, probably more because pessimism is being neutralised, rather than there being an outbreak of pure optimism.

US 10-year government bond yields have also jumped sharply in the last few months and are now at an eight-month high of 1.90 per cent. These yields are, of course, still very low on any long-run historical comparison, but the bond market trends must be viewed in the context of the US Federal Reserve continuing to ramp up its quantitative easing. It is also starting to be noteworthy that the current yield is now sharply higher than the all-time low of 1.40 per cent in July 2012. These sorts of trends are evident in major bond markets in Europe and to a lesser extent Japan.

Global financial markets, in other words, are starting to price in decent economic growth and maybe just the slightest of slight hints that inflation may tick higher from what is a very low base.

For Australia, a stronger world economy will be hugely supportive for confidence, the export sector and improving financial market conditions.

Some of the pessimism surrounding Australia's terms of trade and the negative consequences for national income from the forecasts for a sharp fall in commodity prices could be over-blown. It would be remarkable if, through the course of 2013, any upside in global growth was reflected in higher commodity prices and with that, relative stability in the terms of trade. It would enhance the budget projections, underpin the Australian dollar and would limit any further interest rate cuts from the Reserve Bank of Australia.

It also suggests that markets will be particularly fickle, partly because there is currently an asset allocation bias away from stocks and towards cash, the reversal of which might just supercharge the stock market.

There remains solid news of a steadily unfolding economic recovery not just in the US, but also in China and India. Recent policy initiatives in Japan and Europe confirm a bottoming out of the economic cycle and the rise in stock markets around the world are unambiguously a signal of better times ahead.