Confidence Counts
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
August 26,Ā 2011
Key points
- Most of the normally historically-telling leading indicators continue to point to the United States avoiding a renewed recession. However, risks are clearly heightened as continued erosion of confidence could push perception into reality.
- The Federal Reserve continues to be divided on whether to attempt further monetary stimulus. We question if any efforts will have the desired impact. Meanwhile, the Obama Administration and Congress continue to scramble to be seen as doing something to help, but also have limited policy options.
- European policymakers seem oblivious to the erosion of confidence (and the role it plays) in their financial system and a eurozone recession is becoming more likely. Meanwhile, the hope that China can lift all global economic boats may be diminishing.
Global markets continue to trade in a highly volatile fashion. Confidence is very tenuous and it isn't taking much for investors to react in a big way both on the buy and sell side. Much of the recent focus has been on the European debt crisis. Fears of a new "Lehman-Part II" financial crisis emanating from across the pond have continued to haunt investors, while clearly-slowing growth in Europe contributes to the uneasiness. The globalization of the financial system means that it can be difficult to determine the extent to which the tentacles of any banking problems in other countries may filter through to the US system. This uncertainty contributes to the instability and volatility weāve seen in the equity markets over the past couple of months.
It can be difficult to be an investor during times such as this as emotions are running high. However, fear, panic, (or greed) are not solid pillars of a successful investment strategy. In fact, historically when volatility spiked and investor confidence sank, as we have seen recently, the following year was quite positive for equities. Times like this test whether your investment plan is one that you're actually comfortable with for the longer term. We continue to believe that investors who sell due to fear and panic will ultimately end up with a less successful result than those who stick with a well-thought out long-term plan. That of course requires discipline around diversification and regular rebalancing. There is always another potential crisis around the corner, as well as a possible positive surprise and trying to time the market in the short term can be a foolās errand.
Recession in the cards?
Clearly the risks of a renewed recession in the United States have risen as evidenced by both the stock and bond market action. According to ISI Group, historically when the S&P 500 was down 17% over 11 days, only twice did a recession not followā1987 and 2002. Meanwhile, Treasury yields continue to trade near record lows with the 10-year yield dipping below 2%. We never ignore what the markets are saying, but we also need to look at the entire picture that is developing. First, the stock market is a forward-looking mechanism, so by the time we know for certain what growth rates look like for the third and fourth quarters, the market will be looking into 2012; so waiting for clarity is often not the best strategy before executing a long-term plan.
Taking a look at the broader economic picture yields what we believe is a less convincing likelihood of recession than the market appears to be pricing in. Again according is ISI's research, previous market routs as we've seen recently saw initial jobless claims spike by around 50,000 following big drops like we've seen recently. There has yet to be a spike in claims as they remain near the 400,000 level, down from 420,000 or so earlier this summer. Additionally, although at anemic levels, the US economy is still adding jobs.
Additionally, despite a shaky market, a high unemployment rate, a contentious political environment, and a very negative news cycle in July, retail sales for the month jumped 0.5%; while excluding autos and gas they rose 0.3% and June was revised higher. This comes despite the recent release of the University of Michiganās Consumer Sentiment Index posting its lowest reading since 1980āindicating consumers don't always do what they say. Additionally, according to Ned Davis Research, when consumer confidence was below 66 historically (itās now at 59.5) the average stock market gain in the year following for the DJIA was 14.4%; far better than the performance seen during times of higher confidence. Also, industrial production for July rose 0.9%, while durable goods orders surprised on the upside by jumping 4.0%, with June's number revised higher. Finally, the Index of Leading Economic Indicators (LEI) continues to indicate growth, rising 0.5% in July. There is a caveat to the strength of the LEI: one of the key stronger components has been the yield curve, which has historically inverted (long rates dropping below short rates) before recessions. Thatās less likely this time given that short rates are pegged to zero; so the lack of inversion may be sending a "false" positive message about the economy.
