Making Sense of a Mixed Bag
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
April 29,Ā 2011
Key points
- Earnings season is winding down and is largely positive and CEO confidence is high. We believe this points toward a continued improving labor outlook but could mean more grinding in the stock market. Housing remains moribund but the market seems to be largely dismissive.
- A ratings warning on US debt rattled the stock market but bond markets were relatively unmoved. Issues certainly need to be addressed, but they are more likely to affect money flowing into the economy and highly unlikely to result in failure to pay obligations. Meanwhile, the Fed is striving to communicate more effectivelyābut what are they communicating?
- Japan's problems in the aftermath of the natural disaster seem to be expanding, while Europe is trying to hold together its coalition. Meanwhile, China is trying to engineer slower, but still solid growth.
Market fireworks have increased as weāve seen some triple-digit Dow moves, both up and down, but what does the future hold? We remain relatively optimistic on the stock market going forward, although as the economic recovery matures the gains could be more of a grind.
That maturing was illustrated by the 1Q GDP report, which showed a deceleration of growth to a 1.8% annualized rate from the 3.1% rate seen in the previous quarter. Additionally, personal consumption, an important component of economic growth in the US, fell to 2.7% from 4.0%. Part of the fall in the growth rate of the economy was due to a reduction in government spending, at both the state and Federal levels, resulting in a 1.1 percentage point drop in growth. We expect government spending changes to continue to drag on the growth numbers, but donāt think thatās necessarily a bad thing, while overall growth should rebound at least somewhat in coming quarters as the economic outlook remains relatively solid at this point.
On the corporate side, earnings season is now winding down, and it has largely been a positive one, helping to propel the market higher. Many companies boosted guidance, raised dividends, and projected optimism about the coming quarters, which helps support our belief that the economic expansion is now self-sustaining. In fact, a recent survey by Ned Davis Research showed that CEO confidence is at a level not seen since the second quarter of 2004, and debt markets are reinforcing that confidence among investors with near-record low yields on junk bonds.
Junk bond yields indicate confidence
Source: FactSet, Federal Reserve, Moody's. As of Apr. 26, 2011.
* equals high yield bond yield less 10-yr Treasury yield.
We believe this increased confidence will aid the labor market, but stock market performance following peaks in confidence has been a mixed bagāreinforcing our view that gains may be more challenging to come by over the next year than they have over the last.
Economy on Solid Footing, but Improvements are Moderating
We are now seeing what is expected as an economic expansion becomes more mature. Rapid gains seen at the beginning of a recovery, especially after the severe recession we had, cannot be sustained indefinitely. Likewise, the sharp gains in the stock market are unlikely to persist. However, recent economic data continues to point to solid growth. The Index of Leading Economic Indicators rose 0.4% in March, marking the ninth-straight monthly increase, while manufacturing surveys pointed to continued strong growth, with the Empire Manufacturing Index rising and the Philadelphia Fed Index remaining in solid positive territory at 18.5, although that was a marked retracement from its previous monthās 27-year high. Additionally, industrial production rose 0.8% and capacity utilization rose.
Itās still a bit of a mixed bag as housing remains mired in uncertainty. Recent housing data painted a slightly better picture, with housing starts rising 7.2%, building permits (a leading indicator) gaining 11.2%, and existing home sales advancing 3.7%. These improvements should be taken with a grain of salt, however, as the first two months of the year saw numbers that were near record-lows in some cases. Additionally, we saw existing home prices fall again, indicating we may not have put in a firm bottom. We have noted before that this is likely to be a multiyear process to work through the existing home inventory on the market now and the foreclosures that are still coming down the pipe. However, the stock market seems largely unfazed by the continued weakness as it appears to be discounted and housing now makes up much less of the American economy than it did during the height of the housing boom.
