Balancing Act
Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research
February 11, 2011
Key points
- Strong US economic signals and solid earnings continue to provide a positive backdrop for stocks. We expect pullbacks if optimistic sentiment gets too elevated, but remain optimistic about the stock market.
- Inflation concerns are rising, but the Federal Reserve is unlikely to react with tighter policy. There's not much it can do to fight commodity inflation, but Treasury yields are rising in response to headline inflation, even with little near-term risk of companies passing on rising costs.
- European markets have rebounded, but may be a bit extended as the sovereign debt crisis continues. Meanwhile, some emerging markets are battling rising inflation with tighter monetary policy.
We remain positive on the stock market's prospects—at least through the first half of the year—as we expect stocks to build on previous gains, with indexes recently reaching their highest levels since 2008. The trend since last September has been strong, with occasional pullbacks that have proven to be merely speed bumps.
We still expect relatively minor bouts of selling if sentiment and technical conditions get extended. However, as seen recently when the market pulled back roughly 2% in a session, nervousness over stocks remains among general investors, and pullbacks may be short-lived and shallow.
The Trend Is Your Friend
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Source: FactSet, Standard & Poor's, as of February 7, 2011.
The resilience of the market has been frustrating for bears. With Middle East tensions escalating, debt issues around the world continuing and inflation concerns growing, positive momentum continues, supporting the notion that the market is climbing a "wall of worry." We remain on the side of the bulls and recommend you use any near-term weakness to bring US stocks to your target allocation, to the extent you may be underexposed.
Economic expansion begins
As Liz Ann noted recently, we can officially transition to talk of an expanding economy now that we're above pre-recession levels. History shows that expansion phases typically last at least three years. The now largely completed fourth-quarter earnings season was another winner as revenues and earnings both exceeded expectations, with healthy forward-looking guidance.
Manufacturing continues to lead the expansion, as the regional Chicago Purchasing Managers' Index rose to 68.8—the highest reading since July 2008. On a national level, the Institute of Supply Management (ISM) Manufacturing Index rose to 60.8 in January, its highest since May 2004. Perhaps even more encouraging, new orders rose to 67.8, the best in seven years, while the employment component posted its highest mark in 38 years.
The larger services sector is making solid strides as well, with the ISM Non-Manufacturing Survey rising to 59.4 and its employment increasing to 54.5. Readings greater than 50 for both indexes represent expansions, while readings near 60 indicate strong growth.
Consumers spending—but what about jobs?
These indicators of improved activity are being supported by reports of improving consumer activity. Retail spending data from January was better than expected, while personal spending also showed improvement (though part of that was at the expense of the savings rate). And US growth doesn't just benefit domestic companies: Investors can still look internationally for potential benefits.
Of course, in order to continue, economic growth must produce more jobs to enable a self-sustaining cycle to really get rolling. Companies see more demand, creating the need for more workers, who fill the jobs, increasing discretionary income, thus creating even more demand—and the cycle continues.
Part of the problem of slow job growth can be attributed to massive productivity gains the past couple of years—basically companies getting more from less. Encouragingly, we've seen the year-over-year productivity increase drop to 1.7% from 6.3% a year ago, indicating companies may be reaching the limits of squeezing more out of each worker.
Fewer unemployment claims, more jobs
Additionally, jobless claims continue to trend lower, with the four-week moving average threatening to pierce the 400,000 mark. Automatic Data Processing also reported that 187,000 private jobs were added during January.
Unfortunately, the labor report was largely unhelpful due to distortions caused by severe weather during the past couple months. The report showed an increase of only 36,000 jobs via the payroll survey, though there were some upward revisions to previous months.
It did show that the unemployment rate fell to 9% (the second consecutive 0.4% drop), due in part to discouraged job seekers leaving the ranks of the unemployed. However, recent downward revisions to household data due to the census may have also played a factor (fewer households than previously estimated).
Imprecise new job counting
There remains a divergence between the household survey (from which the unemployment rate is derived) and payroll employment. According to ISI Research, during the past 11 months payroll employment increased by just more than a million, while the household survey increased by more than 2 million. This is somewhat encouraging, as it may reflect more small-business hiring often missed by the payroll survey.
