Developments regarding the coronavirus should remain the markets' focus this week, as not much else is going on. The latest developments are positive for the stock market. Policy moves -- another PBOC rate cut and the Finance Minister's promise to provide direct help to companies -- underscore officials' aim to prevent a big hit to the Chinese economy.
There is little in terms of US economic data this week. Perhaps the most important will be the February Philadelphia Fed Mfg Index and the Markit Mfg PMIs on Thursday and Friday, respectively. They will provide some evidence on the impacts of the virus-induced Chinese slowdown and Boeing 737 Max production shutdown on manufacturing activity.
The risk is that they will show little effect. /1/ Markit Mfg PMI risks a counter-consensus increase, after the Index missed the Mfg ISM's bounce in January. /2/ Friday's report on January Industrial Production showed a large drop in aircraft production, implying a 0.3-0.5% pt subtraction from IP by the 737 Max shutdown, But, this is a one-off subtraction, except for residual effects. /3/ At this point, the Claims data suggest no significant impact on the overall economy. Initial Claims are back near their lows and Continuing Claims appear to be catching up to the recent improvement in Initial.
The US economy's strength raises the question whether Fed policy is too easy. While inflation is not a problem now, will it become one? Is the easy policy fueling a stock market bubble? There can be no certain answer to either question. But, the longer-end of the Treasury market and the dollar exchange rate argue against affirmative answers. If inflation is likely to be a problem and the Fed is now unresponsive to this risk, the yield curve should steepen and the dollar fall. Neither is happening.
Arguably, both the yield curve and dollar are reflecting arbitrage from abroad, as monies flow in from countries with weaker economic growth and even lower rates. But, if that's the case, the stimulus from lower longer-term yields has to be balanced against the drags from weakness abroad and strong dollar. The longer-end of the market does the balancing, and so far is not concerned about an imbalance toward stimulus. Looking ahead, a sharp steepening of the yield curve will provide the answer whether tighter Fed policy is warranted.
Until then, the boost to the stock market from low Treasury yields just reflects a channel through which the latter work to stimulate the economy. If high Price/Earnings (P/E) Ratios serve to block this channel, then yields should fall even more -- thereby justifying even higher P/E Ratios. What will stop the stock market rally will be evidence that US economic growth has become too strong and inflationary. We'll know this is the case when the Treasury yield curve steepens sharply.
The Administration's idea of providing tax incentives to persuade lower-income people to invest in the stock market is a bad idea. It smacks of the pre-Financial Crisis push to include them in the housing boom by having FNMA buy sub-prime mortgages in the secondary market. Both policies fail to recognize the inherent riskiness of putting people into these investments -- particularly people who cannot afford a large loss. While a plunge in home prices might have been difficult to imagine pre-Financial Crisis, a drop in stock prices is much more readily imaginable. Indeed, it is highly conceivable that stocks will rally into the start date of the program and then sell off.
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