LEI still positive
Source: FactSet, U.S. Conference Board. As of Aug. 19, 2011.
Declining confidence and continued erosion in the markets can have a self-fulfilling aspect to them however, which is one reason why the possibility of a recession has grown, in our opinion. The Philly Fed Index falling to -30.7 may be an example of this as the decline in the market may have influenced responses, which in turn led to a huge surprise on the downside, which led to more market lossesāa self-fulfilling prophecy. However, actual data doesn't exactly match the survey. Weāve seen indications of more confidence recently, such as the jobs data mentioned above, as well as a recent Federal Reserve survey showing that demand for loans by businesses is increasing, while credit standards have loosened.
Increase in demand for loans encouraging
Source: FactSet, Federal Reserve. As of Aug. 19, 2011.
A fork in the road
Despite some encouraging data, and relatively attractive valuations based on history, we believe we're at an important inflection point. Continued deterioration in confidence will likely lead to more negative economic data, starting a negative feedback cycle from which it may be difficult to escape. Conversely, a renewed focus on the underlying fundamentals of the economy and some positive surprises could bolster confidence, pushing investors on the sidelines to take advantage of reasonable valuations and push markets higher. We tend to lean to the latter, but the risks of the former are growing.
Washington at a loss
Following the unprecedented step of putting a definitive time period on the near-zero interest rate policy, speculation increased that the Fed would embark on a new stimulus program; be it QE3, shortening the duration of their portfolio (known as a "twist"), or lowering the level of interest they pay on reserves. Some investors were looking for a repeat of the 2010 Jackson Hole implied announcement of QE2. No such luck. We remain opposed to a new round of quantitative easing, and believe the bar is much higherāeither a definitive return to recession, or severe fears of deflation setting in. The unprecedented dissent we saw at the last Fed meeting, with three members of the Federal Open Market Committee (FOMC) opposing the change in the language, indicates to us that further action is further off than some are expecting.
And there may be little the Fed can do to overcome the perceived dysfunction on Capitol Hill and in the White House. The debt crisis debate shook confidence of businesses and consumers alike, and the current environment lends itself to little in the way of needed reforms getting done prior to the 2012 elections. We believe this will drag on confidence and the ability of businesses to plan for the future. We continue to advocate a simplified, reformed tax code for businesses and consumers, a rollback of many onerous regulations, a viable spending plan, and real reform of Medicare and Social Securityābut aren't holding our breath.
Eurozone recession increasingly likely
Across the pond, the crisis of confidence in Europe could have a more lasting negative impact on economic growth than a decline in confidence and economic slowdown in the United States. Reasons include a weak starting point for growth in the eurozone, debt markets demanding steep near-term fiscal spending cuts to reduce deficits, and banks increasingly under the threat of a cash crunch.
Amid the negatives, there have been some positive eurozone developments, such as the late-July second Greek bailout, although that is now in question; and expansion of capabilities of the European Financial Stability Facility (EFSF), and purchases of Spanish and Italian debt by the European Central Bank (ECB).
Positive decline in yields, but will it last?
Source: FactSet, iBoxx. As of Aug. 23, 2011.
Despite the declines in Spanish and Italian sovereign debt yields, the ECB's staying power is questioned amid its reluctance to selectively buy national debts and strict anti-inflation bias. As such, the ECB "sterilizes" its purchases by offsetting any liquidity injections of money into the financial system with withdrawals of liquidity elsewhere. In our opinion, the ECB's ability to continue these operations may be limited, and the ECB needs the EFSF's new powers to be initiated to relieve them from this responsibility.
Modifications to the EFSF have yet to be ratified by the 17 national parliaments that use the euro, with votes not expected until late September or thereafter. Meanwhile, the second Greek bailout is now threatened by Finland's demand for Greece to post collateral as insurance against default, with other countries also desiring similar deals.
