What October Holds For The Financial Markets

As the calendar turns to October and the 4th quarter begins investors have a number of themes that will play out that will drive the capital markets. Central bank activity could play a large role as divergent paths for the Fed, ECB, BOJ and PBOC begin to materialize. For the Fed, they have signaled that they want to raise rates and plan on raising rates at some point in 2015. The ECB on the other hand has an underlying problem with inflation. Growth appears to the main story for both Japan and China.

Inflation is Negative

During the last week of September, the Eurozone reported inflation figures which unfortunately were softer than expected. As Eurozone headline inflation falls back into negative territory, speculation of an expansion of the ECB’s QE program is rising. So far Draghi is taking a wait and see stance and with core inflation actually trending higher, labor markets stabilizing, wage growth picking up and credit conditions also improving it is not hard to see why he is using this tact.

However, data may serve as a justification for additional easing, but ultimately psychology and market sentiment is likely to play a bigger role. With exceptionally easy policies quickly becoming the norm, Draghi may feel he has little choice but to comply with market pressure, which highlights the dilemma global central banks are facing as markets remain reliant on ongoing stimulus.

Eurozone headline inflation has dropped back into negative territory with a -0.1% year over year rate in September. Not a total surprise and driven by the combined effect of lower energy prices and a slightly stronger Euro, which advanced on a trade weighted basis in September. Energy prices dropped 8.9% year over year in September, a further acceleration in the pace of decline from the -7.2% year over year in August. Food and services price inflation meanwhile accelerated slightly and core inflation excluding the most volatile items, remained unchanged from August at 0.9% year over year.

The latest European Commission survey showed that consumer inflation expectations remained virtually unchanged and that retail sentiment is improving as expectations about future business is picking up. This is also related to stabilizing labor market and improved wage dynamics, which together with low headline inflation numbers are boosting real disposable income.

The ECB recently reported that Austria and Germany, are showing signs of regional buoyancy, where house prices may exceed their longer-term fundamental value. The Bundesbank has warned for some time that house prices in some property hot spots are already overvalued, although like the ECB it doesn’t see clear signs that the increases in house prices is leading to any imbalances or possible bubbles.

Extending QE further, however, also means that the ECB will have an even steeper hurdle to climb when it eventually comes to policy normalization. This is what is currently being pondered in the United States by the Federal Reserve. The exceptional, in terms of monetary policy has quickly become the norm and withdrawing cheap money and ever looser policies risks upsetting markets to an extent that will make it difficult for policy makers to take its first step towards normalization. It seems only a stellar outlook and very strong growth justify a withdrawal of stimulus, with neutral monetary policy no longer the baseline, but replacing actual monetary tightening.

Jobs in the U.S. are Softer than Expected

U.S. nonfarm payrolls rose 142k in September, with the jobless rate at 5.1%. August’s 173k job gain was bumped down to 136k, with July’s 245k now 223k, for a net -59k revision. Economists had expected a rise of 200K. Average hourly earnings were unchanged from a 0.4% increase previously. Expectations were for an increase of 0.2%, which would have put the year over year increase to 2.4%.
The workweek slipped to 34.5 from 34.6. The labor force dropped 350k, with household employment down 236k. The labor force participation rate fell to 62.4% from 62.6%. Private payrolls increased only 118k (versus ADP’s +200k) with the goods sector seeing a 13k decline, with manufacturing falling 9k, while construction was up 8k. The service sector climbed 131k, supported by leisure, hospitality’s 35k gain.
The Fed has a monetary policy meeting later in October. The Fed has been wrestling with its conscience as well as the inflation mandate since the July 29 meeting after a heavy dose in volatility via China and the equity market highlighted omens of a global slowdown just as the Fed readied for lift-off. Spilling over to a sharp decline in oil and commodity prices. The Fed has a difficult decision and their thought process has changed the way many investors view the current capital market landscape. Following the payroll numbers it is hard to see them making a move which should lower the value of the dollar across the spectrum.

Prior to the July Fed meeting, investors experienced a one way flow of liquidity in the market which allowed stock prices to remain buoyed. The two way flow has now created a turbulence as divergent paths of the major central banks is now generating market volatility.

The most recent data do not point to a Fed tightening but possibly a normalization of interest rates. If rates were higher, the Fed would not use the current backdrop as a place to begin to tighten, as inflation remains subdued and employment is modestly growing.
The problem is that rates are at zero and eventually need to normalize which has put the Fed into a real tight space.