Given recent market swings, loud political battles, weak economic data and strong corporate earnings, investors are wondering where the market moves from here. In my view, there are just four current areas that will determine the direction of the market: U.S. monetary policy, Chinese GDP growth, the European Union sovereign debt crisis and the price of oil. While other uncertainties might grab investors’ attention from time to time, those four will be monitored and scrutinized obsessively. Below is a layout of the possible short-term scenarios:
U.S. monetary policy – Every central bank in the world is tied to the Fed’s monetary stance and its (currently bloated) balance sheet. Its QE2 plan essentially allowed one part of the government (the Fed) to fund all the other parts (through the Treasury).
- Positive scenario – the U.S. economy experiences a moderate recovery, gradual improvement in job creation and a gradual repair of household and bank balance sheets.
- Negative scenario – the U.S. economy experiences a slower economic recovery, flat employment and a need for continued expansive Fed action.
Chinese GDP growth – The Chinese have essentially accounted for the bulk of incremental global real demand over the past five years. Will real Chinese GDP growth stay around its current target of 7.5% for the next year or will inflation fears cause the leadership to dampen demand levels back down toward 5%? The speed of the growth of the China economy will have a direct relationship with U.S. markets and its underlying companies/stocks.
- Positive scenario – China’s real GDP growth lands at 8% to 10% with sustained feverish levels of capital and infrastructure investment and some reduction in net exports.
- Negative scenario – China’s real GDP growth comes in around 5% with persistent inflation and expansion of net exports.
European Union sovereign debt crisis - All macro traders believe the question is not whether the periphery writes down its sovereign debt, but rather how it does so. Will the EU peripheral states force bondholders to take a haircut on their debt or will the EU, the European Central Bank and Germany somehow manage to bail them all out in a way that does not force big write-downs?
- Positive scenario – Some kind of government bailout that keeps holders of Irish, Greek, and Portuguese sovereign debt from taking big write-offs, thereby averting contagion to the European banking system.
- Negative scenario – The exposure of French and German banks to peripheral sovereign debt and threatens to spread to Italy and Spain. The bluntest early-warning indicator here is the discount to par on eurozone sovereign debt, which is large and growing. On this basis, we appear to be well down the haircut branch of this outcome.
Price of oil - developments in the Middle East/North Africa have materially negatively affected oil prices. The going forward question is how much further disruption in oil exports will there be.
- Positive scenario – There is little further supply disruption, as oil remains at or near $100 a barrel until demand picks up.
- Negative scenario – Further supply disruption occurs and oil spikes to over $125 a barrel without demand picking up.
The tricky part for investors is that the four above mentioned events are interrelated. The outcome of one event will have far reaching impacts on the others. While either the best possible scenarios (moderate U.S. business recovery, high Chinese growth rate, a contained solution to the European debt problem, oil spiking due to high demand) and the worst possible scenarios (U.S. economy improves less slowly, China slows growth due to inflation concerns, the European debt issue spreads and further impacts countries and oil price remain down due to low demand) could all happen. It is far more likely that we will witness a series of events that fall in between, moving the market drastically each time information/news is released and scrutinized.
Disclosure: I am long SPY, DIA, QQQ.