3 Things Investors Are Telling Themselves To Explain The Divergence Between Stocks And The Economy

David Woo

Six months into a rally that has yet to see a meaningful downward correction, the stock market continues to move higher, even in the face of weaker than expected economic data.

Over the past few weeks, the Citigroup Economic Surprise Index has dipped below zero, indicating that economic data releases in the U.S. are coming in below consensus estimates by market economists.

“Four months into the year, we are confronted by two indisputable facts,” says BofA Merrill Lynch rates guru David Woo. “One, U.S. data is weak. Two, markets are no longer troubled by weak U.S. data.”

The question Woo poses in his latest note to clients is simple: “Does anyone still care about weak data?”

Woo says no, citing three things clients are saying to rationalize this apparent disconnect:

Clients who believe we pay too much attention to weak data have laid out three reasons why we are wrong.

One, data points to slow growth ahead but there are no signs yet for a very sharp slowdown (“bad news is not bad enough“).

Two, weak data means the Fed will be on hold for longer (“bad news is good news“).

Three, the impact of US fiscal tightening is ultimately transitory and when it starts to fade, the US economy will roar (“good news will follow bad news“).

Woo concedes that these are all actually good points in that they coincide with the BAML house view on the outlook for markets and the economy.

So, what happens next?

Woo reiterates his stance that “different asset classes are pricing in very different scenarios for global growth” (read more about that here). However, with correlations between U.S. stocks, U.S. junk bonds, commodities, and emerging-market stocks “near the bottom of the range since 2009,” these different scenarios could start to converge if investors remain confident in the U.S. economy.

If that turns out to be the case, Woo says the euro “may be one of the primary beneficiaries” of such a phase shift, citing the following developments:

  • Italy has finally formed a coalition government.
  • Portugal just announced spending cuts to replace the measures that its Constitutional Court rejected last month.
  • Greece approved the reforms for the conclusion of the next program review.
  • The Parliament in Cyprus approved the program package that the government has agreed with the Troika.
  • The European Commission has given more time to all economies to reduce their deficits, including France.

“With the market still short the EUR, it seems to us that higher EUR (against both the JPY and the USD) will be the obvious pain trade in a scenario of a risk meltup,” says Woo. “A break of EUR/JPY above the technical resistance level at 130 could lead to overshooting as trend followers take out the value players.”

The April U.S. retail sales advance release out Friday is the next big U.S. economic data point on the calendar and will give another big clue as to where the U.S. economy is going, and how much of an effect the government spending cuts implemented under the sequester earlier this year are having an impact on the economy.

“Everything seems to be pointing to a weak reading,” says Woo.

Market economists surveyed by Bloomberg predict total retail sales contracted 0.3% in April after falling 0.4% in March. Sales excluding autos are expected to be flat.