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Fears of Austerity rise again, as Stimulus proves ineffective

Economic growth
By Paul Hodges on 01-Jul-2015

Boom Jun15Austerity is in the news again, as the Greek/Eurozone debt negotiations continue.  So it seems interesting to see how financial market sentiment has been moving with regard to the issues of austerity and stimulus.  The above chart is therefore modeled on the familiar IeC Boom/Gloom Index

  • It shows the ratio of sentiment for Austerity versus that for Stimulus (blue column)
  • The right-hand axis shows movements in the US S&P 500 Index over the same period (red line)

It highlights a number of relevant relationships:

  • There was very little thought of Austerity in 2009, when the mood was entirely one of Stimulus
  • It first appeared in 2010, but soon faded when the US Federal Reserve began its QE2 stimulus package
  • But it then jumped to record heights in 2011 and again in 2012 as this proved ineffective
  • This was despite the Fed’s further stimulus packages with Twist in 2011 and QE3 in 2012
  • 2013 – 2014 saw it reduce again, but it never went back to the levels seen in 2009
  • And attention has once again been focused on it since the start of this year

Meanwhile, of course, stock markets continued to gain in line with the Fed’s plan to boost the economy by creating a wealth effect.  Initially, they suffered some corrections, as value-oriented traders worried that the Fed’s stimulus might not produce a sustainable recovery.  But those worries have been brushed aside since 2012.  Traders believe the Fed will never let markets fall, and so have taken on record levels of debt to fund new investments.

Another major support for the S&P 500 has been the level of share buybacks by companies of their own stocks.  As Barron’s observes this week:

20% of Standard & Poor’s 500 companies have bought back stock in sufficient quantity to boost earnings per share by some 4% from the level a year earlier.

This represents money that could have gone into new capital investment, R&D or other wealth-generating activities for the future.  But instead it has been handed back to shareholders in an effort to boost share prices.

This tactic has been very powerful until recently, but the S&P now seems to be finding it very difficult to move higher.  And the volume of buybacks is also likely to reduce now 10-year interest rates are increasing:

  • Companies had often used borrowed money to fund their share purchases via the corporate bond market
  • But this is less attractive after the rise in US 10-year bond rates from 1.64% on 30 January to 2.48% last Friday
  • And this major move in a critical US interest rate occurred even though the Fed rate itself remains close to zero

This highlights an important issue about the likely cause of the next recession, As Barron’s conclude:

The markets will lead to the next recession, not the other way around, which historically has been the pattern. Asset-price appreciation has driven this expansion, and the previous two recessions were caused by their reversals after the dot-com and housing busts. This is what happens when the Fed creates an asset-price-dependent economy, rather than the old days of asset prices reflecting the underlying fundamentals.”