Worry ... Friend or Foe?
by 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 25, 2011
Key points
- Weather-related issues have made recent economic data a bit murky, but we believe the trend remains quite positive. Stocks never move in a straight line and pullbacks are probable, but we remain bullish.
- Interest rates have moved higher, inflation concerns are growing, debt issues remain and global tensions are heightened. All valid concerns, but in our opinion not enough to derail stocksāalthough they could potentially in the future.
- Violence in the Middle East and North Africa is creating tension in global markets, but there are other concerns for emerging markets as well. Europe is becoming a bifurcated situation, with investors distinguishing between those with debt issues and those without.
The general trend in stocks continues to be higher despite increasing concerns over inflation, debt, global conflict, rising interest rates and oil prices, continued housing and job issues, and a variety of other worries. While some can, and do, use one or several of these issues to paint a gloomy picture, we remain optimistic and believe this growing "wall of worry" will actually help elongate the bull run.
Sentiment is always an issue when attempting to determine where the market may head next, and with a solid run in the marketāthe S&P 500Ā® index is up approximately 11% over the past three monthsāoverly optimistic conditions (a contrary indicator) could be expected. However, with growing concerns that are just enough to make investors doubt the sustainability of the recovery (but not rising to the point of actually derailing economic expansion), sentiment conditions remain relatively benign and have improved following the selling that accompanied increased violence in Libya.
Pullbacks can be expected and can be used if you remain under-allocated to stocks to bolster your positions. Stock investing is a long-term process and should be considered with that view, and you should not overreact to likely near-term volatility.
Despite weather-related fog, economic picture still sunny
Severe winter weather through much of the county, especially along the East Coast, has made some recent economic data a little harder to decipher. The aggregation of recent releases, however, continues to paint a picture of an improving economic environment in the United States.
Manufacturing continues to lead the way as the Empire Manufacturing Index rose to 15.43 from 11.92 (though prices paid rose to a concerning 45.78), while the Philadelphia Fed Survey rose to 35.9, its highest level since January 2004. The Industrial Production reading was relatively flat but was certainly impacted by weather, making it difficult to read too much into the data.
Housing remains stagnant, as housing starts increased 14.6%; however, the majority of that was due to the volatile multi-family units component, while single-family home starts fell 1.0% to the lowest level in 20 months. Building permits, a leading indicator, fell 10.4%, but it's important to remember that December's reading was artificially boosted by builders rushing to get permits before new regulations went into effect in January.
These readings do little to dissuade our view that we continue to bounce along the bottom in housing, and will continue to for some time. Mortgage rates have started to climb, although affordability measures remain historically attractive, foreclosures remain high and external supports are expiring. Despite the dour view on housing, it now only makes up about 2% of US gross domestic product (GDP), down from 6% at its peak, leading us to believe it will have a modest effect on the continued expansion of the US economy.
Rates Rising, But Affordability Remains Attractive
Source: FactSet, National Association of Realtors, Federal Home Loan Mortgage Corporation, as of February 22, 2011.
Further, the jobs picture continues to improve, though not as rapidly as we would hope. We believe the much-publicized government-reported change-in-payroll number (reported the first Friday of each month) is not telling the whole story, and is actually understating the improvement we're seeing in the labor market.
Jobless claims keep heading lower, regional manufacturing surveys continue to report increasing hiring plans, small-business confidence is moving higher, and the unemployment rate (which accompanies the change-in-payroll number but is derived from a different survey) has dropped from 9.8% to 9.0%āstill too high, but moving in the right direction. Labor-market improvement is critical to continuation of the economic expansion, and, by extension, stock-market performance, and we're encouraged by what we're seeing.
Fed sees no inflation problemāright or wrong?
The Federal Reserve keeps pointing to housing and jobs as reasons why it continues to hold short-term interest rates near zero and plans to fully implement its current quantitative easing program. Although the Fed acknowledges increased commodity inflation, it remains unconcerned about that bleeding through to broader inflation, and, in fact, rising oil and other commodity prices tend to act as a drag on economic activity.
According the San Francisco Fed, the output gap (potential output minus projected output) is approximately $1 trillion, and the SF Fed only projects it being cut in half over the next year if we get 4-4.5% growth. With so much projected excess capacity, it's difficult to make an argument that broad-based inflation will take hold in the near future.
While we agree that inflation is unlikely to rise quickly in the near term, we are growing more concerned that the Fed is remaining at "emergency" levels for too long. We certainly aren't in a financial emergency anymore and we're worried that the moves needed to combat growing inflation down the road may need to be harsher than if a gradual normalization process were started now.
Budget problems everywhere
Part of the reason the Fed may be staying ultra-accommodative for longer than we'd like may be the reduction in stimulus at the state and federal levels as government bodies deal with deficit issues throughout the United States. As we've noted before, we don't believe the major concern should be over the possibility of defaults at the state and local levels, or by hitting the debt ceiling at the federal level. Bankruptcy by municipalities is not the attractive option some make it out to be, and the vast majority of states and cities can service their current debt relatively easily. It's the cutting in other spending required that's the tough partāand that's where we believe the greater concern lies.
The "easy" cuts have largely been made, and now governments are forced to look at cutting staff, services and funds for improvements in order to balance their budgets. And with the federal government facing its own deficit issues, stimulus funds coming from Washington are drying up.
While we certainly believe this is a necessary (and long overdue) process, it's also going to take money out of the economy and result in more folks out of work. We're watching developments in Washington and the various states and cities throughout the country to try to gauge how much of an impact these cutbacks will have.
