Volatility has picked up in financial markets in recent weeks. It is still mostly noise at this point, but the sell-off has done damage to the technical picture of the market. The NYSE Advance/Decline line for stocks is in the tank, key moving average levels, support levels, and trend channels have been breached by various indices. Foreign stocks have sold off sharply. Commodities are sending a signal of deflation and/or global recession.
It seems as the Fed ends quantitative easing, the rose-colored glasses are coming off.
Of course, the Fed will try to jawbone markets higher and you can already see signs of panic setting in there. Some officials are now citing slowing global growth as a reason to delay a rate hike.
The question for investors is, will it matter. At this point, the Fed is more powerful as the man behind the curtain than an actor with actual influence on the economy. What constraint on the economy would be removed by leaving rates at zero? “Don’t fight the Fed,” doesn’t work during business cycle contractions. Can we have a contraction with rates at zero? Japan did.
The sharp move in the dollar is also likely weighing on investors. Economists will tell you a strong dollar doesn’t matter to the US economy because exports are a small share of GDP, but in terms of the U.S. stock market, the dollar matters. Half of the S&P 500’s revenues are sourced abroad.
Europe is in focus for financial markets. Investors are coming to the conclusion that growth isn’t going to happen in Europe without structural reform and structural reform won’t come easily. The prime risk factor for a euro breakup remains political in nature which means a breakup is probably off the table for at least this year and next year. Maybe European Central Bank President Mario Draghi can convince the Bundesbank to give quantitative easing a shot in an effort to stave off collapse for a while longer, but without structural reform, Europe will be back in the same situation before long.
The turmoil in markets is driving bond yields back down to uncomfortably low levels. You can’t be happy with the current yield picture in the bond market, but a change in strategy isn’t warranted just yet.
The good news…better values are starting to emerge in foreign markets (down 12% YTD) and small-cap shares (down 12% YTD).
Jeremy Jones, CFA
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