Investors are likely to be increasingly concerned about rate increases over the coming months due to the much better than expected non-farm payrolls report. Using the last few recessions as a reference point it is likely that equity gains could become increasingly difficult to come by as the Fed is pressured to remove their accommodative stance and other programs are wound down.
Teun Draaisma at Morgan Stanley recently noted this in his “tightening checklist”. I would expect an upgrade across the checklist. As we expected job creation is certain to begin by Q1 and Fed language should begin to change dramatically.
Despite higher rates coming shortly, MS expects the rally to continue in the near-term. I can’t disagree with this outlook. Stocks are very buoyant heading into Christmas and it’s unlikely that this report will force the Fed’s hand immediately. Like Draaisma, I believe the rally could move higher into year-end based on this optimism, but could then begin to sputter out as 2010 becomes a year of higher rates and transition into an economy without a government crutch. MS analysts report:
We expect the sweet spot to last a bit longer. The cyclical bull market has some further to run, in our view. We expect 20%+ earnings growth in 2010, equity valuations are still attractive versus rates, and sentiment is not ultra-bullish yet. We prefer equities to fixed income, and we expect a further 9% upside to reach our 1200 bull case target for MSCI Europe based on the mid-cycle multiple on mid-cycle earnings of 15x 12% ROE.
Lessons from past tightening cycles. The start oftightening phases tends to lead to some indigestion and a defensive rotation in equity markets, for two quarters or more. The 1994 and 2004 episodes led to a 16% and 8% fall in MSCI Europe over eight and five months. Sector performance was defensive, but Oil and Materials outperformed, too. In the aftermath of secular bear markets tightening phases have been more severe, with equities falling on average 25% over 13 months.
Draaisma notes that it’s silly trying to jump on the back end of a 70% rally in an attempt to time the final leg up. As we wrote earlier this week:
But Draaisma isn’t getting overzealous here. He doesn’t see the rationale in getting overly aggressive in an attempt to capture the last 10% of a 70% rally when the downside could be greater. Draaisma believes market gains will be more difficult going forward and therefore the risk/reward of the current market is substantially more negative than it was a few months ago.
Although this morning’s report is an overwhelming positive for equity markets it could pose a major 2010 hurdle as investors transition from a market with a government crutch to a market without one. In the near-term, a Santa Claus rally might just be developing, however, chasing that move could prove risky as Draaisma says….