Turbulence Ahead

Reality is setting in once again for investors that the Federal Reserve can’t keep funding the so-called recovery forever. Stocks sank yesterday due to stronger-than-expected domestic growth and the likelihood that European growth will soon improve spurred by a rate cut in that region yesterday.

Good news continues to be bad news for stock investors because it offers the Fed a green light to begin throttling back the money pumping machine known as QE3. After years of central bank coddling, investors will have to relearn how to invest without the Fed’s soft cuddly safety net. But don’t expect it to happen in the next several months. Our government must bridge some great divides on budget, debt ceiling, entitlements and taxes first.

The first read on our country’s third-quarter gross domestic product showed growth of 2.8%, up from 2.5% in the second quarter and well above economists’ expectations of 2%. Additionally, the price index for personal consumer expenditures—the Fed’s preferred gauge for inflation—grew 1.9% versus forecasts of a 1.6% rise. Further, today’s jobs report topped expectations by coming in at 204,000, well better than the 120,000 forecast.

But all is not as it appears. The data do not necessarily reveal a significant pick up in the economy. A huge contributor to the growth in GDP was a build-up in inventories that must be sold in the fourth quarter. Personal consumption contributed 1.5% to GDP, but the rate suggested a slowing from the previous quarter’s 1.5%. Net exports from the US slowed from 8% last quarter to 4.5% in the third and imports dropped to 1.9% from 6.9%, reflecting a slowing in demand.

The jobs report overall topped expectations, though there were some weak spots. Total payroll jobs in October increased 204,000, following a revised increase of 163,000 for September (originally up 148,000) and after a revised gain of 238,000 for August (previous estimate was 193,000). The consensus forecast was for a 120,000 rise for the latest month. The net revisions for August and September were up 60,000. Private payrolls gained 212,000 after a 150,000 increase in September. The consensus expected 128,000 in October.

The economy created 204,000 new jobs in October, well ahead of expectations, but the unemployment rate rose modestly from 7.2% to 7.3% in October, as more workers joined the hunt for jobs. Interestingly, according to the Bureau of Labor Statistics, “There were no discernible impacts of the partial federal government shutdown on the estimates of employment, hours, and earnings from the establishment survey.”

But American’s confidence was certainly impacted. Gallup’s Economic Confidence Index fell a whopping 16% to average minus 35 in October, the sharpest monthly drop since Gallup began tracking economic confidence daily in 2008. Confidence did pick up near the end of the month when a deal was reached. According to Econoday, the index in October is the lowest for an entire month since it registered minus 38 in December 2011, as Americans’ confidence slowly recovered from the 2011 US federal debt crisis and subsequent downgrading of the nation’s credit rating.

As the year comes to an end, confidence in our president, congress, and in our very process of government are at all-time lows. The last pillar standing is the Federal Reserve, with their test just ahead. They have bloated the stock market and bent the US Treasury yield curve well out of shape with a money machine that simply has to end soon. Their challenge will be to unwind their program fast enough to avoid running out of money to support it, while tapering gradually enough to avoid spooking the stock and Treasury markets.

The feedback on how the Fed executes will be front-end loaded as markets look ahead. The 7-10 year Treasury index is down 2% in the last several days. Markets must also deal with the next major political wrangling on spending and taxing which is just two months away. After that will come the truth about whether the third quarter’s corporate earnings growth is sustainable or just a snap-back from a slow summer. And then there are the mid-term elections.

Suffice it to say, 2014 may see more than its share of market volatility.