Volatility on the Rise
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
March 11, 2011
- Geopolitical unrest and rising inflation concerns have conspired to increase market volatility. We remain bullish on US stocks and believe that this recent increase in consternation will ultimately be healthy for stocks.
- The US government keeps kicking the debt can down the road, while the Fed seems unconcerned about inflation and is intent on completing QE2. We believe changes are needed at both entities to foster sustainable economic growth.
- The European debt crisis is bubbling up again, while the ECB is talking interest-rate hikes. Future growth depends on the path of both issues.
Stock-market volatility is rising alongside Middle East tension and the corresponding rise in oil prices. Stocks have been moving inversely to oil as concerns have risen that elevated prices could short-circuit the global economic expansion.
But that correlation has broken down over the past several days as oil prices and stock indices have retreated. In fact, with the recent selling in stocks, the Dow, S&P 500 and Nasdaq all moved below their 50-day moving averages—viewed as a relatively important technical indicator. Once this line of support is broken, the possibility certainly exists for more short-term weakness; however, we don't believe this marks the start of return to a bear market, but rather a much-needed correction.
Additional uncertainty was thrust into the market following the tragic earthquake and tsunami in Japan. It's still far too early to accurately assess the full economic impact, but we'll be watching how various factories, and especially ports, in the export-dependent country are able to function in the coming weeks.
Fortunately, much of Japan, and especially Tokyo, was built to withstand earthquakes, which has helped limit some of the damage that might otherwise have occurred. However, with already massive deficit problems and interest rates near zero, there could be challenges in the rebuilding effort that could further strain the Japanese economy. At this point, we don't believe the global impact will be substantial, but we'll continue to follow the situation closely.
We've written extensively about the impact rising oil prices may have on economic growth. In light of much-healthier underlying economic conditions that exist today compared to how things were during the last big spike in 2008, the impact will likely be relatively small. But of course we can't rule out civic unrest spreading to additional oil-intensive nations, which would put further upward pressure on oil prices.
We've noted for several weeks that the stock market was overbought on elevated optimistic sentiment (which often precedes market pullbacks). So at this point we believe recent volatility has been good for longer-term market health—restoring a measure of skepticism among investors. Remember, the market likes to climb a "wall of worry."
According to Bloomberg Business Week, between July 2, 2010 and February 15 of this year, the S&P 500 rose 30%, but fell 1% or more on only 13 days during that stretch. There hasn't been a stretch of calm like that since 1971.
History provides some insight into what we might expect after such a stretch. Again according to Bloomberg Business Week, when 30-day volatility falls below 10 and stays there for at least three days as it did recently, the S&P 500 gain the following month has been an average of 0.3%—about half the average monthly gain.
However, looking at the year following such depressed volatility, the S&P 500 has gained 9.2%, versus the 7.4% yearly average. While we caution against putting too much importance in any one statistic, we're encouraged that history shows positive market tendencies and we remain optimistic on the stock market being able to resume its upward trend after this corrective phase.
Economy continues to flash green
The latest economic releases reinforce our view that US expansion continues at a relatively healthy pace. Manufacturing is leading the way, with the Chicago Purchasing Managers' Index rising to 71.2 in February, the highest reading since July 1988. Meanwhile, the national Institute for Supply Management's (ISM) survey of manufacturers rose to 61.4, its highest level since May 2004. And the service side of the economy is catching up as the non-manufacturing ISM survey rose to a robust 59.7.
The fly in the ointment of recovery remains the relatively weak jobs picture, though the latest report was a strong one. The more-comprehensive household survey (from which the unemployment rate is calculated and which captures more small businesses) showed the unemployment rate dipped to 8.9% last month and 2.3 million more people are employed versus the low of 14 months ago.