In our opinion, policymakers in Europe continue to find new ways of undermining confidence, ranging from collateral demands to a renewed call for a financial transactions tax by Germany's Merkel and France's Sarkozy. Financial markets and banks are based on confidence and trustāthat the people on the other side of the table (or trade) are going to "make good" on their obligation to pay.
European policymakers seem to be in denial about the role of confidence in financial systems, and in response, a contagious illness has begun to feed through in a "whack-a-mole" fashionāuncertainty temporarily subsides only to pop back up again. Current measures are only temporary band-aids to address short-term liquidity needs and have yet to address longer-term solvency. We believe several measures are needed for the eurozone debt crisis to stabilize:
- European banks need more capital.
- The EFSF needs to be made significantly larger.
- Greece needs a more substantial debt restructuring.
- Government revenue prospects need improvement through growth measures such as labor reform and a move away from dependence on the public sector for jobs.
- Tax collection needs to be reformed.
- Closer fiscal coordination is necessary, possibly through the issuance of a common Eurobond.
Some of the measures to stabilize the crisis could happen quickly, while others may be tougher sells; in particular the ability to achieve closer fiscal coordination. This is the underlying flaw of the euro exposed during this crisis: a currency and monetary union without fiscal union may be unsustainable.
Positively, Germany and France have started to discuss "harmonizing" budgets, tax rates and economic governance. However, we believe this will be a long and bumpy road, because some countries may be reluctant to give up their sovereignty to policymakers they don't electāit lacks democratic legitimacy, similar to "taxation without representation."
Longer-term the euro may not be able to sustain its current structure. While we don't believe a euro break-up is imminent, the destabilization that this could entail keeps a lid on our enthusiasm for the region. Read more in A Tale of Two Europes.
Will China aid or hamper global growth?
Global growth is under pressure due to the simultaneous and cumulative effect of an unprecedented series of shocks, ranging from the Arab spring and rise in oil prices, extreme weather patterns, disasters in Japan, US debt ceiling debate and continued eurozone debt crisis of confidence. As such, are there areas globally that could reaccelerate? The International Monetary Fund (IMF) estimates that just over 50% of global economic growth in 2011 will originate from emerging markets, despite constituting only 35% of world gross domestic product (GDP).
However, growth in China, a key driver of many emerging economies, could weaken more than we envisioned several months ago. Reasons include not only a potential slowdown in exports, but also a pullback in several programs we believed had strong governmental support. These include a halt in new proposals for high-speed and conventional rail construction, and a potentially reduced affordable housing build in 2012. While a more thoughtful approach to spending is a good development, infrastructure and housing construction comprise nearly 50% of China's GDP, so a slowdown would likely be felt. In addition to restraint due to still-high inflation, China does not appear close to stepping up sizable fiscal or monetary stimulus to "bailout" global growth.
However, not all is negative and we believe a hard landing in China will be avoided, as we detail in Bears and Bulls in the China Shop. Areas that still have need for infrastructure spending include access to water and addressing power-grid inefficiencies. Additionally, manufacturing in China could reaccelerate; the preliminary read for August as measured by HSBC is following the seasonal trend of a July trough.
Chinese manufacturing tends to trough in July
Source: FactSet, Bloomberg. As of Aug. 23, 2011.
Seasonal avg. over a six-year period excluding a one-year period from May 2008 - June 2009.
Additionally, the message from the markets indicates there may not be undue stress in China's economy, as Chinese banks, steelmakers and real estate developers traded on local exchanges have significantly outperformed the recent global selloff. Lastly, the value of the yuan in the government's managed program and in the non-deliverable forward market (a market for non-convertible currencies largely used for hedging and speculation where notional amounts are not exchanged) has risen, typically coinciding with growth in manufacturing.
China's market held up well on a relative basis during the global selloff, as expectations may be low. While China, and thus emerging markets, could exit the current period of market volatility in a more favorable light, we are not yet ready to turn positive, as new reductions to key Chinese government programs give us pause and we need to see a downward trend in Chinese inflation.
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.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
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