The stock market rally continues to power ahead as we approach year-end. The S&P 500, which hasn’t suffered a correction greater than 2% since July, is on track to produce its seventh consecutive monthly gain in December and deliver a total return in 2006 in excess of 15%. The rally has been broad-based, with all key areas of the global equity markets participating.
U.S. large-cap and small-cap averages are trading at new bull-market highs, as are foreign developed and emerging markets,
as measured by the MSCI EAFE (NYSEARCA:EFA) and Emerging Markets (NYSEARCA:EEM) indexes. In last month’s asset class review, we identified several developments that could cause this bull market, which is now 4.2 years of age, to run into trouble. A review the current state of these risk areas suggests that while a routine stock market correction is clearly overdue and could occur at any time (our best guess is in January), there is no reason at this time to expect a major imminent market top or become prematurely bearish
toward the equity market.
Tighter Monetary/Credit Conditions
We see no evidence that the tide of liquidity driving asset prices higher is receding. The global economy and financial markets remain awash in liquidity, and if anything, liquidity has been expanding rather than contracting. The most recent manifestation of unparalleled liquidity conditions, apart from the simple fact of virtually all global asset markets appreciating in unison, is the record volume of cash acquisitions of publicly traded stocks via M&A and buyout transactions. These cash-for-stock acquisitions, combined with ongoing record levels of stock repurchase activity by public corporations, provide a very supportive factor for stock prices due to their shrinkage of the “float” (i.e. supply) of U.S. stocks.
In the economy, liquidity is closely connected to the continuing expansion of credit collateralized and sustained by rising asset prices. Today, credit is abundant and has become even more readily available in recent months as long-term bond yields have dropped and credit spreads have narrowed. The 10-year Treasury yield’s 65 basis point decline since July has provided a far more significant form of easing than what a reduction of the Fed funds rate would accomplish. A sidelined Federal Reserve has been sufficient for financial conditions to loosen, and unless core inflation reaccelerates, or the dollar comes under extreme pressure, the Fed is not likely to make any additional tightening moves, despite its hawkish rhetoric.
With monetary policy likely on hold through at least the first quarter, the Fed will largely be a spectator of economic and financial market developments in the months ahead. In the financial markets, liquidity is principally driven by the collective appetite of investors to assume risk. At present, investor comfort with and appetite for risk is very high, as would be expected given the very strong performance of financial assets since July.
The 'Carry Trade'
Financial market liquidity today is also driven to an unprecedented degree by the leveraged “carry trade,” in which investors/speculators (principally hedge funds) borrow in low-yielding currencies and invest in a variety of asset classes expected to earn a return higher than their cost of funds. The principal source of cheap capital is Japan, where short term
interest rates are only 0.25%, and to a lesser extent Switzerland, where the cost of funds is 1.75%. The proliferation of global leveraged speculation via the carry trade has created an unrestrained liquidity-creating mechanism unlike anything available in the past, but also introduces an unprecedented risk into asset markets.
The risk to global financial assets is that the Bank of Japan [BOJ], or the Swiss National Bank [SNB], allows interest rates to return to more normal levels, which would trigger a large rally in these heavily shorted currencies while simultaneously raising the cost of funds for leveraged positions. Such a development is likely to precipitate a large-scale unwinding of leveraged positions in an array of risk assets and cause a sudden evaporation of liquidity.
The first small step towards monetary tightening in Japan occurred last spring when the BOJ ended its policy of “quantitative easing”, which resulted in the withdrawal of approximately $200 billion of excess reserves from its banking system, and signaled that Japan’s overnight lending rate would be raised above 0% for the first time in six years.
As a result of these moves by the BOJ, the Yen rallied 8% against the dollar in the space of three weeks in late April and early May, and global stock, bond and commodity markets suffered sharp corrections in late May and June. Subsequently, as the BOJ has taken no further tightening steps (yet) to normalize interest rates, leveraged investors/ speculators have resumed their shorting of the Yen to raise funds to invest in rallying asset markets worldwide.
As a result, the Yen has weakened again and, indeed, has fallen to a record low against the Euro. Evidence that the BOJ is on a path to normalize interest rates will likely provide a cue to get more defensive as the currently plentiful liquidity associated with the carry trade begins to recede.
EFA vs. EEM 1-yr chart: