What a strange world we are living in when Ben Bernanke holds a press conference to say that he’s essentially going to do nothing, and the markets go down 200 points. That was the story last night after the Fed announced it would hold steady on quantitative easing for at least the next several months, watching and waiting to make sure the U.S. economy really is strong enough for the central bank to pull back from the $85 billion money dump it’s been doing every month. This “tapering” is different from interest rate tightening, which probably won’t happen before 2015. Yet mortgage rates have gone up, too, because of worries that the era of easy money is over.
So why the strong market reaction to news that was basically ho-hum? It’s a reflection of the extent to which the Federal Reserve‘s asset buying has reshaped the markets. Over a year ago, savvy investors like PIMCO’s Mohamed El-Erian and Morgan Stanley head of macroeconomic research Ruchir Sharma began telling me that quantitative easing, although initially necessary, was distorting market fundamentals, pushing prices away from where they would naturally be and leading to bubbles in things like emerging market stocks and commodities. It’s a topic I’ve been writing about for some time.
And indeed, at the first whiff of a Fed pull-back a few weeks ago, you saw emerging market equities tank and commodities start to correct as well. The Nikkei went into a bear market, as the long suffering Japanese, the last ones into the central bank money dance, became the first to feel the effects when the music stopped.
The question is what might be coming next. As I wrote in a blog post a couple of weeks ago, not all asset classes are created equal, and I think that rather than a dot-com-style crash, or a Lehman Brothers’ meltdown, we’re going to see a period of market uneasiness as the Federal Reserves begins to think, and talk, about ending the largest money dump in central bank history. Here are some things to watch for:
1. More market volatility around key data announcements. The Fed initially announced that they were looking for 6.5% unemployment to start deconstructing QE; now they are pointing to 7%. Either way, the explicit guidance off the back of a data point means that markets will probably get jittery right before labor figures are announced every first Friday. You may also see some ups and downs with the latest growth figures, consumer sentiment surveys, etc.
2. Risk looks less attractive. The whole point of QE was to push investors into riskier assets, and buoy the overall market as a result. But the fundamentals of these assets don’t always support the investor enthusiasm, as we’ve seen with the correction in some emerging market stocks and currencies, as well as in lower quality corporate bonds. High-dividend-paying blue-chip multinationals still look good – even if they take a hit in a market correction, they are likely to surge back, as good balance sheets and growth prospects mean they’ve become a better risk than even many kinds of sovereign debt.
3. National and sector stories are diverging. QE had a tendency to lift all boats, but as its effects ebb, you’ll see countries and sectors start to diverge. Already, the market fortunes of rich and poor countries are diverging, and national stories are becoming more important. Emerging markets used to trade as a block – now, they are moving country by country. Likewise, sectors that are more sensitive to interest rate policy – things like home-building, construction, durable goods, cars, insurance, and finance – may be more effected by the wind-down of QE.
4. It’s all about wages. Throughout the recovery, pundits (including myself) have complained that markets were disconnected from the real economy. Now, oddly, they are becoming a bit more connected, as investors watch to see what the Fed will do based on unemployment figures. But the bottom line in an economy like the U.S., which is 70% consumer spending, is that you need not only lower unemployment but also wage growth to guarantee a real and sustained recovery. Watch not only wage levels, but also expectations in the Michigan Consumer Confidence survey, to get a feel for when people think they might be getting a raise – it will give you a good sense of where the consumer economy is headed.