And while housing affordability remains near record highs, it will likely take continued improvement in the labor market to start to see sustained recovery in housing. We are becoming more optimistic that we will see a rapidly increasing rate of job recovery as we move through the year. As mentioned above, CEO confidence is at multi-year highs, which should translate into more willingness to hire. Additionally, although weāve seen a couple of weekly readings of initial claims (another leading indicator) above the 400,000 level, we believe its more of a statistical quirk than the start of a new trend as continuing claims fell again. Also, a seldom mentioned, but nonetheless interesting job indicator with the acronym of JOLTS (Job Opening and Labor Turnover Survey) showed job openings jumped to 3.1 million at the end of February from 2.7 million the previous month and up 46% from the low seen in July 2009.
Fed enters a new era of communication
The improvement in the labor market and continued economic growth should enable the Federal Reserve to return to a more normal monetary policy, but at their most recent meeting and subsequent first-ever press conference by Chairman Bernanke they indicated they were in no hurry to do so. Despite rising headline inflation, with the Consumer Price Index (CPI) moving up 0.5% in March, core inflation remains relatively contained with a gain of only 0.1%. More importantly to the Fed, capacity utilization remains three percentage points below the 1972-2010 average, indicating continued slack in the economy; while wage growth, which is what they believe is really needed to have sustainable inflation remains nonexistent.
Wage growth shows no signs of inflation
Source: FactSet, U.S. Dept. of Labor. As of Apr. 26, 2011.
For these reasons, we agree that a near-term spike in inflation is unlikely, but remain concerned that it could flare up eventually if lending growth picks up and the Fed remains too accommodative. The Fed indicated its second round of quantitative easing (QE2) will end as scheduled, but it appears likely they will continue to hold those purchased assets on their balance sheet, indicating a continued slow approach to normalcy. We believe they may have to pick up the pace as economic improvement takes hold and other central banks around the world tighten, to the continued detriment of the dollar.
Government faces problems, but default is not one of them
Like many other countries, the US government continues to face deficit and debt problems. This was highlighted again recently by the negative outlook on US debt by StandardĀ & Poors (S&P). According to the ratings agency, this means that there is a one-in-three chance that the AAA rating of US debt would be downgraded in the next two years. We believe this was little more than a grandstanding political move. We certainly agree that changes need to occur, but the likelihood of the United States defaulting on its debt is as close to nonexistent as you can getāand the reaction of the debt market following the S&P decision reinforces that notion.
Indeed, structural changes have to be made in all areas of spending, including Medicare, Medicaid, and Social Security. Proposals have been made but the outcome of this yearās budgetary process is still far from certain given that Congress just finished last yearās budget. We will be watching the process closely but urge investors not to get too caught up in the inevitable hype. Stories of the debt ceiling not being raised will increase as we get closer to hitting it, and it is highly possible that the Treasury Department will have to use some accounting tricks to extend the deadline. But we believe the deal to raise the ceiling will get done before any real economic consequences are realizedāso stay calm.
Japan outlook lowered
The situation in Japan is not quite as sanguine. Japan joins the United States as the two major economies with expanding deficits in 2011, and even before the quake and tsunami in Japan, ratings agencies were uncomfortable with Japanās outlook given lack of fiscal restraint and political gridlock. Since the disaster, lack of decisive Japanese government action and continued delays in restoring power has resulted in continuous downward revisions to growth. Adding to the lower growth, individuals have exhibited spending restraint.
Meanwhile rebuilding estimates continue to rise, and just two months after downgrading the rating, S&P lowered Japanās outlook to negative at the end of April, due to the likelihood that disaster costs would raise the countryās debt load. S&P said that while 30 trillion yen ($366 billion) was its base case estimate of rebuilding, costs could rise to as much as 50 trillion yen ($611 billion).
Rebuilding, when it eventually happens, is likely to give a short-term boost to the economy, but is unlikely to generate sustained growth, as it merely replaces structuresānot generate new productive sources of growth. We remain neutral on Japanese equities, viewing the upside and downside as roughly balanced, while believing better opportunities exist elsewhere.
Euro-zone sovereign debt problem will be an ongoing issue
"Bailouts" for Greece and Ireland, and any bailout negotiated for Portugal, have only helped nations meet current obligations by providing near-term "liquidity" capital. However, longer-term solvency is still in question, as weak growth prospects, deficit spending and high (and increasing) interest costs due to elevated debt levels results in continued rising debt burdens.
