MarketView for December 18

 

 

Summary  

 

The major equity indexes staged an explosive rally on Wednesday, driving the Dow and the S&P 500 to all-time closing highs after the Federal Reserve announced it would start to unwind its historic stimulus.

 

While the Fed's move came as a surprise to many in the market, it confirmed that the U.S. economy was on firmer footing and put to rest the question of when the Fed would begin to scale back its bond-buying program, a relief to some investors, analysts said.

 

The Fed said it would reduce its monthly asset purchases by $10 billion to $75 billion, while it also indicated that its key interest rate would stay at rock bottom even longer than previously promised. It said it "likely will be appropriate" to keep overnight rates near zero "well past the time" that the jobless rate falls below 6.5 percent.

 

Yet the decision to move now rather than later pointed to better prospects for the U.S. economy and the labor market. It also marked a turning point for the largest monetary policy experiment ever.

 

Stocks extended losses just after the announcement, but quickly turned higher and began rallying. The day's move marked the largest swing from the day's high to the low for the S&P 500 in two years. All 10 S&P 500 sector indexes ended higher.

 

Fed Chairman Ben Bernanke began hinting at a reduction in the stimulus back in May. The issue of when the Fed would make its move had been a source of uncertainty for markets since then. The Fed surprised markets three months ago by choosing not to reduce its third round of quantitative easing. Most surveys had forecast the move would occur after December, but recent strong economic data seemed to suggest that the timeline could be pushed up.

 

The CBOE Volatility Index, Wall Street's barometer of anxiety, slid 14.9 percent to end at 13.80.

 

Energy companies' helped lead both the Dow and the S&P 500 higher as oil prices gained. Shares of Exxon gained 2.9 percent to close at $99.54, after hitting an all-time intraday high of $99.95.

 

Shares of Lennar rose 6.3 percent to close at $37.43 after the company reported a 32 percent increase in fourth-quarter earnings. Data on Wednesday indicated that housing starts hit to their highest level in nearly six years in November, a sign of strength in the housing market.

 

Tech underperformed the broader market, with shares of Jabil Circuit falling 20.5 percent to $15.67 a day after it forecast current-quarter results way below Wall Street's estimates. The outlook weighed on other companies in the technology space, including Apple, which ended the day down 0.8 percent to close at $550.77.

 

Shares of Ford fell 6.3 percent to $15.65 after the automaker warned on Wednesday that the cost of launching new vehicles and a deteriorating Venezuelan economy would take a bite out of its 2014 pretax profit.

 

Volume was well above average for the month. Approximately 8.1 billion shares changed hands on the major equity exchanges, a number that was above this month’s average of 6.1 billion shares, according to data from BATS Global Markets.

 

The Taper Begins

 

The Federal Reserve on Wednesday began the task of winding down the era of easy money, on the theory that the economy was finally strong enough for it to start scaling down its massive bond-buying stimulus. The central bank modestly trimmed the pace of its monthly asset purchases, by $10 billion to $75 billion, and sought to temper the long-awaited move by suggesting its key interest rate would stay at rock bottom even longer than previously promised.

 

At his last scheduled news conference as Fed chairman, Ben Bernanke said the purchases would likely be cut at a "measured" pace through much of next year if job gains continued as expected, with the program fully shuttered by late-2014.

 

The move, which surprised some investors but did not cause the market shock many had feared, was a nod to better prospects for the economy and labor market. It marked a historic turning point for the largest monetary policy experiment ever.

 

"The recovery clearly remains far from complete," Bernanke said. But "we're hopeful ... we'll begin to see the whites of the eyes of the end of the recovery, and the beginning of the more normal period of economic growth."

 

Bernanke said he consulted closely on the decision with Fed Vice Chair Janet Yellen, who is set to succeed him once he steps down on January 31 after eight years at the helm. "She fully supports what we did today," he said.

 

Wall Street took the action as a validation that the outlook for the economy was improving. After a brief pullback, stocks rallied sharply, with both S&P 500 and Dow industrials closing at all-time highs.

 

At the same time, Treasury bond prices fell, but the move was modest, capped by the Fed's strengthened commitment to keep interest rates near zero for a long time irrespective of the reduction in its asset purchases. The Fed said monthly purchases of both mortgage and Treasury bonds would be trimmed by $5 billion each, starting in January.

 

The Fed's extraordinary money-printing has helped drive stocks to record highs and sparked sharp gyrations in foreign currencies, including a drop in emerging markets earlier this year as investors anticipated an end to the easing.

 

The Fed launched its third and latest round of quantitative easing, or QE, 15 months ago to kick-start hiring and growth in an economy recovering only slowly from the recession. Now, a centerpiece of its crisis-era policy, the program has left the Fed holding roughly $4 trillion of bonds, and the path it must follow in dialing it down is rife with numerous risks, including the possibility of higher-than-targeted interest rates and a loss of investor confidence.

 

To soothe investors' nerves, the Fed said it "likely will be appropriate" to keep overnight rates near zero "well past the time" that the jobless rate falls below 6.5 percent, especially if inflation expectations remain below target. The Fed has held rates near zero since late 2008.

 

It was a noteworthy tweak to an earlier pledge to keep benchmark credit costs steady at least until the jobless rate, which dropped to a five-year low of 7.0 percent in November, hits 6.5 percent.

