Over the course of the last three years the two primary forces that have moved financial and economic markets are trends in inflation and central bank balance sheets. Currently, global stock markets have two major tailwinds at their backs which may lead to the consensus being wrong again. Most market pundits and major investment bank research departments see a weak first half for 2012 followed by a strong second half. Given most domestic economies are benefitting from falling inflation rates and global central bank reserve expansion, global equity markets may surprise to the upside in the first half and then weaken in the second half once inflation heats back up again.
S&P 500 Held Captive by Euro
We have now witnessed several months of improving US economic data coming in above economic consensus expectations. As highlighted back in November (Could Credit Markets Kill a Fledgling US Economic Recovery?), US economic data has been consistently improving but fears over European contagion have kept a lid on US equity prices and has the potential to pull the US economy down with it just as the US pulled the world down with it in 2008. The link between trends in the Euro and European credit spreads with the S&P 500 is outlined below.
The top panel is the S&P 500 (Black) and the Euro (Blue). I have the Euro Ted Spread (Green) and the 2-Yr EUR Currency Swap (Red) in the middle panel (shown inverted for directional similarity), and the third panel is the correlation of the S&P 500 to the EUR currency. The S&P 500 and the Euro are the most correlated they have been since the bull market began. Here is a quick summary of the figure below:
- When the EUR rises the S&P 500 trends up
- When the EUR begins to fall the S&P 500 stops advancing (RANGE BOUND)
- When the EUR is in free fall the S&P 500 finally sells off.
Source: Bloomberg
Main Point: If the EUR can stabilize and bottom then I would expect the S&P 500 to rally. If the EUR slowly grinds down then I think the S&P 500 remains range bound as long as US economics improve. If the EUR goes into free fall then the S&P 500 could sell off hard.
Watching: Looking for recovery in Euro and associated sell off in Europe-based credit spreads (shown inverted in middle panel).
All Eyes on the Euro
Given the close link between the Euro and the S&P 500, the Euro should be watched closely and we may have a good technical setup to lead to a Euro rebound. The Euro is back to early 2011 lows and just achieved the required 20%+ threshold for the TrendStall Indicator (2nd panel) to provide a BUY signal on the WEEKLY chart. Just need one week’s downtick to generate a signal. Weekly RSI is bombed out and we may see another multi week rally in the EUR which would likely coincide with a rally in the S&P 500 to retest its 2011 highs.
Source: Bloomberg
Two Major Tailwinds Bears Should Respect
As mentioned in the opening paragraph, two of the most powerful forces to economies and equities are the trends in inflation and central bank balance sheet levels. When central banks print money (coupled with weakening inflationary pressures that benefit corporate profits and consumer discretionary spending), there is typically a bullish response several months down the road. Likewise, we have seen that when central banks stop expanding their balance sheets (coupled with rising inflationary pressures) stock markets and economies run into trouble. To highlight the importance of inflationary trends I commented on a building US manufacturing rebound benefitting from easing inflationary pressures back in October (A Window of Opportunity).
A few charts are presented below to highlight the link between central bank balance sheets and equities. The first chart below is the US Federal Reserve’s balance sheet in the top panel (in trillion USD) with the ECB’s balance sheet in the middle panel (billion EUR), with the combined balance sheets shown in USD in the bottom panel. We can see that both of the world’s two biggest central banks rapidly expanded their balance sheets late in 2008 and within months world equity markets stopped falling and began new bull markets. Global markets ran into trouble mid 2010 and the ECB began to print once more on a smaller scale followed by another ramp up in the US Fed’s balance sheet with the launch of QE2. World markets ran into trouble again this year and all four major world central banks (US Fed, ECB, BOJ, BOE) are responding by expanding their balance sheets once more. This global expansion in central bank reserves will likely have the same outcome as the prior two global central bank reserve expansions, an equity recovery 3-6 months later.
Source: Bloomberg
The link between stock market performance and central bank balance sheets is made abundantly clear in the chart below which shows Federal Reserve expansions in green and reductions in red. Notice the corresponding rise and fall in the S&P. Right now, we are being treated to a fourth expansion in the US Fed’s balance sheet and this is most likely why stocks haven't broken down.
Source: Bloomberg
If world central banks throw enough mud (money) at the wall, eventually some of it is going to stick and bid up equity markets to the chagrin of financial pundits calling for a weak first half in 2012. Can we have a major financial freeze as we did in 2008? Sure, anything is possible. However, as world central banks are quicker to react to financial stress than they were back then and if they continue to aggressively expand their balance sheets while commodity inflationary pressures remain muted, then world economies may be able to trade sideways while US equities rally based on higher economic growth rates in the US compared to the rest of the world.
In terms of gauging WHEN equity markets will respond to the tailwinds of central bank injections and favorable inflationary trends I would watch the Euro, Euro currency swap spreads, and the European “Ted Spread.” These two spreads were highlighted in the middle panel of the first chart (shown inverted) above. If they breakdown then that would tend to indicate the mud is sticking. However, if they fail to roll over and the Euro goes into free fall and fails to catch a bid here soon, that would be the indication that market forces are outweighing central bank intervention.
Summary
We have another late 2008 to early 2009 setup in which global central banks have printed trillions and inflationary pressures are easing which should act as two major tailwinds to equities. However, we need to see credit spreads ease to gives us a good sense that central bank medicine is working. If credit spreads continue to advance and the Euro weakens considerably, then world equity markets are likely to sink even further. For this reason, perhaps the best key macro indicators for investors to keep their eyes on are the EUR/USD spot rate and the Euro Ted Spread and 2-Yr Euro currency swap rates. I will be monitoring both closely and will alert readers in further articles or short blog posts on Financial Sense if any major developments occur.
