Equity markets have been driven upwards by liquidity. Is that liquidity still in place? On the one hand, Western central banks are signalling that they are considering exits from quantitative easing. On the other, that easing is still in place: Fed lending to banks is still falling but MBS purchases are taking its place; the ECB’s lending to financial companies is falling, but it is also making direct asset purchases; and the BoE, though it has signalled an end to QE in Q1 of 2010, still has some money to spend. My two liquidity measures, the US BBB spread and the Bloomberg Financial Conditions Index, are showing continued improvement. In addition, US economic data is surprising on the upside again (unemployment, and today industrial production and capacity utilisation).
All of this makes me think that equity markets are likely to go up for a bit longer. I am still inclined to buy a convincing upside breakout on the S&P. At some point, the market may focus on the lack of debt availability to small firms in the US and deflationary conditions in Europe, but for now the story seems to be all about recovery.
There is an obvious risk to this view: the equity market could anticipate the exit from QE. On the other hand, even without QE, interest rates will still be very low, and with an ongoing recovery story the markets could continue to rise.