Buy sensitive stocks as economy improves
Investors should prepare for a stockmarket rebound after robust action from the Federal Reserve and the European Central Bank
The direction of the markets continues to be dominated by the eurozone crisis, and economic data remains mixed, with the UK the only brighter spot recently.
The markets’ and policymakers’ consistent hope is that monetary easing will prove effective in stimulating demand in the real economy. So far, while we have had pulses of stronger activity after each dose of quantitative easing (QE), the sustainability of the recovery has been hampered by subdued growth in employment, with weak investment from the private sector failing to compensate for lower government spending.
The European Central Bank (ECB) has loosened policy further. ECB president Mario Draghi has offered to purchase eurozone countries’ short-term bonds. This time the ECB will not claim seniority, but will rank on equal terms with other investors. Admittedly, the ECB will only purchase a country’s bonds on condition it adheres to pre-agreed reforms.
However, this move should serve to meaningfully reduce financial stress within the eurozone and reduce the risk of deflation in southern Europe. As a consequence, the environment for economic growth has improved.
Given that the US Federal Reserve has announced a further round of quantitative easing, which has no limit in terms of its duration or size, the case for investing in equities appears quite potent.
We have outlined before our concern that more QE would result in another bout of high inflation, which would fail to spread to wages and therefore result in a drag on real activity. It is, therefore, not insignificant that the Fed has chosen to embark on another round of QE asset purchases at a time when the US economy seems to have little risk of either deflation or a meltdown of the financial system.
The Fed’s goal is to boost employment. However, so far QE has failed to help employment because it doesn’t shift value from the producer to the consumer. Perhaps the Fed has become emboldened now that there has been a slowdown in Chinese economic growth. Risks of another damaging spike in commodity prices and a subsequent inflation shock to the US consumer have decreased.
While there will undoubtedly be an inflationary reaction to the latest round of loose monetary policy, it is hoped that this time the inflation will rear its head in rising prices for domestic assets. With US consumer credit growth already positive, it is possible that the purchase of mortgage-backed securities will serve to stabilise house prices further and improve consumer confidence.
If this feeds through to spending, then global restocking of goods for inventories may bottom out at the same time as demand for goods and services improves. As a result, we should see a rise in corporate investment, which is needed to kick-start a positive feedback loop between production and demand. This feedback loop is consistent with rising growth in employment and consumption and a sustainable economic recovery.