Liz Ann Sonders: Teflon Market

Liz Ann Sonders: Teflon Market

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by Liz Ann Sonders, Brad Sorensen, Jeffrey Kleintop, Charles Schwab & Co, Inc.

Calm, Confident…Complacent?

Nothing seems to be able to phase the stock market recently. Political infighting, Presidential tweets, North Korean missile launches, oil falling below $50, European political uncertainty, higher bond yields, and the Fed raising rates: none of those forces have knocked stocks off their recent uptrend. Volatility has remained remarkably low for an extended period, and the S&P 500 hasn't seen a 1% down day since October 11, 2016—the second longest span in history. Remarkably, at this stage of the eight-year bull market (reached on March 9), stock gains have accelerated in recent months while volatility has declined.

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Volatility remains low

Volatility remains low

Source: FactSet, Chicago Board Options Exchange. As of Mar. 14, 2017.

As stocks continue to move higher

As stocks continue to move higher

Source: FactSet, Standard & Poor's. As of Mar. 14, 2017.

Just when we were starting to get concerned about the potential of a true "melt-up" in U.S. stocks, the indexes trended sideways to slightly lower during the first two weeks in March, allowing the prior gains to be digested, and for sentiment conditions to ease a bit. According to the Ned Davis Research (NDR) Daily Trading Sentiment Composite, investor sentiment moved back into neutral territory recently, easing concerns about a near-term, sentiment-driven pullback. But is this the calm before the storm?

This period of calm isn't going to last forever, and we caution investors to remain disciplined around diversification and rebalancing. Part of the reason for the depressed volatility may be the rise in passive investing—index funds don't move in and out of stocks nearly as much as actively managed funds do. That trend may be reversing, which would likely increase volatility (read details of our thinking at "Radioactive: Is Passive's Dominance Over Active Set to Wane?" by Liz Ann Sonders). Additionally, political rancor, foreign election uncertainty, geopolitical tensions, and a more hawkish Federal Reserve all have the chance to contribute to a pullback. We have made a couple of moves in an attempt to allow portfolio gains from stocks to continue, while potentially providing a bit of a buffer against the possibility of an uptick in volatility. We remain overweight to U.S. stocks as we believe the bull market continues, but we recently shifted to a large cap bias (read details in "Big Machine: Why Large Caps Are Likely to Outperform"). Additionally, on the sector front, we added the health care sector to our outperform ratings, adding the potential of a little defense in a largely cyclically-bullish tactical bent (read more about health care here).

Well-deserved confidence?

While there may be pockets of complacency, the recent market run and accompanying higher confidence among business, consumers and investors appears well-founded by economic fundamentals, which supports our belief that the secular bull market has further to run. Confidence spikes have been seen in both the National Federation of Independent Business (NFIB) small business confidence and the Conference Board's consumer confidence indexes. In addition, the forward-looking new order components of both the ISM Manufacturing and Non-Manufacturing Indexes  spiked higher in the most recent readings (65.1 and 61.2, respectively—with values above 50 indicating expansion). And the "hard" data is now starting to confirm the "soft" (survey/confidence-based) data. The February retail sales report showed a 0.2% increase, excluding autos and gas, while January's reading was revised higher. The labor market also remains strong, with ADP reporting a surprising 298,000 new jobs in February and the Labor Department reporting  235,000 jobs were added; while the unemployment rate fell to 4.7%.

One recent concern has been the weakening of the Atlanta Fed GDPNow survey, which currently predicts first quarter gross domestic product (GDP) growth to be a tepid 0.9%.

GDP forecast has come down

GDP forecast has come down

Source: FactSet, Federal Reserve. As of Mar. 15, 2017.

We want to caution investors against extrapolating that weakening into the rest of the year, while pointing out that the less-followed NY Fed GDP Nowcast has first quarter growth at 3.2%. Also remember that GDP growth is backward-looking and the stock market is forward looking; which is why leading economic indicators are more valuable "forecasting" tools for the stock market. Most indexes of leading indicators, such as initial jobless claims, show the trajectory remaining decidedly higher.

Fed raises, and signals more to come

Helping to bolster our belief in a strengthening economy—and our bullish stance—is the increased hawkishness of the Federal Reserve and their decision to hike rates at the March Federal Open Market Committee (FOMC) meeting. Additionally, the Fed signaled willingness to continue to hike rates in the coming months, which would mark the first time we would see more than one hike in a year since the financial crisis. Impressively, the market took the rate hike in stride, indicating to us that investors believe the Fed should accelerate the normalization process in keeping with strength in both of the Fed's mandates (jobs and inflation). The most recent consumer price index (CPI) reading, ex-food and energy, was up 2.2% year-over-year (y/y); while average hourly earnings (AHE) from the labor report showed a 2.8% increase y/y. The market may be at risk if  the Fed has to significantly accelerate its hiking campaign, but for now, markets are taking it in stride and remain calm.

