The first is the Fed has linked its mortgage-backed bond purchases to an attempt to reduce the unemployment rate, which is unprecedented in its specificity. As such, the Fed has left itself some room to increase its planned purchases if unemployment does not move down noticeably.
Secondly, it is important to note the Fed took these steps despite the fact inflationary expectations have been starting to move higher, suggesting the central bank is willing to risk higher inflation levels in exchange for a jolt to economic growth.
To be sure, the US economy is still weak and remains dependent on policy help, but we have seen the data turn modestly more positive.
Bank lending standards have been easing, demand for credit is expanding and borrowing rates are up. After a long and painful downturn, the housing market is also showing signs of life.
It seems to us as if the tremendous amount of liquidity the Fed has injected into the system is finally leaking into the real economy.
For its part, the ECB’s recent actions are an indication that Europe’s central bank will be willing to provide open-ended assistance to countries that are willing to sacrifice some of their fiscal independence.
From an economic perspective, Europe remains deeply troubled, but the bold actions by the ECB provide some hope that improvements may be on the horizon.
Awaiting the next leg of the bull market
Although global economic data has been relatively weak in recent years, risk asset prices have nonetheless advanced. We would attribute this trend to the fact that weak economic growth does not, by itself, limit the potential for risk assets.
In our view, the liquidity-driven reflationary policies of the world’s central banks have been a more important factor for asset prices than economic growth levels have been.
Looking ahead, however, it is worth asking what it will take for a sustained bull market phase in risk assets to continue. In our view, there would be several preconditions.
Preconditions to market strength
The first is that European policymakers and the ECB must remain committed to protecting that region’s sovereign bond market and financial system. Recent actions in Europe suggest they will do so, but there is ample room for policy error.
In the United States, we believe we would need to see some progress in terms of tackling the fiscal cliff issues and creating a longer-term plan for fiscal stability.
Additionally, investors would need to be assured that China is undergoing a soft landing and the world would also need to avoid any sort of geopolitical incident that could cause a spike in oil prices.
None of these developments is assured, but neither is any impossible to achieve. We are modestly optimistic the trends will be pointing in the right direction as the year draws to a close and into 2013.
However, uncertainty remains high and investors are poised to react strongly to any unforeseen events, so the probabilities of volatile market periods are elevated.
On balance, we would argue that while a consolidation of the gains we have seen in the last few months could happen at any time (and, indeed, some would argue that such a consolidation is overdue), we expect stocks should continue to outperform Treasuries and cash over the next twelve months.