Above the Fray
by Liz Ann Sonders , Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
and 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
April 1, 2011
Key points
- Attacks on Libya and ongoing recovery efforts in Japan have dominated the headlines, but behind the scenes US economic growth remains solid and we remain optimistic on the stock market.
- Commodity prices have backed off a bit and the Fed is likely to see QE2 through to its June 2011 end. Of particular concern is the unwillingness or inability for Congress to agree on a budget that addresses the growing deficit issues in the US.
- Japan has a significant debt burden with which to deal as it rebuilds, while Europe is struggling to come up with a comprehensive plan to deal with the eurozone debt crisis.
Investing can be frustrating and confusing when the world looks as it does today. Ongoing conflicts in the Middle East and Northern Africa (MENA), including a US-led attack on Libya, and the continuing post-earthquake developments in Japan have dominated headlines. How should an investor respond? As you might expect, we believe itâs important to stay focused on your long-term investing goals and remember that stock market investing is not a short-term endeavor for most investors. The question is: do these events warrant a change to your current investment strategy?
While we are watching the MENA area carefully and would likely change our outlook if the violence spread to Saudi Arabia, the affect on financial markets of the current situation seems relatively limited in scope. Libyaâs oil production is likely offline for the foreseeable future, but according to Reuters, it is only the 17th largest oil-producing nation in the world, with about 1.6 million barrels of production per day. While that may sound like a lot, Saudi Arabia has said they can easily ramp up their production to make up for the shortfall, likely within a couple of months. So while the risks have risen, as reflected in the price of oil, and the cushion should another disruption come along has been lessened, the oil market remains relatively stable for now.
For now, the events in Japan are more serious, although nuclear meltdown fears have subsided. There are still uncertainties as to the scale of the rebuilding efforts, but current rough estimates peg the number at around $300 billion, which will likely be financed internally. As far as the global economic effect, Japanâs economy only represents about 9% of global gross domestic product (GDP), and estimates currently put the affect on global growth at around a 0.5% reduction in 2011.
Markets have recovered from disasters
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Source: FactSet, Standard & Poor's. As of Mar. 24, 2011.
CorrectionâŠbut data doesnât indicate something worse
The stock market had a much-anticipated correction just following Japanâs earthquake. We noted in the last issue that after a historically long period of low volatility, a steady upward trend and elevated optimistic sentiment, the market was overdue for a pullback. However, we donât believe this pullback is the start of a new trend, rather more likely a temporary cleansing to correct overly exuberant sentiment conditions and allows the market to ultimately move higher, notwithstanding a greater degree of volatility.
Large parts of the US economy continue to show signs of strength. Manufacturing continues to lead the way with regional surveys posting robust readings. The Philly Fed Survey rose to its highest level since January 1984, while the Empire Manufacturing Survey moved to a very strong 17.50 reading. Both of these readings were confirmed on a national level by the 61.2 reading of the ISM Manufacturing Index.
Additionally, the Index of Leading Economic Indicators posted its eighth-consecutive monthly gain at 0.8%. And while not as rapid as we would like, the labor market continues to improve and we believe is picking up speed, which will likely be key to Fed policy and market performance in the second half of the year. The four-week moving average of jobless claims, which is a leading indicator for labor, has moved solidly below the critical 400,000 level, while many of the employment sub-indicators in business surveys indicate a greater willingness to hire. This increasing strength was bolstered by the March labor report, which showed the unemployment rate decreased to 8.8%, the lowest level since March 2009, while the economy added 216,000 jobs.
Fed holds the line-but for too long?
The Federal Reserve, at its most recent meeting on March 15, noted an improving labor market, although it couched the improvement as "gradual." The Fed continues to focus on the slow pace of labor improvement and is maintaining record low interest rates and its current bond buying program known as QE2. The danger of course is that inflation or inflation expectations start to heat up, which would then force the Fedâs hand to tighten more quickly than most market pundits are now expecting. Recent inflation readings sow the seeds for concern but core measures remain benign. The Producer Price Index (PPI) rose 1.6%, which was the largest headline gain since June 2009, but the core Consumer Price Index (CPI) only moved 0.2% higher.
We donât believe that inflation is currently a big concern with minimal wage pressures and low labor costs. But with the economy continuing to be flooded with money, an increase in the velocity of money - the rate that money moves through the economy - would elevate inflation risk and may force the Fed to get ahead of that curve.
Housing remains gloomy
Unfortunately, despite the efforts of the Fed and the federal government, housing appears to be sliding again, although weather-related problems may be skewing the numbers to the weak side. Regardless, we canât ignore existing home sales dropping 9.6% and prices falling to their lowest level since April of 2002. Additionally, building permits fell to their lowest level in over 40 years, while new home sales fell 16.9% to a record low.
That said, while housing is important, its influence on the economy has lessened substantially, falling from over 6% of GDP at the bubble peak to about 2% presently. Also, housing affordability remains at a record high, job growth should help support demand, and the Conference Boardâs recent survey showed consumersâ plans to buy a home spiked to levels not seen in over a decade. There are also pockets of strength in the housing numbers and we believe we need to analyze housing at a local/regional level, not just nationally.
Housing situation still difficult
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Source: FactSet. Nat'l Assoc. of Realtors. As of Mar. 24, 2011.
Squabbling in Washington continues
Time is running out for Congress and the President to agree on a 2011 budget and/or to pass another extension of the temporary budget to avoid a government shutdown. At issue is how to address the massive deficit the current budget continues to accrue. The level of spending cuts, and tax increases, continues to be hotly debated.