 

"The actions today are intended to keep the level of accommodation the same overall," said Bernanke, who held out the prospect of fresh stimulus if the economy stumbled. He said officials could further bolster their low-rate pledge, or even cut the interest rate they pay banks on excess reserves held at the Fed in a bid to spur lending.

 

In fresh quarterly forecasts, the central bank lowered its expectations for both inflation and unemployment over the next few years, acknowledging the jobless rate had fallen more quickly than expected. It now sees it reaching a range of 6.3 percent to 6.6 percent by the end of 2014, from a previous prediction of 6.4 percent to 6.8 percent.

 

Three policymakers expect the first rate rise to come in 2016, up from only two in September, while 12 of the Fed's 17 top officials still see the move in 2015. Futures markets do not see better-than-even odds of a rate hike until September 2015.

 

Critics of the bond buying, including some Fed officials, have worried the program could unleash inflation or fuel hard-to-detect asset price bubbles. At the same time, some have credited the purchases with stabilizing an economy and banking system that had been crippled by the 2008 financial crisis and with staving off what could have been a damaging cycle of deflation.

 

One policymaker, Eric Rosengren of the Boston Fed, dissented against the decision, which he felt was premature given the still-high unemployment rate.

 

Bernanke stressed the Fed was not giving up on supporting the economy, and said it would take action if inflation failed to rise to the central bank's 2 percent target. Inflation as measured by the Fed's preferred price gauge rose just 0.7 percent in the 12 months through October.

 

Even so, recent growth in jobs, retail sales and housing, as well as a fresh budget deal in Congress, had convinced a growing number of economists the Fed would trim the bond purchases.

 

However many thought the central bank would wait until early in the new year, given persistently low inflation and the fact that the world's largest economy has stumbled several times in its crawl out of the 2007-2009 recession.

 

Housing Starts Up Sharply

 

Housing starts surged to their highest level in nearly six years in November, a sign of strength in the housing market that could give the Federal Reserve ammunition to start cutting back its bond purchases.

 

The Commerce Department reported on Wednesday that housing starts were up 22.7 percent, the largest increase since January 1990, to a seasonally adjusted annual rate of 1.09 million units making it the highest level for that index since February 2008. As such, groundbreaking increased 1.8 percent in October to an 889,000 unit pace. Economists had expected starts to come in at a 950,000-unit rate in November and set a 915,000-unit pace in October.

 

A run-up in mortgage rates, in anticipation of the Fed tapering its monthly bond purchases, took some edge off the sector's recovery earlier in the year, but not enough to halt the process as a steady increase in household formation from a multi-decade low point has helped support demand.

 

The housing starts data was the latest indication the economy was strengthening, with employment rising solidly in October and November, and retail sales and industrial production exceeding expectations last month.

 

Last month, groundbreaking for single-family homes, the largest segment of the market, rose a terrific 20.8 percent to a 727,000-unit pace, the highest level since March 2008.

 

Starts for volatile multi-family homes jumped 26.8 percent to a 364,000-unit rate. Multi-family starts have risen strongly through the course of the housing recovery, buoyed by demand for rental apartments as still-high unemployment and stringent lending practices by banks priced potential homeowners out of the market.

 

While permits to build homes fell 3.1 percent in November to a 1.01 million-unit pace, they were above economists' expectations for a 990,000-unit pace. Permits lead starts by at least a month.

 

The drop in permits last month is likely to be temporary. Homebuilder confidence rose in December, with builders upbeat on current sales conditions, future sales and prospective buyers, a report showed on Tuesday.

 

The stock of houses on the market remains lean and the inventory of homes under construction is at a 4-1/2 year low. In November, permits were weighed down by a 10.8 percent drop in approvals for the multifamily sector. Permits for single-family homes rose 2.1 percent.

 

Economy Continues to Expand

 

Private-sector activity continued to expand in December as service-sector growth picked up and hiring increased, an industry report showed on Wednesday. According to Markit, a financial data firm, its preliminary composite Purchasing Managers Index (PMI) - a weighted average of its manufacturing and services indexes - was 56.2 this month, unchanged from November. Readings above 50 indicate expansion.

 

December's service sector PMI rose to 56.0 from 55.9 as new orders increased, prompting businesses to take on more staff. The employment index, after hitting an eight-month low of 52.4 last month, jumped to 55.7 in December, the fastest rate of growth since Markit's data collection began in late 2009. Across the private sector, the employment gauge rose to 55.4 from 52.4.

 

"The particularly encouraging news is that employment growth has picked up in both services and manufacturing, suggesting non-farm payroll growth should easily exceed 200,000 in December," said Markit chief economist Chris Williamson. "Firms have become increasingly optimistic about the outlook, especially because inflows of new work are rising at one of the fastest rates seen since 2009," he said.

 

Employers added 203,000 new jobs in November, according to the Labor Department's non-farm payrolls report. A continuation of that pace could prompt the Federal Reserve to start unwinding its stimulus spending sooner rather than later.

 

Markit's "flash" reading is based on replies from about 85 percent of the U.S. companies in the services sector that were surveyed. A final reading will be released on the first business day of the following month.