The same can't be said for politicians in Washington, where the rancor remains elevated as President Trump pursues his legislative agenda. This is where the sausage starts to get made, which is typically not pretty, but it's precisely the checks and balances set up by our founders that can give voters on both sides of the aisle some comfort. We continue to believe health care, tax and regulatory reform  will occur, but the process may take longer than many investors had been hoping for, which could lead to some volatility in stocks.

Politics doesn't stop at the borders

Even for U.S.-based investors, political issues extend beyond the borders as they could also impact volatility both here and abroad. Europe successfully passed its first political test of 2017. The Netherlands held general elections on March 15. The vote will be followed by elections in key European Union (EU) members France (in April/May) and Germany (in September). In the Netherlands, the Party for Freedom, led by Geert Wilders, led for much of the campaign on a platform of leaving the EU and halting immigration. The outcome has left the anti-EU party isolated and unlikely to participate in the coalition government to be formed by current Prime Minister Mark Rutte, whose center-right People's Party for Freedom and Democracy won the most seats.

A rising worry among investors was that every global vote was going to be a surprise win for populists after 2016's surprise outcomes. This proved to be too much of an extrapolation, and the risk of a "Nexit," or exit from the EU by the Netherlands, remains low. Plunging EU immigration—the issue fueling much of the anti-EU sentiment—may mean the political influence of populists peaked in 2016, as you can see in the chart below (for more on this see commentary on "The future of Europe: EU 2.0 and its impact on the markets").

Number of EU asylum seekers has plunged and so may the political clout of populists in Europe

Number of EU asylum seekers has plunged and so may the political clout of populists in Europe

Source: Charles Schwab, Eurostat data as of 3/15/2017.

Trade talks

The Trump administration's trade stance will be a big focus of the meeting between President Trump and German Chancellor Merkel at the White House, and at the G20 meeting of finance ministers and central bankers in Germany. The markets are still waiting to see what form the Trump administration’s ideas on "America first" and "economic nationalism" will take.

Merkel may warn Trump that Europe could retaliate against protectionist measures. While Mexico is first on the list of bilateral trade negotiations with Commerce Secretary Wilbur Ross—who is preparing to submit a letter to Mexico next week indicating his intention to launch NAFTA renegotiations in 90 days—the United States has a much wider trade deficit with Germany than Mexico, as you can see in the chart below. Trade is the lifeblood of the German economy; Germans export a lot more than they import. The German current account surplus, which is a broad measure of the trade balance, reached 9% of GDP in 2016, making it the largest in the world (excluding the much smaller countries of Taiwan and Singapore). Merkel may worry that other trading partners may follow the lead of the United States, a major threat to the world’s most export dependent major country.

U.S. trade balance by country

U.S. trade balance by country

Source: Charles Schwab, International Monetary Fund data for 2015 as of 3/15/2017.

Brexit begins

The British Parliament passed a law this week allowing Prime Minister Theresa May to formally submit official notice of "Brexit" to the EU, and begin what may be two years of negotiations. She is expected to do so in the next two weeks, which could turn what President of the European Council Donald Tusk called a process that is "constructive, and conducted in an orderly manner" into a messy divorce, "taking the form of threats." UK stocks are up this year, even measured in dollar terms, and could be at risk if it begins to appear that a deal may not happen within the two year timeframe.

Complicating the risk to stocks from Brexit talks, Scottish First Minister Nicola Sturgeon said she is seeking a new independence referendum for Scotland. A prior Scottish independence referendum failed in 2014. Polls show Brexit hasn't had much impact on overall Scottish sentiment on leaving the United Kingdom, but if the negotiations turn acrimonious, the market may begin to price in a breakup of the United Kingdom.

So what?

Stocks have been remarkably resilient and calm has permeated the investing landscape; but that doesn’t mean investors should be complacent. Taking profits in outsized positions and maintaining a diversified portfolio are important to being successful long-term investors. Politics, both here and abroad, could contribute to periods of uncertainty among investors, and contribute to times of greater risk aversion. The U.S. bull market should continue, but we also believe volatility will pick up and pullbacks could occur, so remain disciplined.



Important Disclosures