We also know that retirement account balances have rebounded with the market's rise, and some people opting out of the workforce may be doing so because their retirement prospects have improved. We hesitate to draw too many conclusions at this point, but are cautiously optimistic about near-term job growth.
Additionally, wage gains remain slow—a two-sided coin. Small compensation increases bode well for companies' profit margins as labor remains the largest expense for many firms, but consumer spending—the primary driver of the US economy—will struggle to increase if incomes are relatively stagnant.
Compensation Gains Remain Weak
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Source: FactSet, US Department of Labor, as of February 7, 2011.
Inflation concerns start to rise
Compounding problems facing consumers and businesses are rising commodity costs. Companies are having trouble passing those costs on to consumers in this hyper-competitive environment, but to the extent they are, consumers have to foot the bill. However, core inflation in the US remains quite tame, leading the Federal Reserve to maintain its quantitative easing program of purchasing US Treasury bonds (QE2) while giving no indication of concern about runaway inflation. Why?
As we've noted in previous articles, food and energy (commodity) inflation has a much different effect on the economy than wage-based inflation. Commodity inflation tends to act more like a tax on consumers, therefore dragging on economic activity. Core inflation, on which the Fed focuses, is typically a result of higher incomes chasing fewer goods, resulting in higher prices across a spectrum of goods.
Commodity inflation harder to fight
In the second case, the Fed can remove money from the economy, raise interest rates and moderate the pace of price gains. With commodity inflation, it's trickier. In order to bring down commodity prices, the Fed has to engineer a reduction in economic activity. In short, were the Fed to aggressively attack commodity prices, a return to recession would be a very real possibility.
That doesn't mean we're not concerned about rising commodity prices. As mentioned above, they're already causing tensions to escalate in the Middle East, while dampening consumers' ability to expand discretionary spending. And a solution that would be both effective and palatable to the world economies is difficult to envision.
The rise in commodity prices illustrates the balancing act facing central banks around the world. There's legitimate concern that the flood of liquidity following the economic crisis may be fueling another commodity "bubble."
Unfortunately, we've seen how previous bubbles have ended—from technology stocks to housing. Now, central banks face the task of removing liquidity in such a way that drains some air out of the potential bubble while still maintaining reasonably strong economic growth.
When does elevated debt become problematic?
Central bank action—or inaction—can have wide-ranging consequences. The US dollar has been trending lower again on the view that the Fed could be one of the last major central banks to begin raising interest rates, and because the United States has made little headway toward improving its fiscal health. Thus far, debt markets have given the United States a pass, but more austerity will likely be demanded eventually—potentially resulting in higher rates, in direct contrast to what the Fed is trying to engineer.
Japan seems to get away with a high level of government debt and hasn't aggressively tackled austerity. However, Japan's outlook is worse than that of the United States, with debt twice as high and moribund economic growth.
The lack of Japanese austerity plans prompted a credit-ratings downgrade by Standard & Poor's to AA- in January (Japan lost its AAA rating in 2001). However, there was little reaction by Japanese government bonds, stocks or the yen, as a crisis remains further down the road because debt continues to be funded by domestic savers. Despite a debt-to-GDP ratio of more than 200% and a government deficit, Japan remains a nation of surplus—in terms of trade and national savings—as represented by its current account.
Domestic Funding Supports Debt
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Source: FactSet, OECD, as of February 7, 2011.
*Average of Portugal, Spain, Ireland and Italy.
In contrast, weak European nations are reliant on external funding. The recession and subsequent bank losses—as well as a poor outlook of slow growth rates, uncompetitive labor markets and the lack of discrete currencies that would allow member nations' economies to adjust—contributed to the European debt crisis.
European debt crisis on hold?
Talk continues about European policymakers negotiating a "grand bargain" to provide a larger source of bailout funds to potentially reduce debt burdens for weak European nations. Improved sentiment resulted in European stocks and the euro rallying, and banks reduced excess reserves at the European Central Bank (ECB).
