Again, New Highs

Playa del Carmen     November 8, 2014     Article 3

Only two weeks ago, things looked pretty dicey for the markets. But other things happen, and perceptions change, even if the underlying fundamentals remain basically the same. This time, the game changer was Japan.

The Bank of Japan published its regular semi-annual report on the outlook for the economy, and finally accepted that PM Shizo Abe’s plans to reactivate growth and trigger inflation are not working as desired. Inflation is up, but already starting to lose momentum. And growth is erratic, and also losing strength, due to the inability of consumption and investment to overcome the sales tax increase implemented back in April.

So, the central bank went ahead and, totally unexpectedly, announced a second massive stimulus program. The new plan entails an increase in monetary supply M3, more purchases of longer-term government bonds, and more stocks, ETF’s, and Reit’s to be bought in the marketplace. Also, the huge Japanese pension fund (about the size of the whole Mexican economy) was authorized to double, from 12% to 25%, the amount of domestic stocks in its portfolio, also double from 12% to 25% the position in international stocks, and increase its holdings of Japanese government bonds. All in all, the plan about triples the amount of yen to be injected into the economy.

Meanwhile, back in the US, the Fed held its monetary policy meeting and ended QE, or bond purchases, as expected, but surprised everyone with a mildly hawkish message. Given the very fragile situation in Europe, the deceleration in China, and the weak Japanese economy, the Fed had been expected to be relatively soft in its message. But not only did they mostly ignore the poor global background, they referred to the US economy as strengthening moderately and labor market weakness diminishing, and they advised that if inflation were to move towards the 2% objective faster than expected, then the rate of interest would be raised sooner than thought.

The European Central Bank also held its latest meeting and decided to make no changes to policy, in order to give the latest measures time to work, although Mario Draghi did reiterate that more stimulus will be applied, if needed. The Bank of England meeting again resulted in no action on the interest rate.

In the end, it seems investors believe that the increase in Japanese monetary stimulus will at least offset the Fed’s end of QE, and that the general level of liquidity in the system will remain the same. In fact, the amount of money slushing around might even be greater, especially if the European Central Bank finally decides to go all out on QE and start buying corporate and sovereign bonds in the market.

Evidently, it is the central banks’ decisions, and not the economy’s behavior, that are shaping investors’ perceptions for now. So, in the markets, the US dollar climbed against the euro, jumped against the yen, and gained against most currencies. Treasury bonds’ yields moved up, while German interest rates retreated even more. Commodity prices – oil, copper, gold – continued to drop in response to the dollar’s strength. And US stock markets returned to new historic highs on the idea that not only will liquidity remain super abundant, but also that there will be unexpected demand for stocks coming from Japan.

In our view, the stock market’s uptrend is not really on solid footing if it depends on the money being created by the central banks, and is not really a reflection of an improving economic background.

Patricia Berry