Edmond Jackson's Stockwatch: The Big Picture

The truth about US money printing will become clear in months ahead

September and October are often tricky months as investors check reality after carefree summer holidays. This year a spate of awkward economic and political news coincides with the US Federal Reserve set to finish tapering its latest money printing programme: interest rates may stay very low but going into 2015 we should start to see proof whether the US economy and firms can prosper with far less stimulus. This round of "QE" has been exceptional, up to $85 billion (£52.1 million) a month, and I suspect that firms' strong second quarter 2014 numbers benefited from a momentum effect which is likely to extend until at least the third quarter and probably the fourth quarter.

Note a contrast in market opinion: the US market as "pumped up by the Fed" versus valuations being justified by corporate earnings and dividends. I respect the stimulus has likely helped the real economy, but may also have accentuated its cycle, hence liable to turn at some point. Companies have grown profits since 2009 - a lengthy upturn albeit from deep recession - and the stockmarket has rallied for two years without a 10% correction. QE may well be effective and the market's rise since early 2012 might be a rational response by way of earnings expectations; so it is also logical to be alert to the trend in US company results now this stimulus is ending. The US stockmarket remains pied piper for most others.

Ultra-low interest rates anaesthetised investors to political risks - now a rude awakening

Stockmarkets paused amid the Ukraine crisis due to the economic effects of sanctions on Russia reverberating through Europe, but have largely ignored the rise of Islamic Jihadists in the Middle East - believing that oil supply is unlikely to be compromised. The assumption has been, "economics are more vital than politics" especially the US Fed’s actions. But the US market has lately seen a drop amid concerns how sanctions are adding to challenges in Europe; and the rise of Germany's home-grown equivalent to the UK Independence Party may complicate introducing QE. It remains to be seen how the sanctions on Russia play out and their medium-term effect. Suddenly stockmarkets have realised they should have paid more attention to political risk; and if it continues to manifest along with weak economic news then they will drop further

Changing perception of weak European data

Until just recently investors have bought a European recovery story with shares and fund sales doing well over the last two years. But little has changed in European fundamentals beyond the central bank president Mario Draghi promising "to do whatever it takes" to protect the eurozone. Up to early September weak data was generally seen as good news to buy stocks because it increased the chances of QE; but now it is becoming realised the central bank has a tricky task delivering this and poor factory data from France and Germany has weighed on sentiment. Markets still bounce some days in hope of stimulus, but opinion is more divided as to the likely outcome.

Significantly, the weaker position in Europe may compromise the Bank of England's need to start raising UK interest rates to limit debt expansion and house price rises; however doing so would risk the UK recovery amid lower demand for exports.

No genuine profit warnings as yet

In the London market I notice companies reporting broadly "in line with expectations". Good results sometimes fail to attract new buyers of shares such that profit-taking gets the upper hand; possibly a symptom of a mature bull market. 2014 has seen many UK stocks consolidate in a volatile-sideways trend after a strong 2012/13. Trouble-spots do not appear to be ominous for the wider economy though: the debacle at Tesco is self-inflicted and reflects cut-throat behaviour among supermarkets; while Tate & Lyle has had supply constraints as a result of the harsh US winter.

Pay attention to cyclical/consumer firms reporting: a pregnant risk in the UK economy is whether a resurgence in household debt means trouble as and when interest rates rise. While it may only involve a segment of the population it could still affect consumer spending, also because larger mortgages are needed as house prices rise. Smaller companies are more exposed to change, which explains why some such shares have fallen.

Lower oil prices are a double-edged sword

A drop below $100 a barrel is the main reason why oil & gas shares are weak, causing brokers to encourage bid speculation - e.g. regarding Tullow Oil. This seems premature, the industry being more likely to see what evolves than dial up risk with takeovers. Lower oil prices imply weaker demand i.e. affirming the "secular stagnation" theory of economics that suggests overall global growth will be muted for considerable time. While investors responded to this eagerly from 2012, when it triggered QE, debts have continued to mount - hence the risk of a "moment of truth" where the situation is suddenly realised as unsustainable. This is probably the biggest risk to asset prices de-rating; low oil prices being a smoke signal

A related risk is the rising US dollar - especially if the US economy strengthens and interest rates rise sooner and faster than expected - as developing countries have high exposure to dollar-denominated debt. Remember how 2014 started with a mini-crisis of confidence regarding emerging markets’ debt; this issue hasn't gone away but also smoulders within the pile of autumn leaves, liable to turn into flames if given air.

China remains the biggest quandary

After its debt to GDP ratio has breached 250% - the fastest-ever pace of growth in credit, to $25 trillion equivalent - the Chinese leadership has realised it must get a grip, any extra debt creating very little economic benefit. Yet the lessons of economic history show that when nations indulge anything near such increases in debt, a sharp recession follows. So is China centrally-controlled capable of something radically different? Industrial production is slipping and growth in fixed asset investment falling more sharply, which at least implies change from a ridiculous extent of infrastructure projects - the so-called "ghost cities". This September the central bank has injected a colossal $81 billion equivalent into the financial system via loans to the five biggest banks, and cut reserve requirements for smaller banks, in an effort to boost corporate lending; however there appears to be a lack of enthusiasm to take up loans as if firms have hit their debt ceiling.

For how long can the trump card be played?

What has so far quelled such risks to stockmarkets is "Where else can investors go for yield?" With bond markets looking overvalued and zilch returns from deposits, shares have been a relative safe haven. The ultimate test for current market values is therefore dividends: will payouts be sustained? Even in a stressed industry such as supermarkets, Morrisons has asserted it maintains its target for 5% dividend growth despite plunging profits, given its very strong cash flow and reserves. Analysts are more sceptical as to next year though.

Generally the outlook for dividends is firm - so if any of the various macro risks I describe, conspire for a market fall, then it will attract buyers. Obviously projections can change if economies deteriorate and company directors become more cautious; a reason why I will keep a very close eye on dividend plans in Stockwatch features.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.