Will a Rally Follow the Shutdown?

10/15/2013 12:00 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

If the shutdown ends without disaster, investors might want to prepare for a possible rally in December. However, writes MoneyShow's Jim Jubak, also of Jubak's Picks, then old worries, like China and the Fed, might creep back into the picture.

It's hard to take your eyes off the government shutdown/debt ceiling crisis in Washington for the same reason we rubberneck at a car crash:

Disaster is fascinating.

But let's pry our eyes away for the moment and look further down the road.

Assuming this crisis does get resolved short of financial Armageddon—and I think it will, although probably only after a close call with a US debt default badly rattling global financial markets—then what?

Let me try to look ahead at the rest of the year and into 2014 to see what's likely to happen in the markets.

First, and I think we're all agreed on this, we get a relief rally whenever this mess is over. (Of course, this almost universal belief in a relief rally may be the reason stocks haven't fallen very far and that the markets haven't created very many bargains.)

Ready for the rally?

We've already seen a good example of this at the end of last week, when optimism that the White House and House Republicans were close to a deal soared. We got a very impressive 2.2% rally in the Standard & Poor's 500 (SPX) on Thursday, October 10, and a decent follow on of 0.63% on Friday, October 11.

Those markets and stocks that had been hit harder by fears of a US default, and by the consequent flight to safety, rebounded even more strongly than the US markets. This was particularly true for emerging markets, which had suffered their usual relatively larger decline, when fear increases among investors—even when these countries aren't the source of the fear. The iShares MSCI Indonesia ETF (EIDO), for example, rose 3.6% on October 10. The iShares MSCI India ETF (INDA) climbed 3.2% and iShares MSCI Turkey ETF (TUR) was up 2.8%.

How long the relief rally runs and how big it is depends on how quickly the economic fears that were preying on the market's mind return to the front of investors' thinking. Remember back before the US budget and debt ceiling crisis? The fears then were 1) how slow growth might get in China, and 2) the US Federal Reserve's inevitable move to begin tapering off its $85 billion in monthly purchases of US Treasurys and mortgage-backed securities.

Rally killer No. 1: China doubts

Over the weekend, China's government announced that exports unexpectedly fell in September. Exports dropped 0.3% from September, 2012. Economists surveyed by Bloomberg had expected 5.5% annual growth in exports. In August, exports had climbed at a 7.2% annual rate. (Imports climbed 7.4% in September, more than economists had forecast.)

The worry, you'll remember, is that China's economic growth will fall below the government's target rate of 7.5% for the year. Last week, China's Premier Li Keqiang said that China's GDP had grown by more than 7.5% in the first nine months of 2013.

It's unlikely that China's official data will show any deviation from the government's goal in the run-up to the November meeting of the Communist Party's Central Committee that will set economic policy and discuss how to integrate the country's economic policy and socialism with Chinese characteristics. The official data is extremely unlikely to rock the boat before that meeting, but whether or not that data is reliable is another question. And if it isn't, the true growth rate of the Chinese economy will show up in the performance of the global economy, whatever the official Chinese numbers say. A forecast that China's growth will miss the government' target was a key reason that the International Monetary Fund cut its projection for global 2014 growth to 2.9% in 2013 and 3.6% in 2014, from a July forecast of 3.1% in 2013 and 3.8% for 2014.

On the evidence of what happened earlier this year, when fears of lower-than-expected Chinese economic growth hit emerging markets hard, I think a return of those fears would cut into any emerging market rally. Worries about the speed of China's growth would also put downward pressure on commodity economies and their stocks as well, and could revive doubts about the speed of any economic recovery in the eurozone.

Rally killer No. 2: The Fed's next move

Second, at some point, markets go back to trying to predict when the Federal Reserve will begin its taper. Markets moved up very strongly in September as the markets increasingly convinced themselves that the US economy was weak enough and the situation in Washington uncertain enough to put off any taper on the Fed's asset purchases into October or later.

This view that was vindicated when the Fed surprisingly didn't taper at its September 18 meeting.

Time to raise some cash

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The markets haven't really focused on what a new schedule for a Fed taper might be—investors have had other things on their mind. The next meeting of the Fed's Open Market Committee is on October 30, and it's extremely unlikely that the US central bank will move that quickly. Even if US politicians wrap up the current mess relatively quickly, the Fed simply won't have enough data by the time it meets to know how much damage the government shutdown and the debt ceiling uncertainty did to the US economy.

There is no November meeting and so, realistically, the earliest the Federal Reserve could decide to begin winding down its current program of quantitative easing is its December 18 meeting.

That timing, plus the happy data likely to precede the November meeting of China's central committee, is good reason to think that any post-solution rally could last into December.

After that, the direction of the financial markets is likely to depend on the balance between US economic growth and Federal Reserve policy. If growth is slow, markets will start to believe that any taper might be pushed off from the Fed's January 29 meeting to the March 19 or even the April 30 meeting. (The Open Market Committee doesn't meet in February or May.) That will be supportive of global financial markets—the dollar will weaken or at least remain relatively weak, and that will support emerging markets and the yen (and Japanese stocks).

Unless, of course, US economic growth is too weak. Surprisingly slow US growth in the fourth-quarter numbers delivered in early January (assuming we have functioning economic data feeds from the federal government by then) would not be good news for a US stock market that, despite everything thrown at it, remains near historic highs. Markets would respond favorably if growth is slow enough to keep the Fed from removing cheap cash from the system, but the markets would start to worry about US and global growth (China exports a lot of stuff to the United States) if US GDP looked like it was even thinking about dropping toward negative territory.

Can it run into Christmas?

So where does that leave us—assuming, of course, that Washington pulls a solution out of its hat sometime in the next week to ten days?

Looking at generally bullish conditions into December for US markets, for Japanese stocks, and for emerging markets. I think Japan is likely to deliver the biggest upward move at the lowest risk, since most scenarios lead to a weaker yen. Emerging markets are likely to bounce the highest, but they also have the biggest downside risk because of their close connection to China.

The end of December and into January is a lot harder to call, since we don't really know how badly the shutdown and the uncertainties about the debt ceiling have hurt a US economy, where underlying strength was hard to read even before the crisis in Washington.

Readings from my crystal ball get a lot murkier after, say, mid-December.

One final thought: I'd be a lot more enthusiastic about putting new money to work here if the government shutdown/debt ceiling crisis had produced a significant selloff and had created some real bargains in the process. Mind you, as someone who, while raising cash, remains long the equity markets, I'm not deeply unhappy at the lack of a big downward move. But the lack of a correction and the lack of bargains does raise the risk of adding new positions here or adding to existing ones. To invest at this point means we are still expecting that US stocks will climb from historic highs to even higher levels.

That can happen. US stocks are not terribly expensive if we're still in the growth stages of this economic cycle. (On the other hand, they are expensive if growth is about to turn down.) But I think it is important to recognize—and to factor into your stock and asset selection—that as we move into 2014, as we move into the murkier regions of my crystal ball's predictive powers, the risk/reward ratio isn't jumping up and down for joy.

We're still counting on some version of the Goldilocks market—not too hot and not to cold—for gains from here.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. Click here for a full list of the stocks in the fund as of the end of June.

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