Friday's US data was very much a reason for stock market optimism by Shant Movsesian

Tuesday, 23rd April 2019 13:01 - by Shant

It is not hard to see why market pundits are in constant debate over the ultimate drivers of stock markets these days.  Thursday was a perfect example of why.  On the data schedule, we got the release of US consumer spending figures for the month of March and the numbers were good.  In fact, they were very good.  Total retail sales grew by 1.6% which far outstripped expectations of a 0.9% rise, with the retail control group - which factors in changing spending habits - up 1.0% vs 0.4% consensus.  Stripping out gas and auto sales (with higher prices to boot), sales were up 0.9% which represents a strong month overall, prompting upward revisions to the Q1 growth figures which see the first estimates reported next week.  

We also saw the weekly data producing the lowest number of jobless claims in 50 years, underlining the strength of the labour market which has continued to see strong growth from month to month, barring a weak February which saw payrolls rise by a little over 33,000 - jarred by the government shutdown.  While earnings (wage) growth is struggling to gain traction in times of high employment, steady inflation levels mean disposable incomes are still coming out on top when considering the aggregates.  It is safe to say the US economy is faring well and any slowdown in pace is at this stage, little to be concerned about.  It is perhaps the wage and claims data which is the most supportive of economic strength in the US, and spending data - as above - can be erratic.  Nevertheless, March was strong amid low unemployment so the current metrics only point to a positive dynamic in the economy. 

However, the response from the equity markets was tame, to say the least. The leading S&P 500 has tested up to around 2920 this week, holding off this level since, though a strong economy reflected in the data should have been the perfect prompt to retest the highs, no?  Well, therein lies the perceived anomaly in the equity market.  Strong data naturally leads to to the belief that the Fed may be forced into resume their tightening cycle.  As such, are we to believe that the only true positive driver of equity valuation is cheap money?  The evidence would suggest so and this is developing into a dangerous dynamic which will ultimately come to a head once the real economy is affected. 

If we are to assume that the Fed has managed to reach and achieve the equilibrium (neutral) rate, then the economy can tick along nicely for as long as inflation and low employment can run side by side and produce steady, stable growth going forward.  However, we all know that the real world does not operate like this with a healthy dose of forceful policy measures from the current White House administration thrown into the mix.  Much as the Fed wanted a higher neutral rate in order to build a larger buffer in the event of the next economic downturn, limits have been reached and in previous posts, I have often referred to the response to the sharp rise in US yields in October/November last year when the benchmark 10yr Note hit 3.25%.  We now see a tight range here around what is developing into a pivotal 2.50% - in line with Fed Funds. 

So not to labour the point, financial markets are running on a very strong assumption; that financial conditions can be loosened further should the need arise.  This narrative is well versed through the market, but it does represent a worrying dynamic when PE ratios become extended, which they are now in a number of cases - and which in turn has forced stock pickers to focus on relative value.  This incremental build-up of value is another topic of conversation but does nevertheless feed into the notion that at some stage, limits will be stretched.  Hence the chorus of caution and fear surrounding a perceived bubble.  

Given that positive economic data no longer offers the confidence to buy into risk - and this has been prevalent for some time now - it is no wonder that a number of analysts are urging a skew towards defensive stocks within their portfolio.  This fresh example of a detachment from the real economy should sound another alarm bell as to why this is the case and next week's Q1 growth data will serve up another taster of what lies beneath the belly of market sentiment. 

 The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.