Are stocks too hot, too cold or just right asks J.P.Morgan’s Dan Morris

3rd June 2013

J.P. Morgan Asset Management’s global strategist Dan Morris looks at recent market developments.

Too hot, too cold, or just right?

The Nikkei has staged an impressive rally since November of last year, but Japanese equities hit a bit of a stumbling block in the month of May. A weaker Yen, resulting from the Bank of Japan’s (BoJ) extremely accommodative monetary policy, had been broadly supportive of Japanese equity markets in 2013. This equity market strength also occurred on the back of lower interest rates, as equities initially pushed higher without a corresponding rise in Japanese Government Bond (JGB) yields. However, JGB yields have increased at a faster clip than equities since early April (Figure 1), and the strong rise during the final two weeks of May seems to have been particularly disruptive to the Japanese equity market.

Figure 1: Ratio of Nikkei Price to 10y Japanese Government Bond Yield


Last data 30 May 2013. Source: Bank of Japan, Nikkei, Standard & Poor’s, FactSet, , J.P. Morgan Asset Management.

The Nikkei and S&P 500 had been moving in tandem since the beginning of 2013, but the recent decline in Japanese equities has not resulted in a corresponding decline in US stocks (Figure 2). The difference is that the US economy is actually strengthening, which is supportive of equities, while any improvement in the Japanese economy is primarily a result of extremely aggressive fiscal and monetary policy.

Figure 2: Nikkei decline not affecting US equities


Last data 30 May 2013. Source: Bank of Japan, Nikkei, Standard & Poor’s, FactSet, , J.P. Morgan Asset Management.

Although Japanese monetary policy is slated to remain extremely easy for the foreseeable future, the direction of US monetary policy is less certain. In their December 2012 statement, the FOMC stated that the Fed Funds Rate would remain “exceptionally low” as long as the unemployment rate remained above 6.5% and inflation expectations were no more than 0.5% above the Fed’s longer-run goal of 2%. This statement, however, did not provide any details on how long the Fed’s current asset purchase program was expected to last, as it is dependent on the perceived strength and sustainability of US economic growth.

With private payrolls averaging gains of over 200,000 per month during the past six months and other US economic data holding up, rumblings about tapering the Fed’s purchase program have emerged. May’s payroll numbers this Friday will be important in setting expectations of the rate of a slowdown in QE. Meanwhile, ten-year US Treasury yields have jumped over 40 basis points in the month of May, due to two factors: 1) the expectation that the Fed will begin tapering asset purchases, meaning a decline in demand, and 2) stronger GDP growth raising real yields.

More signs of an improvement in the US economy or any indications that the Fed is slowing asset purchases will push Treasury yields higher. As Treasury yields rise, the impact on riskier parts of the fixed income market are magnified. Accompanying the increase in sovereign yields have been bigger jumps in yields for emerging market debt and high yield (see Figure 3). Spreads could well continue to widen as interest rates normalise.

Figure 3: Treasury yields and credit spreads both pushing higher


Last data 31 May 2013. Source: ECB, Federal Reserve, J.P. Morgan, Bloomberg, J.P. Morgan Asset Management.

Turning to Europe, the European Commission extended deadlines for complying with deficit reduction targets for France, Spain and the Netherlands, while simultaneously releasing Italy from the program (due to sufficient action in 2012). The ECB stands ready to act, having stated its commitment to do “whatever it takes” to preserve the euro. Further, effective monetary policy measures are hard to envisage. As in the US, monetary policy has approached the limits of its power to stimulate the economy. The advantage the ECB has is that by eschewing QE, it does not face the challenge of unwinding the programme, with the attendant risk of a spike in bond yields and a correction in equity markets. One possible option for the ECB are efforts to boost SME lending, as credit growth remains depressed across the eurozone (see Figure 4). This is unlikely to have much impact on equity markets, though, as large capitalisation companies already have ready access to funding via the public bond markets.


Figure 4: Credit growth from bank lending


Last data 30 May 2013. Source: ECB, Federal Reserve, J.P. Morgan, Bloomberg, J.P. Morgan Asset Management

Finally, BoJ policy will stick to its current programme, but investors should be cognizant of any conflicting messages that equity and bond markets may send. Rising interest rates due to higher inflation will continue to pose a challenge to Japanese equity indices. In sum, the question for investors today is whether monetary policy is too hot, too cold, or just right.

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