Meanwhile, political resistance to further bailouts for these weak peripheral eurozone nations continues to rise. Germany's Merkel Christian Democrats party continues to lose ground in the polls and the German parliament has postponed a vote on the longer term European Stabilization Mechanism (ESM) plan to the autumn. Additionally, distaste for the euro as a whole was demonstrated by a jump in voters supporting the True Finns party in Finland, which may become part of a coalition government. The True Finns will likely demand strong fiscal discipline plans from any nation requesting bailout funds.
Despite continued missed fiscal targets from Greece and Portugal, and the possibility of a Greek or Irish debt restructuring, as well as continued flailing by eurozone politicians, we are encouraged that Spain still appears likely to avoid a bailout. As such, current programs are likely sufficient to meet short-term needs of weak nations, keeping contagion contained. However, we believe European banks need to continue to raise capital to cover any losses on sovereign debt, which is typically not marked-to-market and does not have provisions for losses.
European profits have been strong, but growth could slow
Despite the continued debt crisis, the beginning of the European earnings season has been positive, with good reports from a wide range of consumer goods, technology and automotive companies. However, weāre concerned about downside risks to forward earnings estimates due to the European Central Bank (ECB) beginning to hike rates, and the resultant impact on the euro (likely continued strengthening), while fiscal austerity measures are set to increase in size.
The ECB sets rates for the whole of the eurozone, much like the Fed sets rates for the entire United States. Despite debt woes in the peripheral countries, overall eurozone inflation has continued to surprise to the upside. The ECB views headline inflation when making policy decisions, but it is clear from the chart below that even examining inflation ex-food and energy, the core Consumer Price Index (CPI) has been surprising to the upside in the eurozone; the opposite of the experience in the United States over the past year.
Eurozone inflation surprises to upside
Source: FactSet, Bloomberg. As of Apr. 27, 2011.
The ECB is focused on keeping inflation expectations in check, as they can become a precursor to inflation in the future. If inflation expectations begin rising, it can be difficult to get back under control, and policy tightening may need to be more aggressive in response.
Wages tend to be a key factor for inflation to take hold in developed economies, as they affect all sectors and tend to be the largest input cost for most companies. Labor unions have a large influence in Europe, and if inflation expectations set in, workers could begin to demand higher wages. Companies would then increase prices to cover the higher costs, in what the ECB terms "second-round effects." The concern is that this could take effect in Germany, the eurozoneās largest economy at 27% of eurozone GDP, where unemployment is at a record post-reunification low.
We are concerned that a series of rate hikes may damage export prospects, due in part to the possibility it could raise the value of the euro. Morgan Stanley notes that Germany and Finland tend to be sensitive to higher interest and exchange rates due to their large industrial sectors and cyclical goods specializations. Meanwhile, Spain and other southern European nations export primarily consumer-oriented goods that typically have low pricing power in a globally competitive world.
China still powering ahead
To the east, China's economy continues to surprise to the upside, despite fears of a hard landing, where growth slows too rapidly. While first quarter GDP slowed relative to the fourth quarter's pace, it was still higher than forecast, and as a result, inflation continues to be a problem and monetary tightening will continue.
As a command economy, China has many levers for controlling growth. The government has put in strict measures aimed at property speculation, which appears to be working; housing sales have slowed and mortgage credit is tight. However, railway investment has remained strong, and the government recently raised its 2011 funding for affordable housing.
Chinese property developer stocks technical strength
Source: FactSet, Shanghai Stock Exchange. As of Apr. 27, 2011.
Importantly for global growth due to the impact on commodity and equipment demand, Chinese property developer stocks are showing signs of tenuous technical strength, reversing a nearly 18-month trend and a possible harbinger of improved future prospects. We believe China's growth will eventually slow, but to a more healthy and sustainable pace.
Visit www.schwab.com/oninternational for more international perspective.
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.
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