The "hopium" effect will start to wear off soon, but there should be one dose of it left. Although prices are likely to settle lower through the rest of the week (barring improbably good data Thursday morning), the EU summit meeting slated to run June 28th-29th neatly lines up with the end of the quarter, giving interested parties a double shot. The allure of the end-of-quarter markup skit, along with the promise of one more pony ride in the Big Hope tent, seem like a good bet to conspire to keep ticket prices up through the end of the quarter.
After that, things don't look so good.
You may wonder if the hopium is strong enough to even last that long, but we think it is, absent some really ugly headline. Given the level of expectation, the Dow should have sold off triple-digits after the Fed put forth nothing more than a continuation of Operation Twist. However, after the seers got out their long knives and carved up the entrails of the statement, they claimed that the combination of "unemployment remains elevated" and "inflation has declined" (it doesn't get much more sensational than that) guaranteed that QE-3 was in the bag at the next meeting. Of course it is.
On top of that, EU President Herman Van Rampuy is said to have a "blueprint" for "discussion" of short-term eurobills (jointly guaranteed) and other sundries. A blueprint for discussion, well, with momentous progress like that the Stoxx ought to be up 2% today. Cheekiness aside, one can readily imagine a supply of late-breaking afternoon rumors out of Europe next week designed to ding the euro shorts and dress up those crucial quarterly numbers.
The questions left at the end of the day were, was the Fed correct? And are things really starting to look bad or not, as the traders kept up the chant of "bad is good?"
As far as the Fed goes, yes it was correct. In the first place, discontinuing Operation Twist would have been a de facto tightening. There are undoubtedly risks in continuing the Twist policy, but the risks from tightening in the face of the likely European storm appear greater. In the second place, the chief threat to the domestic economy is external rather than internal.
If Europe is to have its crisis moment, something we have been predicting as the necessary prelude to action and recently seconded by Goldman Sachs COO Gary Cohn, the Fed is going to need spare ammunition. Launching QE-3 now would have sent commodity prices soaring. along with the stock markets. The problem with the former is that with core inflation still running at 0.2% monthly, a spike in oil and other inputs would not have been welcomed by the developed countries. The problem with the latter is that each rally based upon central banking liquidity results in the EU apparatus happily shelving difficult decisions and falling back onto their own hope trade. The blowback effect is to strengthen the potential power of any crisis episode.
The market is mistaken, though, in thinking that it can rally into an August Fed meeting. Equity traders undermined themselves by rallying into the current one. The belief that the Fed would feel itself obligated to launch major monetary easing with the stock markets up 8% (S&P 500) to 12% (Nasdaq) on the year was simply out of touch with reality. The markets can be very good at crushing rational thinking with their own versions of reality, but it cannot buffalo the Federal Reserve with some garden-variety hope rally. It hasn't worked yet.
It isn't the prices themselves that motivate the Fed anyway. It's the underlying reality that prices reflect, a useful symptom-versus-disease distinction to keep in mind. For all the talk about the Fed bailing out stock markets, the central bank really doesn't consider it a matter of life and death if the market isn't up 10% every year. It's weakening economic conditions taking prices down that provoke the Fed into action. Ergo, it will require substantial evidence of a concrete slowdown for the Fed to act at the next meeting in six weeks, and such evidence isn't going to be ignored by the stock market, hope or no hope. If anything, the usual script is for the markets to first start having anxiety attacks about the impending end of the world, followed by lamentations that the Fed is powerless to prevent it.
That leaves us with the other question, namely whether the economy is slowing down, and if so how much?
A week ago we said that caution is overtaking the economy, and the evidence continues to pile up in support of that notion. The latest data has largely disappointed. The New York Fed survey was barely positive, disappointing hopes for a much better report. Consumer sentiment fell considerably, homebuilder sentiment remained essentially unchanged at low levels, May industrial production appears to have declined slightly and weekly retail sales reports remain on the soft side.
Weekly claims might be rising, though it is too early to tell, and the JOLTS survey reported fewer job openings than a month ago, though still better than a year ago. Housing starts remain much improved over last year, and permit activity picked up. But the levels are still well below average and there are hints that new construction growth may also be about to pause - the Architecture Billings Index declined for a second month in a row, with May falling faster than April. The American Trucking Association reported a second consecutive monthly decline in tonnage, and the business CEO Roundtable showed a decrease in confidence.
Caution appears to be showing up in corporate results as well. In the last few days, companies as diverse as consumer staple giant Procter & Gamble (PG), electronics contract manufacturer Jabil Circuit (JBL), retailer Bed Bath & Beyond (BBBY) and software vendor Red Hat (RHT) have all lowered guidance. They are all still making money and talking about solid cash flow and balance sheets, with no one talking down the stock. Nonetheless, they all lowered guidance and talked of caution. The CEO of Jabil, which tends to be a canary-in-the-coal-mine kind of company, talked about "such macro uncertainty and lack of end market tailwinds."
We may be setting up for an echo of August 2011. The political gridlock in the United States a year ago ended up slowing the economy and earning a downgrade to the U.S. credit rating. The country is in a better place structurally than it was a year ago, but the likely failure of the impending EU summit to surmount minimalist incrementalism could easily produce a similar result for equities, with accelerating fears of slowdown brought on by political paralysis. Since the FOMC hope-trade got going in earnest last Friday, the trader mantra was that "bad is good," because bad news would bring on Fed action. They may have neglected to include themselves in the equation.