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2014 stock market outlook: Fed dependent?

Will economic fundamentals catch up to the market, and can the Fed exit QE?

  • By JURRIEN TIMMER, CO–PORTFOLIO MANAGER OF THE FIDELITY® GLOBAL STRATEGIES FUND AND DIRECTOR OF GLOBAL MACRO,
  • Fidelity Viewpoints
  • – 11/22/2013
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Jurrien Timmer’s takeaways

  • The stock market is up more than 25% this year, yet earnings growth has slowed to a crawl.
  • The Fed’s open-ended QE3 program has been a smashing success in bidding up asset prices and reducing volatility.
  • Key question: Will the Fed be able to exit QE and raise rates, without wreaking havoc on the markets and the economy?

Stocks have been on a tear this year. Economic growth remains modest but stable. Earnings growth remains positive but barely so. Valuations are way up, but still at reasonable levels. And investor sentiment is ebullient, to say the least.

But there’s a big disconnect. The stock market is up more than 25% this year, yet earnings growth has slowed to a crawl. How is this possible? Two words: monetary policy. The Fed’s open-ended QE3 program has been a smashing success in bidding up asset prices and reducing volatility.

The other side of the coin, however, is that this steady drip of monetary support has also created a dependency of sorts on easy money. Remember what happened last spring when the Fed started floating around the idea of even a modest tapering? The bond and credit markets went into a tailspin and the stock market slumped as well. Just the expectation of a mere reduction of the amount of asset purchases had such an impact on liquidity, and, in turn, mortgage rates, and, in turn, the economy, that the Fed had to backtrack from its taper threat. Needless to say, investors cheered the news and stocks took off.

Then we got a decent employment report in October, showing a 200+ thousand gain in payroll, as well as an above-consensus third-quarter GDP report. All of a sudden, a December taper was getting priced into the market.

The fears of an early taper, however, were once again calmed when Fed Chair nominee Janet Yellen appeared before Congress recently. She made it clear that the Fed would remain very accomodative until the economy is strong enough to be able to withstand an exit from QE3, and eventually even an increase in interest rates. In so many words, she said that the risk of subpar growth from insufficient QE is greater than the risk of bubbles or financial instability from too much QE.

So as quickly as a December taper was priced in, it was priced back out, and risk assets rallied to higher highs. The S&P 500® has reached 1,800. Few investors would have considered that likely at the beginning of the year.

What it may mean for 2014

So what happens next? How will this all play out in 2014? Will it be the year of the taper or the year of the dove?

Will the economy finally reach so-called escape velocity, i.e., sustained higher growth, as so many economists (including the Fed’s own) have been calling for for so long? If so, will the Fed be able to exit QE and even raise rates, without wreaking havoc on the bond market, and by extension the stock market and the economy?

Or will the economic recovery remain as subpar as it has been for the past few years, forcing the Fed to create an ever larger balance sheet? If QE3 fails to work in accelerating economic growth, could the market become a bubble that will collapse under its own weight? Will the Fed have to keep printing money out of fear that another taper threat will have the same effect as the last one did? What if the Fed’s balance sheet grows to five trillion? Six trillion? Ten trillion? How much is too much? Is the Fed painting itself into an ever tighter corner?

These are important questions. Clearly the Fed is hoping that the economy reaches escape velocity and that it gets a “get out of jail free” card, as it were, to exit QE3 and eventually normalize rates, without incurring a bond market hangover. But what if it doesn’t happen? What’s the exit strategy? I wonder if the Fed has one.

Perhaps this will all end in a bubble, the way the NASDAQ did in 2000 and housing did in 2007. With the way things are going, that scenario is not completely implausible, unless earnings growth reaccelerates or stocks correct long enough to allow the fundamentals to catch up.

Learn more

  • Fidelity® Global Strategies Fund (FDYSX), co-managed by Jurrien Timmer.
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Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
The information presented above reflects the opinions of Jurrien Timmer, director of Global Macro and co-manager of Fidelity® Global Strategies Fund, November 19, 2013. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
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