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Central banks fuel a questionable euphoria

Markets are being driven by economic events, emotion and over-reaction to central bank words and deeds. <137>Traders work as a television screen shows U.S. Federal Reserve Chairman Ben Bernanke on the floor of the New York Stock Exchange, September 13, 2012. REUTERS/Brendan McDermid (UNITED STATES - Tags: BUSINESS)<137><137><252><137>

BRENDAN MCDERMID/REUTERS

So now we know the surefire recipe for a tasty global market rally.

Take a couple of activist central bankers willing to tread where none of their cautious predecessors dared, stir in a favourable German court ruling on the legality of the permanent European bailout fund and sprinkle on some favourable economic news while ignoring the disappointing data. Then add the gaudy sales projections for the latest must-have smarter-than-ever phone from tech juggernaut Apple and top it off with just enough Middle East unrest to drive oil prices higher without dampening investors' spirits.

The results were truly impressive. The S&P 500 reached its highest point since the halcyon days of 2007. The MSCI world index climbed to a level not seen in more than 13 months, the MSCI emerging markets index scored its largest gain since June and Canadian equities rose to their best level since April. Commodities shot up for the seventh day in a row.

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Not surprisingly, money poured back into global equity and commodity funds merely in anticipation of more central bank easing. U.S. equity funds alone were the grateful recipients of more than $9-billion (U.S.) in the second week of September, a nine-month high, according to the fund-flow trackers at EPFR Global. Commodity funds scored a net gain of $1.8-billion, slightly more than half of it earmarked for gold and other precious metals.

And there may be more bullishness to come, because the simple fact is that the U.S. Federal Reserve's pump-priming efforts have proved far more beneficial to financial markets, especially equities, than the actual economy they are meant to be pumping up. It's doubtful that the latest round of aggressive quantitative easing unveiled last week will fare any differently.

Similarly, the European Central Bank's plan to buy up troubled sovereign bonds will undoubtedly hold speculators at bay, while giving dithering politicians another opportunity to delay painful but critical reforms needed to resolve the debt crisis and get the euro zone's stumbling economies back on the rails.

No wonder veteran fund managers, even the optimistic ones, remain cautious.

"Investors appear to be focused on the central bank's ability to lift markets, while Chairman [Ben] Bernanke remains concerned about the Fed's inability to lift the economy," notes Murray Belzberg, president of Perennial Asset Management, who is still short equities. "So far, the market is getting the better of us, but we do not foresee any more changes coming from the Fed or the European Central Bank. Markets will once again need to focus on economic performance."

The market fundamentals are not bad, insists Harvey Rowen, CEO of Starmont Asset Management in San Francisco. If viewed through the lens of traditional valuation measures, loads of companies are in decent shape and plenty are reasonably priced. "That hasn't been what's driving this market."

Rather, it has been economic events, emotion and over-reaction to central bank words and deeds. "And it's likely to stay that way until the [U.S.] elections are over, there's a little more clarity in Europe and the Chinese appoint new leaders and start to turn their attention to their economy again."

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Mr. Rowen predicts that volatility, which was extremely low during the summer doldrums, will again become a regular market feature over the next several months. So investors should continue playing defence. Starmont remains underweight equities.

"We're not taking a lot of risk on the bond side either," he adds.

"The 10-year Treasury note is probably the riskiest investment in the world right now. Our view is interest rates have got to rise in time. And the price of those Treasuries, which are artificially inflated because of the low interest rates, will only go down."

Of course, volatility can cut both ways. "People think volatility means a falling market," Mr. Rowen says. But he expects both ups and downs the rest of this year and into the early part of 2013. "What we try to do is protect against a real black swan event, the outlier in terms of the bell curve, take advantage of the ups and ride this thing out until we can get more comfort."

He sees markets limping along, with little to drive prices once the Fed-triggered euphoria wears off, unless the European situation blows up. The good corporate profit outlook in the U.S. and other markets is already priced in and the lame-duck U.S. Congress is likely to remain a picture of political paralysis and unable to tackle the notorious fiscal cliff.

He does highlight one potential game-changer that proves some risks hide in plain sight – a Republican win in November that would put the party of austerity in control of both the White House and Congress.

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If the victorious Republicans were to implement vice-presidential nominee Paul Ryan's budget-slashing proposals, "then we could have the same result that austerity plans have had in Europe. So if that's the result on Nov. 6, we're going to be watching very closely what happens and looking for ways to prevent the kinds of dislocations that happened to clients' portfolios in Europe."

In the meantime, though, "muddling through for the next few months is probably going to be the state of the game."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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