Private-Sector Employment Rebounding
Source: FactSet, US Dept. of Labor, as of February 22, 2011. * Includes federal, state and local employees.
Emerging markets pressured by inflation
In contrast to easy monetary policy in the United States, emerging countries are contending with spiking inflation. This has created concern that central banks may need to quickly tighten policy to catch up and prevent the expectation of rising prices from setting in, which could contribute to an emerging-market stock sell-off.
Food price increases garner headlines but are simply one symptom of economic recovery in emerging markets. The main thrust of rising prices comes from economic growth that's in an expansion phase. Emerging-market economies are well above 2008 levels, unemployment is falling, and wages are rising, all propelling consumer spending on a variety of goods and services.
Emerging World Fully Recovered, Developed Hasn't
Source: FactSet, as of February 23, 2011. * Equal-weighted average of China, South Korea,
Brazil and India. Indexed to 100 = March 30, 2001. ** Equal-weighted average of United
States, Germany, France, United Kingdom, Italy, Japan and Canada. Indexed to 100 = March 30, 2001.
Meanwhile, most emerging-market interest rates remain stimulative, providing strong returns for businesses borrowing at low rates and participating in economies growing well above lending rates. Foreign investors seeking higher expected returns further stimulate emerging-market economies with their capital inflows. As a result, emerging-market central banks feel the need to clamp down on growth by raising rates. Raising rates while consumers are also being squeezed by higher prices for foodāa large outlay for many consumers in emerging nationsācould result in a drop in economic activity.
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.
Middle East and North Africa wildcard
Unrest in the Middle East and North Africa (MENA) poses a risk to the global economy to the extent there are oil-supply disruptions, with Algeria, Iran, Iraq, Kuwait, Libya, Qatar, the United Arab Emirates and Saudi Arabia among the top 20 oil-producing nations. Given that Saudi Arabia is the largest producer and controls the most excess capacity, its future is likely the determinant of whether regional instability transforms into a major global crisis.
We doubt any prognosticator that claims to know the final outcome from geopolitical unrest. Outside of large-scale conflicts, the most likely scenario is that supply disruptions would be short in nature due to excess capacity by Saudi Arabia and others, and due to the importance of oil income to economies possessing the natural resource. Minor supply disruptions result in little change to our longer-term economic outlook, but the rise in uncertainty from oil supply disruptions provides a good "excuse" for profit-taking by investors after a strong run in developed-country stocks since August.
China's growth set to slow, but instability unlikely
Some have postured that MENA protests could spread to China and create instability. However, a key distinguishing factor is that Chinese citizens have benefitted from rapid economic growth, with incomes having risen 10-20% per year during the past decade.
That said, strong economic performance and a slowdown in the growth of the workforce have resulted in tight labor markets, allowing individuals to ask for pay raises. Protests in China are generally tied to specific issues such as wages and are less likely to be connected with a desire to oust the government.
Despite rising wages, the labor cost per unit of goods produced in China since 2005 has been relatively flat according to the World Bank, due to gains in productivity, and the price of goods imported from China have trended down over time.
Prices of Goods From China Have Declined
Source: FactSet, Bloomberg, as of February 22, 2011.
However, China's disinflationary influence on global prices could be waning, as continued strong growth has resulted in building inflationary pressure.
Inflation pressure in China, combined with measures to tighten lending standards and reduce speculative investment, could be beginning to bite, as all three independent versions of China's leading economic indicator declined in concert for the first time in December.
Global growth would be at risk if Chinese credit creation slows too much, particularly for loans to local governments directed toward infrastructure spending. Lack of transparency by Chinese banks makes measuring their health difficult, but low rates of non-performing loans and high levels of government reserves at the national level could suggest a low risk of a debt crisis at this time.
Spotlight on European debt returns in March
The European debt crisis remains, and despite hopes of progress toward a "grand bargain" solution to address the problems of weaker European countries, politics, views of unequal burdens and cultural differences toward spending continue to complicate matters as has European Central Bank (ECB) leadership uncertainty.
As such, Portuguese 10-year government bond yields have continued to trade above 7%, the level that ultimately resulted in bailouts for Greece and Ireland. When including the impact of inflation, Portugal's expected nominal growth of just more than 3% while interest rates are greater than 7% means the economy can't grow out of its debt, as its debt-to-GDP ratio continues to riseāan unsustainable situation.
Meanwhile, Portugal has a large amount of debt maturing from March to June, creating pressure on European policymakers to complete a comprehensive solution that strengthens the initial European Financial Stability Facility to address near-term problems, whereas the European Stability Mechanism begins in 2013. Policymakers have the self-imposed deadline of a March 24-25 summit, with weekly meetings scheduled in March.
There are positive signs investors are delineating between the strong and weak in Europe, instead of lumping all players together. Despite increased reliance on the ECB for funding by Portuguese, Irish and Greek banks, Spanish banks' reliance on the ECB is at the lowest level in two years and Spanish 10-year government yields have declined since the start of the year.
Additionally, strong reception for Credit Suisse's contingent convertible bond issue, (which had demand of $22 billion despite its $2 billion offer size) is a good signal that markets are willing to grant capital, enabling banks to strengthen their balance sheets.
We remain skeptical the euro-zone as a whole can outperform over the intermediate term, and strong relative performance by European stocks this year could result in a "sell the news" reaction upon the announcement of a "grand bargain."
Important Disclosures
The MSCI EAFEĀ® 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 500Ā® 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.
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