There are several major headwinds and tailwinds in today's markets. Here we examine each and its potential impact on the market:
Tailwind: The "Fed Put"
"Don't Fight the Fed" has been the operative word for a long time. That looks like it will continue. Widespread expectations were that the Federal Reserve would taper Quantitative Easing (QE). On Thursday, the Federal Open Market Committee (FOMC) voted to keep asset purchases unchanged at $45 billion in Treasury securities and $40 billion in mortgage-backed securities.
The Fed's decision to continue ultra-easy monetary policy is not surprising. Their dual mandate of optimal inflation and low unemployment does not leave it with much of a choice. The economy is not creating enough new jobs for the Fed to reduce stimulus. In addition, inflation is too low at a core rate of 1.4% for the Fed to justify reducing QE. Some inflation is positive, as it indicates that the economy is putting some pressure on capacity, utilization and wages. If the Fed cannot get inflation higher, the economy is at risk of dropping into deflation.
The continuation of QE is very good for the stock market over the next 12-18 months, as it pushes people away from low interest paying bonds and into stocks. The Fed has reinforced its commitment to doing whatever it takes to stimulate economic growth. If something bad were to happen politically or economically, the Fed would be right there to do everything in its power to support the economy and the stock market. The "Fed put" is back on.
Tailwind: Merkel's Victory in Germany
Over the past several months, Europe's economy has officially pulled out of recession. Positive GDP growth in Europe has been a welcome sign for the global economy. We expect continued improvement, although at a very gradual pace.
For growth to re-emerge in Europe, the "dead wood" needs to be cleaned out first. Many of the more socialist countries in Europe cannot afford to be in Europe any longer. For Europe to really get better, these countries will need to be either cleaned out or pushed out. If Europe can cut out the countries dragging it down, the stock market would like that very much. This process cannot happen without a strong leader in a European powerhouse country to lead the charge. Angela Merkel is that leader. On Sunday, she was the overwhelming victor in the German elections. She will start her 3rd term as chancellor of Germany - a position she has held since 2005.
We believe her victory is just as positive for Europe's economy and stock markets worldwide as the Fed's decision not to taper QE. She's a popular leader in a powerful country. Merkel is one of only a handful of European leaders to survive the debt crisis (19 European leaders have been dismissed since 2010). Forbe's magazine rated her as the 2nd most powerful person in the world - behind President Obama. She has the power and the position to change Europe for the better. We think she will.
Headwind: Politics in the U.S.
In order to avoid a government shutdown, politicians need to reach a funding agreement within the next 2 weeks. As of now, the idea of Republicans and Democrats agreeing on anything seems unlikely. On Friday, the Republican-led House of Representatives passed a government spending plan that would de-fund Obamacare. Later that same day, President Obama stated that Republican legislators were focused on politics and "trying to mess with me."
If things get personal, the gloves-off political brawl between Republicans and Democrats could be a barrier for the market and the economy. Both parties have done things that have hurt the country. No one knows how the next few weeks will unfold, but we see three potential outcomes:
- The GOP digs in and then buckles. Historically, Republicans do a lot of talking and blustering, but they fall down when real negotiations take place. Most people expect history to repeat itself and Republicans will approve Obamacare and kick the can down the road to the next big debate, the debt ceiling.
- The GOP digs in beyond expectations, then buckles.
- The GOP digs in and doesn't buckle. The Republicans could decide that they want to come together on this. There is a possibility that when the Senate rejects the House's de-funding bill, Republicans will separate out the pieces and then send a new bill back to Senate. This is where real negotiations start to occur and the potential for government shut down increases.
The question is: how does the stock market respond to each of those scenarios?
The market probably doesn't react much to the first two scenarios, but it does to the third. As things get progressively uncertain, the reaction in the stock markets would likely be messy. However, we believe that any government shutdown would be short lived. We know from history that the American people will not allow it to go on for long. One of the parties will give in to negotiations and we will move ahead.
Conclusion: Short-Term Volatility Gives Way to Long-Term Gains
There are a lot of moving pieces to today's market. We see the current headwinds coming from the political stalemate in Washington as being potentially negative, but also temporary. The Fed's decision to continue QE and Angela Merkel's victory in Germany are both huge tailwinds that will have much longer impact than political squabbles.
An improving Europe and the Fed continuing to push the economy can only help the stock market in the long run. Regardless of what happens in Washington, the companies we hold in our portfolios have very bright fundamental outlooks over the next 18 to 24 months. In addition, our portfolios tend to be less volatile than the market when we hit the inevitable rough patches along the way. Our Cornerstone and Income Builder portfolios have long-term volatility measures as much as 20% less than the S&P 500. We believe our clients are well-positioned for the long-term and that any short-term volatility in the market will be overtaken by long-term growth.
Recent market actions continue to encourage us that better worldwide economic news is becoming more apparent. Over the last month - the top performing sectors have been the Industrial stocks such as Emerson (EMR) and Cummins, Inc. (CMI) and Consumer Cyclicals such as TJX Companies (TJX), VF Corp (VFC), and Stanley (SWK). In addition, stocks in Europe, Asia and the Far East have outperformed stocks in the United States, as measured by the EAFE Index (EFA) relative to the S&P 500 (SPY).
Disclosure: Clients and employees of DCM own EMR, CMI, TJX, VFC, SWK, EFA and SPY.