The larger company-focused payroll report showed an increase of 192,000 jobs—still lower than we'd like to see, but well up from the recent trend. Netting out the loss of public-sector jobs, private-sector growth was a gain of 222,000 jobs. Other leading indicators of job growth are up sharply, including NABE's survey of small businesses and their hiring plans, finally showing increasing confidence among the all-important small business sector.
Small Businesses Starting to Hire
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Source: FactSet, National Association of Business Economics, as of March 7, 2011.
Additionally, the employment component of the aforementioned ISM Manufacturing Index rose to a 38-year high, while the same component of the Non-Manufacturing Index rose to its highest level since April of 2006. Finally, initial jobless claims recently saw the four-week moving average break below 400,000 for the first time since July 2008—just before the financial crisis. We believe this paints a positive picture for employment for the remainder of 2011.
Fed and Feds remain stubborn
Partly due to the improvement in the labor market and the health of the economic expansion, we continue to believe the Federal Reserve should begin reining in its extremely accommodative policies. The fed funds rate was effectively set at zero during the height of the financial crisis, in order to combat an "emergency" situation. We're well past that emergency now and we believe the time has come to slowly remove the training wheels from the economy and return to a more normal monetary policy.
However, during recent Congressional testimony, Fed Chairman Ben Bernanke gave no indication normalization was anywhere on the Fed's radar—pointing to continued sluggishness in employment as a primary reason. The Fed also seems intent on completing the full $600 billion second-round quantitative easing (QE2) program, despite the recent flow of positive economic data.
The dangers of staying at the well too long are primarily two-fold in our mind. First, though core inflation remains quite tame and slack remains in the economy, with all of the money sloshing around the marketplace, a quick rise in inflation is not out of the question—possibly forcing the Fed to react quickly and strongly, which could damage the economy. Second, by not normalizing policy, another unforeseen shock to the system would leave the Fed with few bullets to fight with.
The federal government continues to spar over the 2011 budget and how much to cut. Congress was forced to pass a two-week extension of its deadline to pass a budget due to the impasse, but it did include $2 billion in cuts—at least a small step in the right direction. But we continue to believe the current spending pattern is unsustainable and bond markets may very well start to punish the United States with rising yields if more serious action isn't taken to address the situation.
Gap Needs to Close Rapidly
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Source: FactSet, Congressional Budget Office, as of March 7, 2011.
* Projected numbers under President Barack Obama's proposed budget.
Finally, as interesting as the federal fireworks have been, they've paled in comparison to jousting going on at the state level. States can't run deficits, and thus there's much more urgency for them to cut spending. Agreeing on how to do that, however, isn't an easy task, though it's certain cuts made at the state level will have an impact on communities throughout the country. Much of the "easy" cutting has been done, and we're watching closely to see how future cuts may impact the economic expansion.
European debt consternation remains
In contrast to the United States, which keeps kicking the can down the road, Europe has been forced to face its debt troubles now, with headlines likely to heat up in coming weeks. Despite beginning talks two months ago regarding an expansion of the European Financial Stability Facility (EFSF) to rescue weaker European nations, policymakers don't seem any closer to agreement. Continued delay has only exacerbated the crisis of confidence regarding longer-term solvency of weak nations, as well as the ability of the EFSF to address potential future bailouts.
The problem is that the EFSF only addresses short-term liquidity needs, but even Greece's "bailout" results in the debt-to-GDP ratio rising to unsustainable levels, keeping insolvency on the table, which could likely result in a future debt restructuring. As an illustration of the lack of relief provided by the EFSF, both Greek and Irish government bond yields continue experience upward pressure, despite "bailouts."
Continued European Debt Anxiety
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Source: FactSet, iBoxx, as of March 8, 2011.
The confidence crisis has rolled to Portugal, aided by country-specific issues such as insufficient improvement on fiscal targets, political uncertainty and upcoming government debt maturities. As banks and sovereigns tend to be closely connected, low confidence has resulted in funding problems for Portuguese banks.
