JUNE 15 AND 16 saw the first back-to-back 1% declines in stock prices since early March, as equity markets gave back some of their recent gains. For the week, the Dow Jones Industrial Average fell 3% to 8,540, the Standard & Poor’s 500 Index declined 2.6% to 921 and the Nasdaq Composite gave up 1.7% to 1,827. The same week also saw a reduction in commodity prices and some improvements in the Treasury markets.

 

Many of the headlines that week were focused on the ongoing debate about healthcare policy reform. The potential changes being discussed by the Obama Administration and Congress are massive and have been subject to widespread debate. Much attention has been focused on how the country would be able to finance some of the initiatives being discussed, which are estimated to cost US$1.5 trillion ($2.2 trillion) over the next 10 years. In our opinion, it would be unlikely that a majority in Congress would be able to agree on a plan that would increase taxes and/or decrease spending by that amount, and therefore, we expect that the scope of healthcare reform is likely to be scaled back somewhat.

 

Also in the headlines recently has been discussion over the possibility that China may alter its currency peg to the US dollar. By our analysis, such a move is unlikely any time soon. For China to make this change, it would need to accept a higher valuation for its own currency, and we do not believe this is a step that policymakers in China would be willing to accept.

 

Turning back to the more immediate drivers of market performance, the most recent economic data continues to suggest that the US economy is close to emerging from what has been the longest recession in post-World War II history. The most recent reading of the Index of Leading Economic Indicators suggests that the worst is behind us, and an environment of low interest rates around the world and the rapid increase in money growth point to a situation of ample liquidity.

 

Many problems do remain, of course, not the least of which is the still-troubled labour market. As we have been suggesting for some time, we do believe the economy has moved past its period of greatest weakness, but we do not expect to see any sort of robust recovery any time soon.

 

The US Federal Reserve will hold its interest rate policy meeting this week, and we expect the central bank to sound a somewhat more optimistic note on the economy. Despite some speculation to the contrary, however, we do not believe the Fed will signal an increase in rates any time in the immediate future. True, the economy has been showing signs of life, but the situation remains fragile. Additionally, we are not among those who believe that inflation is a near-term concern. Although commodity prices have increased in recent months, those advances have been offset by other prices (such as foods) that have been falling. All told, inflation continues to hover around the zero line.

 

Fed policy has been focused on restoring liquidity to the markets, which has helped provide a strong tailwind for equity prices over the past several months. Although we do not believe a reversal of Fed policy is among the risk factors facing stocks, we also do not believe the liquidity-fuelled rally can continue unabated. Investors will need to see some clearer evidence of economic recovery. As a result, we believe the setback in stock prices two weeks ago may have a bit to go as equity markets take a breather from their 40% advance over the course of three months.