Strong U.S. data means taper talk likely

U.S. economic data took a turn up this week, increasing the likelihood of quantitative tapering sooner rather than later.

Read: Fed may taper in December

This is what happened: U.S. GDP for Q3 was revised from 2.8% to 3.6% (albeit inventory build was a contributor). Total vehicle sales in November were 16.3 million, the highest annualized pace since mid-2007.

Consumer confidence that had dropped in response to the government shut down and debt ceiling scare rebounded strongly. Energy demand, calculated by the weekly energy consumption in America, is running up 6% compared to last year.

The U.S. added 203,000 jobs in November, bringing the 2013 running total to about 2 million net new jobs. The unemployment rate dropped from 7.2% to 7.0%. Not surprising, the CitiGroup Economic Surprise Index spiked higher. Poke whatever holes you want in these numbers, the data is strengthening as we near the end of the year.

The last time the U.S. Fed tested the waters to gauge a response to the prospects of reducing quantitative easing, bond yields spiked higher, income-paying stocks moved lower and broader markets in general declined. This economic data augers more taper talk and it will be interesting to see how the markets react. Bond yields have crept almost back to 3.0%, based on the U.S. 10-year Treasury yield and the Canadian 10-year Government bond isn’t far behind.

The first round of taper talk that started in May and ran into the summer months, resulted in yields moving up from sub 2% to briefly touch 3% (2nd chart). Now where will they go this round? We don’t think the move will be as dramatic in its speed but we would not be surprised to see yields reach 3.5% or even 4.0%. The risk of an overreaction is still real and a higher spike, albeit temporary, shouldn’t be ruled out.

Read: News outlets rapped over Fed taper data release

If yields do grind higher, it will be interesting to see how the equity markets react. They took rising yields in stride during the month of May from the 1.6 to 2.0% move, but then all of a sudden reacted negatively once yields broke the 2.0% level. So the question is whether we will see a similar pattern as bond yields move above 3.0%. Either way it is best to focus on lower duration bonds or less interest rate sensitive equities wherever possible.

QUESTION OF THE WEEK

With the S&P 500 making record highs and up over 20% year to date, how has it faired historically in years following a strong bull market rally?

Since 1950, there have been 20 years where the S&P 500 has returned over 20%. Sixteen of the following calendar years have ended in positive territory, with an average return of 13.87%. So if history is any indication, next year should bode well for equities.

Two of the negative years marked the start of a recession, 1981 and 1990, and the other two marked a sizeable correction. Having recently come out of the great recession of 2008/2009, coupled with improving economic growth and labor data from the developed world, we put a very low probability on the chance of another recession.

As an example, look at today’s U.S. job data: 203,000 new jobs were created last month, which marks the 45th month in a row of job creation. The unemployment rate now stands at 7%, far below the 10.1% rate we saw in the depths of the recession. It would take a formidable event to reverse the momentum that has been building over the past four years.

Even if we see a correction, it is likely to be short term in nature as overall fundamentals are much stronger now than they were in 2007. Consumer and corporate balance sheets are far less leveraged, sentiment is rising and companies are finally transitioning from cutting cost to reinvesting in the business.

So long as we end this year with sustained momentum, the great run seen in 2013 should be followed by at least a good one in 2014.

Read: Top Financial Phrases of 2013

Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @Gareth_RGMP