Economic data has been the main driver of the market lately, and yesterday pretty much all the economic data we received missed expectations. Chinese, EMU, German and U.S Flash Manufacturing PMIs all either declined from last month and missed expectations, or stayed at the same levels as last month but still signaled contraction in the manufacturing sector.
So, with the economic data so bad—why did stocks rally yesterday?
The answer is changing market expectations of Europe. Keep in mind that the market is a discounting mechanism—it’s always trying to factor in future occurrences in today’s prices. Yesterday, the markets expectations of some potential future events in Europe trumped the reality of weak economic data.
In particular, the market rally yesterday, which was led by European markets, was based on the fact that there is a growing belief (supported by some evidence) that Europe will abandon its multi-year campaign of austerity for PIIGS countries (which has led to stagnant economic growth in the EMU) and instead focus on fostering economic growth.
Additionally, yesterday’s bad economic data in the EMU was seen as increasing the chances of the ECB cutting rates next week, which the market views as a economic positive for the region.
All this relates back to the markets main concern and the catalyst for the recent correction, which is the stalling of global economic growth and the creeping of deflation, which is emanating from Europe.
The reasoning for yesterday rally goes something like this:
If Europe abandons austerity and starts to foster economic growth, and if the ECB not only cuts interest rates but also does additional, unconventional easing measures like a new LTRO or even QE, then the ECB will finally join the Bank of Japan, Bank of England and Fed in being ultra accommodative and directly combating deflation and spurring economic growth.
If this actually happens, and the EU and the ECB actually follow through with measures designed to stimulate growth, then it is a bullish game changer—and in that scenario you would want to buy European markets with both hands, similarly to how we should have bought the S&P at the start of QE2 and how we bought DXJ when Abe was elected. It’s very, very similar—if it comes to fruition.
Keep in mind, though, there are a lot of “ifs” that are assumed in that statement—and while several articles are hailing the end of austerity in Europe and calling for a rate cut, those of us who have traded this crisis from the beginning are well aware of European Leader’s multiple “false starts” with regards to taking steps to resolve the crisis.
From a “how do we know” standpoint, we should continue to watch the SXPP (STOXX Basic Materials Index) to see if it can bottom, and the ECB meeting next week to see 1) If they even do a rate cut (its not certain) and 2) If they reference any unconventional measures are being considered.
I for one will continue to be cautious, as there will be plenty of money to be made being long Europe if and when the tide turns and the EU and ECB are ready to embrace economic growth.