Small signs of US recovery crowded out by Fed QE fears

But speculation that stimulus withdrawal would hugely damage stock prices may be somewhat overplayed, says Liam Ward-Proud

US ECONOMIC data has shown some promising signs in recent weeks. Retail sales were better than expected in May, with spending rising 0.6 per cent. Employment figures were also modestly positive, with the US economy adding 175,000 jobs last month. Rating agency Standard & Poor’s, meanwhile, has lifted its long-term outlook on the US economy from “negative” to “stable”. It is a sign of today’s bizarre market environment that these encouraging indicators have to some extent been drowned out.

The watchword of the moment is “tapering” – the potential slowing of the Federal Reserve’s quantitative easing (QE) programme. The Federal Open Markets Committee meets today and tomorrow, and is widely expected to keep current policy unchanged. Fed chairman Ben Bernanke has stressed the “data-dependence” of tapering, insisting that it will only begin when the economic fundamentals are sufficiently healthy. But this has led to a paradox where positive economic news, raising the probability of stimulus withdrawal, can actually be received negatively by investors. Mike van Dulken of Accendo Markets calls this line of thinking “good news is bad, bad news is good”, testament to what some see as the destabilising role played by the Fed recently.

The widespread fear of stimulus withdrawal has certainly spooked investors. US equities, judged by the S&P 500, have dropped from year-to-date highs of over 1,669 in late May to just over 1,608 at the beginning of June, halting the enormous gains made throughout April. Some ground has since been remade. But the question remains whether this decline is the sign of an impending market rout, or whether the danger posed by QE withdrawal is exaggerated.

“The recent falls are nothing but a correction of April’s excesses”, says City Index’s chief market strategist Joshua Raymond. “If you look at the actual communications put out by the Federal Reserve, the amount of commentary about the dangers of imminent tapering seems exaggerated,” he says.

Many believe, like Raymond, that tapering is simply not on the cards yet. Investment officers at Coutts, in a recent note, said “we expect stimulus from the Fed and other major central banks to remain at highly accommodative levels for the foreseeable future”.

And even if stimulus withdrawal were on the horizon, it is not clear that this would spell disaster for US equity markets. The Coutts note stresses that, since 1963, US equities have on average fallen just 4.3 per cent after monetary tightening (defined as an interest rate hike). Further, stock prices have typically begun to rebound around three months after past rate hikes, meaning that any price correction may not turn into a full-blown bear market, as some fear. If this view is correct, the eventual end of QE does not necessarily imply calamitous falls in global equity prices. Instead, we could see a price correction of a similar order to recent weeks.

But what does this mean for your portfolio in the near future? If tomorrow’s announcement sees the stimulus remain in place, “the usual risk-loving stocks may continue to do well in coming months”, says Raymond. Financial institutions such as Goldman Sachs have performed excellently since the start of the year, rising from just over $130 in January to around the $165 mark this week. In addition, ETX Capital market strategist Ishaq Siddiqi sees typically cyclical stocks, construction and industrials for example, also benefitting from a continuation of the status quo.

The dollar, on the other hand, may weaken slightly if QE is kept at the same rate. DailyFX currency analyst Christopher Vecchio says that “we favour the dollar to bottom out soon after the announcement, as it did in September 2012”. Raymond, however, points out that, despite the chances of short-term volatility, “the longer-term fortunes of the dollar are tied to the fortunes of the US economy.” This is a key point; regardless of what is announced tomorrow, investors would do well to keep a keen eye on the tentative signs of a recovery.

Fears of tapering may have had a more immediate effect on markets of late, but economic fundamentals will decide the fortunes of the world’s largest economy in the years to come.