Frankly, the government is going to have to âpay the piperâ eventually. Running deficits at the current level is untenable as global lenders will be likely to demand higher interest rates in order to finance our debt. With state and local spending already being slashed across the country, we are watching the results of these budget debates carefully. While massive reform across a variety of programs is needed, including entitlements, we doubt it will occur this time around. But sharp cuts in discretionary spending could have an effect on the economy, something weâll be analyzing if and when a budget deal gets done.
Japan also postponing debt reduction
Like in the United States, lack of fiscal responsibility in Japan has resulted in a growing mountain of debt, at over 220% of GDP. The recent earthquake and tsunami disaster will add to Japanâs debt, with rebuilding now estimated at over $300 billion by the Japanese government. The costs of funding this investment will likely weigh on both consumers and corporations, in the form of proposals to raise the sales tax and postpone a corporate tax cut.
Some have questioned whether the Japanese government would sell US Treasuries to fund rebuilding, but $300 billion is only 2.1% of the overall $14 trillion in US Treasuries outstanding, and Japanâs $886 billion in Treasuries is only a portion of its $6 trillion in total assets. While asset sales could occur, we believe the majority of rebuilding funding will likely come from new bond sales, typically purchased by domestic savers, and possibly the Bank of Japan.
We caution investors who are looking to invest in Japan as a result of the disaster. The beneficiaries of rebuilding are likely to be the same companies who are involved in infrastructure build-outs in China, Brazil and elsewhere around the globe, and not necessarily Japanese companies. Meanwhile, Japanese consumers will be pinched as they fund recovery and reconstruct lost wealth, and businesses could be affected by continued power supply issues.
Excess government debt the developed worldâs thorn
Outside of the United States and Japan, many developed countries need to reduce sovereign debt. In the eurozone, rounds of debt crisis flare-ups have occurred as confidence in policymakersâ willpower to address the problem has fluctuated. Promises of a more aggressive and proactive crisis solution were raised at the beginning of 2011, with a March 25 delivery date for a "grand bargain."
However, political wrangling due to economic and cultural differences, and lack of voter support for bailing out other nationsâ problems, resulted in lack of a definitive deal.
While some aspects of a permanent European Stability Mechanism (ESM) that begins in mid-2013 were sketched out, details were pushed out until June of this year. Meanwhile, there was no expansion in the ability of the 440 billion euro European Financial Stability Facility (EFSF) to provide more than the 250 billion euros that the facility is able to lend in order to maintain its triple-A credit rating.
Regardless, both the near-term EFSF and longer-term ESM only address liquidity needs, and fail to change the risk of insolvency. Even under the revised terms for Greece, which received a lower rate and extended maturity, Standard & Poorâs is expecting that its debt-to-GDP rises to 160%. Continuing to run fiscal deficits and borrow money at rates in excess of economic growth means Greece cannot grow out of its debt problemsâthis is no bailout. As a result, the yield on three-year Greek government bonds, those due when the EFSF ends, has reached 17%. Greece, as well as Ireland, will likely need debt restructuring in order to return to a path of solvency.
Portugal likely needs assistance as well, as market yields on Portuguese 10-year government bonds have remained above the 7% level viewed as unsustainable by the government. Risks have come to a head as austerity measures were voted down, causing the resignation of the Prime Minister, and leading up to funding needs, first on April 15, and again on June 15.
Market separating European nations
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Source: FactSet, iBoxx, as of April 1, 2011.
The good news, if any, is that Spainâs debt woes may be easing. Spain has made progress by implementing austerity measures including labor reform and reducing the fiscal deficit, and is addressing its bank problems. If Spain avoids a bailout, the current size of the EFSF may be large enough to address needs of weaker countries, potentially staving off systemic risk - where one large failure could result in problems throughout the European banking system.
Growth in Europe and the UK threatened
While systemic risk to the European banking system has eased, European banks remain hampered in their ability to extend credit, the lifeblood of economic growth. Banks holding government debt of troubled nations could experience write-downs and likely need to raise capital. In the United Kingdom, public outcry over bank bailouts has resulted in proposals of higher capital requirements, restrictions on business lines, and limits on pay in excess of those imposed on US banks.
Additionally, support from central banks in terms of easy monetary policy is waning, with a possible European Central Bank (ECB) rate hike in April, and concerns over inflation in the United Kingdom causing division within the Bank of England. Lastly, fiscal austerity will continue to weigh on growth and employment. We remain concerned about the ability for the UK and the eurozone economies to grow in the face of these headwinds.
While European shares may seem attractively valued, outside of companies with high exposure to growth coming from the United States and emerging world, we remain suspect of the ability for European stocks in general to outperform.
Monetary policy dominating currency moves
Despite European debt woes, the euro has strengthened versus the US dollar recently, primarily due to differences in monetary policy between the United States and the European Central Bank (ECB). The ECB has a sole mandate of fighting inflation and has indicated a rate hike in April. Meanwhile, the US Fed remains hamstrung by high employment, the second half of its dual mandate. The result is growing interest rate differentials, attracting traders to the euro.
Central bank differences impacting US dollar
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Source: FactSet, Bloomberg, Federal Reserve, as of March 30, 2011.
However, the US dollar could bounce short-term if the ECB fails to hike in April or if strong US growth brings questions of an early exit from QE2 or rate hikes being pulled forward. Read more on currency in our Q&A and weak dollar articles.
China a leading indicator
China is the primary contributor to global growth, and its economy and stock market tend to lead economic trends worldwide. While Chinese economic growth is still strong and more tightening measures are likely, it is possible that inflation could be peaking along with the prices of agricultural commodities, which could slow the sharp pace of tightening and reduce the threat of a hard landing. This could lead to outperformance by Chinese stocks, a prelude to continued global growth.
Visit www.schwab.com/oninternational more international perspective.
Important Disclosures
The MSCI EAFEÂź 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 500Âź 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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