Americans always seem to think the world revolves around them. While most people have a more international outlook today, it is easy to assume the U.S. economy can drive economic growth around the world.
The market is at its highest levels for the year, with the S&P 500 and its tracking exchange traded fund, the SPDR S&P 500 ETF (NYSEARCA:SPY), having rallied nearly 12% in the last two months. Market leaders in cyclical sectors have been particularly strong, with companies such as GE (NYSE:GE), Chevron (NYSE:CVX), and Citigroup (NYSE:C), up over 15% in the last several months.
While the U.S. economy is still growing, unemployment levels continue to rise, and key manufacturing and service data continues to show contraction as well. Leading economic data in the EU and Asia also continues to deteriorate, with Japan recently reporting anemic quarterly economic growth of just .3%, and Chinese export growth flat month-to-month. Many companies heavily leveraged to Europe, such as Phillip Morris International (NYSE:PM), McDonald's (NYSE:MCD), and even Apple, have also recently reported a significant deterioration in European consumer spending as well.
Equities have consistently rallied the hardest on statements by Draghi about the determination of the ECB to enact significant further quantitative despite mixed economic data.
This is why I find Draghi's recent actions so interesting.
Just a week after Draghi indicated the ECB was looking at various policy options to lower the PIIGS' borrowing costs, members of the ECB's governing council also indicated the ECB is planning to take strong actions, and the ECB's recent bond purchasing program should obviously lower the PIIGS' short-term borrowing costs.
The market rally has clearly not been primarily driven by fundamentals, and while valuing equities in an uncertain environment is always tenuous, earnings reports have been mixed, and the economic data continues to deteriorate. Still, the ECB has effectively scared many shorts out of the market in the short-term.
This is also why I think that shorting the market prior to the Fed speech in Jackson Hole and the ECB's recent actions has been so difficult. The market has risen for nearly six consecutive weeks, and a rally based on hopes of further quantitative easing by Central Banks will not end on weak economic data. Indeed, the concerns over the PIIGS' short-term borrowing costs and the weak economic growth outlook in Europe is exactly why investors are hopeful Draghi and Bernanke will take even stronger actions in the next couple months.
Still, the ECB remains significantly constrained by the Central Banks' strict mandates and political opposition to more aggressive monetary initiatives. Most European governments also refuse to pursue new fiscal policies as well. The ECB cannot print money to stimulate growth, and many member states continue to face significant borrowing costs as well. ECB officials have continually made public comments about the determination and power of the European Central Bank, and the ECB's governing council has still failed to substantively address the PIIGS' long-term borrowing costs and deteriorating economies.
While the ECB's recently announced bond buying program is impressive, the central bank still has limited tools to address the PIIGS' significantly slowing economies, and the PIIGS' economic and fiscal woes are two sides of the same coin. While the ECB is focused on the short-term borrowing rates of the PIIGS, sovereign debt yields will also remain elevated as long as the market views these countries' long-term debt loads as unsustainable.
One of the main reasons the market has consistently rallied over the last several months on the hope of more aggressive quantitative easing in Europe and the U.S. is because of the belief that Europe's fiscal woes and the EU's weak economy are essentially the same issue. Still, if Draghi is unable to pursue more aggressive additional monetary initiatives, and European governments continue to be fiscally constrained, the EU economy will likely continue to weaken even if the PIIGS' borrowing costs fall in the short-term. Spain's recent GDP numbers were well below expectations, and the PIIGS still have no ability to pursue fiscal stimulus.
To conclude, cyclicals and commodities have rallied hard over the past several months, but the growth outlook remains weak, and the ECB has raised the stakes significantly for future actions. Bullish sentiment amongst equity traders is also at the highest levels we have seen all year as well. While fundamentals may be irrelevant today, the market has still priced in fairly strong expectations for ECB actions, and Draghi and European governments will likely face significant opposition to new and more aggressive monetary and fiscal policies.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.