Earnings Heat Up
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
Key points
- Earnings season is heating up and will provide a status update on the "soft patch" and where companies' confidence level lies. Stocks have been more volatile but are they telling us something about potential future direction?
- Debt ceiling talks continue in Washington, with a deal still likely to come in the final days before the supposed August 2 deadline. The make-up of spending cuts, tax changes, and any entitlement reform may be key to longer-term market reaction.
- Contagion fears are growing in Europe and solutions are difficult to come by. International exposure, however, remains important and we suggest investors look toward markets such as China, Japan, Canada, and Germany.
Stocks have been more volatile, rallying strongly, while bonds fell, before moving lower again as uncertainty grew over the job market and debt problems in the United States and abroad.
What is the market telling us?
Source: FactSet, Standard & Poor's, Federal Reserve. As of July 11, 2011.
The market has returned to "risk on, risk off" trading, with the focus on the debt crisis in Europe and the US debt ceiling deadline. From the chart above, stocks and yields headed lower as risks of a Greek default grew, but reversed course once an agreement was reached and the austerity package was passed, and again switched direction on renewed Italian debt fears. But is that all there is to it? We don't believe so. Remember that the stock market is a forward-looking mechanism and we believe the action in stocks and bonds is also at least partially indicative of the US economic outlook for the second half of the year. We continue to believe the softness we’ve seen over the past couple of months is largely attributable to temporary factors, and that a recovery is likely in the second half.
In choppier markets we suggest investors who need to add to their equity exposure use any weakness to add to positions as we continue to believe the trend through at least year end will be higher.
There could be continued near-term volatility, however, with second quarter earnings season heating up. With new disclosure rules and crackdowns on perceived inside information being given to analysts, visibility is perhaps more opaque than it has been in years, leading to the possibility of more surprises. Expectations have been ratcheted down a bit over the past month as analysts attempt to factor in the impact of the soft economic data, but Bloomberg reports analysts are forecasting a still-robust 13.3% year-over-year gain for S&P 500 earnings. As usual the focus will be on the commentary accompanying the profit announcements. We are watching to see if companies indicate they have plans to put some of their massive cash balances to work through hiring more workers, and/or investing in capital projects to take advantage of the accelerated depreciation incentive in the tax code for 2011. Corporate confidence remains key to accelerating the economic recovery and we'll be watching for signals that businesses are becoming more comfortable with the outlook going forward.
Soft-patch ending?
Economic data remains relatively soft but there are glimmers of hope. The ISM Manufacturing Index rose from 53.5 to 55.3, with both the new orders and employment components posting modest gains. However, the gain in the headline number is tempered slightly as it was influenced by a jump in inventories. Meanwhile, the ISM Non-Manufacturing Index remains solidly in expansion territory, and even though new orders fell modestly, employment moved slightly higher.
Focus remains on the jobs picture, which has taken a hit over the past couple of months. It continues to appear that the labor market's weakness has been largely influenced by temporary factors. You can see from the chart below that jobless claims, the most leading of the various labor statistics, moved above the important 400,000 level soon after the disaster in Japan.
Claims moved up following earthquake
Source: FactSet, U.S. Dept. of Labor. As of July 11, 2011.
As production and supply chains are coming back on line in Japan, we believe claims will move back below 400,000, indicating an improving labor market. We've seen a bit of positive news as Automatic Data Processing (ADP) reported that private payrolls jumped from a gain of 36,000 in May to 157,000 in June. Unfortunately, the Department of Labor payroll report showed that only 18,000 jobs were added and the previous two months' gains were revised lower by 44,000, while the unemployment rate moved from 9.1% to 9.2%. Also, average hourly earnings were flat. The latter report was undoubtedly disappointing, but it is important to remember that it's a lagging indicator and we would expect claims to improve before the payroll report.
US debt ceiling remains in focus
The elephant in the room continues to be the ongoing debate in Washington with regard to the debt ceiling. The ceiling was actually hit back in the middle of May, but accounting maneuvers allowed the supposed "drop dead" date to be extended to August 2. Even that is a bit of a misnomer as the United States; would continue to have various options to shift money around in order to continue to pay its dept obligations on time and in full but there is little doubt that going past that date would cause significant problems in the marketplace.
We continue to strongly believe that an agreement will be reached in the days before August 2 and that the United States will avoid the more nasty scenarios being suggested. However, the details of that deal may be important to market performance going forward. If the bond market judges the deal too weak in addressing the longer-term deficit and debt, we could see yields rise and ratings agencies make more noise about downgrading US debt. Conversely, if the agreement takes too much money out of the economy in the very near term through spending cuts and tax hikes, stocks may have a more difficult time as growth could be dented.
We continue to advocate solutions with an eye toward promoting economic growth. To us, that means spending cuts, regulatory reform, passing trade deals that have languished for far too long, structural changes to entitlement programs, and a revamp of the tax code on both the corporate and personal fronts. How far down the road we get on these issues during this debate will likely frame the direction we head in through at least the November 2012 elections.