Potential solutions include modifications to increase the European Financial Stability Facility (EFSF), as the current 440 billion euro size is limited to lending roughly 250 billion euros in order to maintain a triple-A credit rating. Additionally, there's discussion of using the EFSF to purchase short-term government debt on the open market at current rates and exchanging it for long-term debt at lower rates, reducing debt burdens.
Somewhat discouragingly, an early February meeting of European heads of state resulted only in ideas to pursue closer fiscal unity, without coming to terms on ways to address the current debt situation. Additionally, government bond markets of weaker nations have not participated in the rally. For example, 10-year yields in Portugal are roughly unchanged from January's high levels, and both Portuguese and Irish banks remain reliant on the ECB for funding.
The euro-zone debt crisis remains a "two steps forward, one step back" situation, with progress slow and subject to volatility. Upcoming dates to watch include Ireland's February 25 election and Greece's February 28 quarterly loan disbursement, and European policymakers are aiming for March 25 to reach a broader solution. We're concerned that sentiment has become overly optimistic, with European stocks subject to a "buy the rumor, sell the news" reaction if and when a grand bargain is reached.
UK economy remains at risk
Not all sentiment is bullish as far as consumers in the United Kingdom are concerned. The economy fell 0.5% in the fourth quarter, and while it was "flattish" excluding bad weather, conditions continue to deteriorate.
January ushered in a 2.5% increase in the Value Added Tax (VAT) on UK retail sales for the second straight year. Additionally, real wages are broadly unchanged since 2005—the longest period of stagnation since the 1920s, according to Bank of England's (BoE) Mervyn King.
A recent Financial Services Authority survey showed households have little in way of spare discretionary income after paying for essentials, and credit is declining. Fiscal austerity is also contributing to a subdued outlook.
Despite stagnant growth in the United Kingdom, inflation remains a concern. December's 3.7% rate continues the trend over the past year of exceeding the BoE's 2% target, and the 2011 VAT increase could keep this trend in place. We're concerned an interest-rate hike could further crimp recovery prospects.
Rate hikes needed in emerging markets
In contrast to developed economies, growth in emerging economies has recovered quickly, particularly in Asia. Interest rates remain low, and abundant money due to foreign inflows and high levels of bank lending is resulting in rising inflation rates.
Inflation, particularly in emerging economies, has replaced double-dip concerns in developed economies that dominated 2010. A surge in inflation and clampdown on growth via aggressive rate hikes could slow growth in the developing world, the main source of global growth, posing a risk to the world economy.
Although mentioned above as an issue for the United States, we're more concerned about food-price spikes in emerging economies. This is because food, as a percent of spending, can be roughly twice that in developed economies, and has a better chance of passing through to general prices across the economy.
The combination of weather, a falling US dollar and easy money policies in developed economies may be exacerbating rising food prices. However, fixing supply shortages will take time, and there remains a longer-term secular demand trend.
Emerging Markets Underperforming
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Source: FactSet, MSCI, as of February 7, 2011. *Total Return indexed to 100 = February 6, 2011. A number greater than (less than) one denotes greater outperformance (underperformance) of the Emerging Markets Index relative to the EAFE Index.
We downgraded our view on emerging markets in November. We like the long-term investment case, but emerging-market stocks are likely to remain in a transition period accompanied by higher volatility until food supply shortages are addressed, monetary policy is sorted out and investors get visibility on growth.
Lastly, a note on unrest in the Middle East. Protests and discontent could spread beyond Egypt and Tunisia, as other countries also contend with oppressive governments, high unemployment and accelerating food inflation. The risk to the global economy would come from supply disruptions in oil-producing nations, but the belief is that these countries have resources that could be spent to quell unrest. Thus far, there's been little broader impact outside the region, but the situation is fluid and is a risk we're monitoring.
Important Disclosures
The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
The S&P 500® index is an index of widely traded stocks.
Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.
Past performance is no guarantee of future results.
Investing in sectors may involve a greater degree of risk than investments with broader diversification.
International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Copyright (c) Charles Schwab & Co.
