Reasons for the Rally

February 4, 2013

The week ahead should be dominated by questions about the sustainability of the 2013 stock market rally. 
-David Kelly, chief global strategist, JPMorgan

The week ahead should be dominated by questions about the sustainability of the 2013 stock market rally.  Since January 1st, the S&P 500 has risen by 6.1%, which would have been a respectable gain for an entire year.   Global markets have generally followed suit with the FTSE up 7.6%, year-to-date, the DAX up 2.9%, the Nikkei up 7.7% and the Shanghai Composite up 6.6%.  At the same time, government bond yields have drifted up, with the U.S. 10-year Treasury yield rising from 1.76% to 2.01% and German 10-year bund yields rising from 1.32% to 1.67%.  Meanwhile, yields on bonds that are perceived to be riskier, such as Italian government bonds and U.S. high-yield corporate bonds have fallen.   


In other words, 2013, so far, has been a “risk-on” year.   It is, of course, very difficult to predict how long this trend will last.  A good place to start, however, is in understanding what has been behind the rally so far..


This is not a rally driven by economic momentum.  The U.S. saw real GDP growth turn negative in the fourth quarter of 2012, and while that number overstates economic weakness there is little reason to expect a sharp bounce in output in early 2013, particularly because of the fiscal drag implied by the New Year’s Day compromise in Congress.  


Moreover, while employment trends continue to be comforting for now, first-quarter economic momentum looks suspect with clear weakness in chain-store sales numbers and a slight month-to-month decline in light vehicle sales.  Housing activity continues to improve but overall, the U.S. economy can at best be described as expanding rather than accelerating.  The few numbers due out this week should confirm this description, with flat Unemployment Claims, the ISM Non-Manufacturing Index falling relative to January, Productivity registering a sharp decline and both Exports and Imports potentially slipping in December.


Nor should the rally be ascribed to more enlightened policies.  In the U.S., a tighter-than-optimal tax agreement on New Year’s Day leaves the economy with significant fiscal drag with the distinct danger of more to come should the parties fail to agree on an alternative way to cut long-term spending to replace the long-dreaded “sequester” now scheduled to kick in on March 1st.  Meanwhile the Fed’s continued balance sheet expansion appears to be achieving little in jump-starting lending activity. 


The new Japanese government has proposed more monetary and fiscal expansion, but this cannot inspire confidence given the track record of these tools in achieving a Japanese revival over the last 20 years.  Finally in Europe, while the ECB has successfully convinced markets that the banks are safe and that it will protect the sovereign debt market, the governments themselves remain on a relentless path of deficit reduction through austerity, which, in a recessionary economy, is normally both painful and ineffective.


What has happened is that “tail risks” have fallen.  Over the course of the past year, the danger of a financial collapse in Europe has receded, a “hard landing” in China has been avoided, continued gains in U.S. energy production have reduced our vulnerability to a middle-east oil shock and the New Year’s day agreement, combined with a three-month suspension of the debt ceiling, has reduced the danger of a Washington-produced crisis.  As these tail risks have fallen, the “tail valuations”, that is to say the cheapness of stocks relative to the extremely expensive global fixed income markets, has induced investors to move money from bonds into stocks.  One sign of this is that the first three weeks of January saw a bigger inflow into stock mutual funds than any month in the past five years.  While the pace of these flows is likely to abate, the trend may well continue.  The bottom line is that, even with slow global growth, until the world gets a little scarier, equities are likely to continue to outperform fixed income investments.