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Markets plunge on new economic fears

Since the Fed began to cut back on asset purchases, stock markets appear more vulnerable to signs of economic weakness.

BRENDAN McDERMID/REUTERS

Stock markets staged a violent selloff after the release of disappointing U.S. manufacturing data, as investors begin to worry about life without extraordinary measures by the U.S. Federal Reserve Board.

The Institute for Supply Management reported a U.S. factory index of 51.3 on Monday – still in expansion territory, but far short of what analysts had expected. The new orders index showed its greatest drop since 1980.

That economic miss might not have been such a big deal in past months, when investors shrugged off disappointments on the theory that bad news would make the Fed all the more committed to its program of monetary stimulus, known as quantitative easing, or QE.

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"Stocks would eventually find a footing when a quantitative easing program was on, which made buying the dip always the right thing to do," said Greg Newman, senior wealth adviser at the Newman Group, a ScotiaMcLeod affiliate.

But it's a different story now that the Fed is slowly withdrawing, or "tapering," that program. Since the Fed began to cut back on asset purchases, stock markets appear more vulnerable to signs of economic weakness.

Stocks fell across the board, with the S&P 500 index having its worst single day since June with a 2.3-per-cent decline. The S&P/TSX composite index lost 1.5 per cent.

All eyes are now on the U.S. employment figures that will be released Friday. A disappointing number could add to pressure on stocks. The benchmark S&P 500 index has lost 5.8 per cent since hitting a record high on Jan. 15.

Several competing fears have dragged the market lower. Many investors perceive U.S. stocks to be overvalued after a long bull run. Concerns are growing about China's economy, which has suffered weak manufacturing results of its own. In addition, the Fed's tapering has led to a flight out of several emerging market currencies, as higher interest rates in the United States attract capital out of the developing world.

"Most of the emerging markets are dependent on foreign capital. Suddenly it's leaving and there's nothing to replace it," said Lorne Steinberg, president and portfolio manager at Lorne Steinberg Wealth Management.

As the emerging market selloff unfolds, stock markets look fragile despite what is a reasonably encouraging big picture. The global economy is expanding, propelled by improving fundamentals in the United States and Europe, according to the International Monetary Fund's recently upgraded forecast.

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Meanwhile, the fourth-quarter earnings season has been a decent one, despite the rash of early warnings. With about 70 per cent of S&P 500 companies having reported, earnings per share are coming in about 2 per cent higher than were forecast, according to a Merrill Lynch note. So far, 55 per cent of companies have exceeded expectations on earnings, 64 per cent have beaten them on sales, and 42 per cent have beaten both.

But with the Fed in retreat and emerging markets in trouble, even a mild economic stumble can be the catalyst for a stock selloff. Never mind that at least some of the deterioration in the latest manufacturing data is likely probably the result of January's miserable weather.

Part of the market reaction to the drop in the ISM index may lie in the changing relationship between the Fed and the stock market.

Throughout the course of this the latest round of quantitative easing, bad economic news was received relatively well by investors because it meant the Fed would have to maintain its stimulus. QE would only be withdrawn if the real economy was strong enough, so stocks had a backstop. But the Fed now seems bent on winding up its stimulus program by year-end. It would take a material change in the U.S. economic outlook to dissuade the Fed from that plan, observers say – and the ISM numbers weren't even close.

"If we start to string a few months of bad data points together, it might be enough to convince the market that QE is back on the table," . … We will be looking forward to the employment report on Friday to get a better gauge," said James Telfser, portfolio manager at Caldwell Investment Management.

If the U.S. labour market falters, bad news could become good news again, at least for stock investors.

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About the Author
Investing reporter

Tim Shufelt joined the Globe and Mail in August, 2013, primarily to cover investments for Report on Business. Prior to the Globe, he worked as a staff writer at Canadian Business magazine, a business reporter at the Financial Post, and covered city news and courts for the Ottawa Citizen. More

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