A bailout for Portugal can't be ruled out, because 10-year government yields have been trading above the 7% level—a level the Portuguese government has labeled as unsustainable—since February 4. This despite denying the need for bailout. Interest rates at 7%, while nominal growth is expected to be around 3%, means Portugal cannot grow out of its debt problem and debt-to-GDP continues to rise.
European policymakers are meeting weekly this month ahead of a self-imposed deadline for resolution at a March 24-25 summit. We believe the most likely result will be little change to the EFSF, continuing to only address liquidity but not solvency. Any support for easing terms in Greece and Ireland are likely to come with conditions such as debt limits (a debt brake) and a broad agreement to pursue reforms, without specific policies or targets.
Because bank problems have been at the root of debt issues for many sovereigns, investors desire a better read on euro-zone banks' health. Last year's stress test was discredited after Irish banks needed subsequent bailouts, and hopes for a more-rigorous test this year may fall short. Indications are that this year's test will repeat failures from last year, such as not accounting for the possibility of government defaults and allowing country-specific (and therefore inconsistent) definitions of capital ratios.
Lastly, hawkish talk by the European Central Bank (ECB), which indicated a potential rate hike in April, is adding pressure. The possibility of a rate hike has raised the effective rate at which countries tap the EFSF, and could further hamper still-fragile economic growth in much of the euro-zone, which faces the headwind of tough fiscal austerity measures. We believe strong relative performance by European stocks this year could reverse as a result of a disappointing EFSF resolution and renewed European growth concerns.
Europe the main source of current US dollar decline
Investors wondering why the dollar hasn't received support from unrest in the Middle East have several issues to consider.
There are always many factors that influence exchange rates. The biggest factor for the recent decline is differences in monetary policy between the United States and the ECB. The ECB has a sole mandate of fighting inflation, and despite little increase in core euro-zone inflation, the headline rate is above the 2% target. This has led ECB President Jean-Claude Trichet to indicate a possible rate hike in April, while the US Fed is intent on maintaining easy policy. The result is that the difference in interest rates grows, attracting traders to the euro in anticipation of higher relative yields.
Meanwhile, Middle East unrest has not brought safe-haven demand for the dollar because the United States is the world's largest net oil importer and consumer. Differences in central bank mandates result in the Fed likely viewing an oil spike as a risk to growth, and thus reason to continue easy policy, while the ECB may see generalized inflation as the bigger risk. In the short term, the US dollar could experience some renewed support if European policymakers fail to deliver a sufficient solution to deal with government debt and/or growth in Europe slips.
However, the longer-term trend for the US dollar may be continued decline and debate over its status as a reserve currency, which has started to heat up again. Declining dollar exposure by China has added to concern, but China is simply prudently diversifying. China's large exposure to the dollar in 2003 of more than 80% was reduced to less than 50% in 2010.
Currencies are a relative trade, and if you're negative on the dollar, you must be positive on another currency. Right now there's no credible alternative to the dollar in terms of a large, liquid market, backed by the relative stability of the US Treasury, but over the much longer term we could see a move to multiple reserve currencies, where goods are traded in euros, dollars and Chinese yuan.
Chinese stocks anticipate growth slowdown
When Chinese tightening broadened to include rate hikes in late October, concerns arose about a "hard landing," when growth slows too much. This resulted in both Chinese and emerging-market (EM) stocks underperforming developed markets, due to China's importance to the EM universe and similar issues with growth and inflation facing many EM nations.
While interest rates remain accommodative in China, money supply—another measure of financial conditions—indicates tightness. A decline in China's leading indicators and decelerating purchasing manager indexes indicate China's growth could be slowing. With money-supply growth back to historical averages, the majority of stock-market underperformance may be complete, but renewed outperformance will require more convincing evidence of slowing growth and moderating inflation.
Chinese Stocks Tend to Follow Money Supply
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Source: FactSet, People's Bank of China, Shanghai Stock Exchange, as of March 8, 2011.
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