Too much good news can be bad news - at least that is how the markets see it.
The recent string of better than expected economic data is consistent with the rapid pace of healing in the credit markets - the key driver of the recession. In fact, last week marked the 12th week that the financial indicators we use to evaluate the overall health of the economy have shown steady improvement. The data increasingly paints a picture of a still weak, but rapidly improving U.S. economy. However, this news isn’t being interpreted as all good by the markets.
Market participants’ concerns are shifting from a potential lengthening and deepening of the recession to inflation that might be stoked by a rapid recovery. In the past, high and rising inflation has proven to be a far harder problem to solve than a weakening economy in recession. Now that the economy is beginning to gain traction, the issue is becoming how quickly and effectively policymakers will rein in stimulus to avoid inflation. The uncertainty of the timing and effectiveness of the Fed’s response - and concerns that action pulling back the stimulus too soon could tip the global economy back in to a second downturn - are weighing on investors’ confidence.
We believe there will be substantial inflation in raw material prices. However, we expect only a modest rebound in prices for finished goods, measured by the traditional gauge of inflation - the Consumer Price Index, given abundant labor and factory capacity around the world that will take years to absorb. We do not believe the Fed will move aggressively due to the lack of significant inflation in finished goods prices and the risk of undermining the improvement in the banks, credit markets, and the economy.
Good news still is good news - after all, the economy is improving and the stock and corporate bond markets have rebounded sharply from the lows of early March. It is increasingly likely that the worst of the financial crisis is behind us. However, the better performance has resulted in some risks. For instance, the combination of higher mortgage rates and higher gasoline prices could pose a threat to the recovery if these trends continue unabated. As a result, volatility may return to the markets over the coming months. We stress the importance of a commitment to your long-term investment strategy. As always, please contact me if you have any questions.
Greg Powell, CIMA