Perception vs. Reality
September 30, 2011
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
Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
- Economic data continues to reveal sluggish activity, and markets have been increasingly trading in a "risk-on, risk-off" mode. While frustrating at times, opportunities can be found for investors who are patient.
- The Federal Reserve continues to try to stimulate greater economic growth, most recently with the announcement of "operation twist." We have serious doubts this will engender any broad upturn, but it could help mortgage refinancings. We continue to look toward Washington to move beyond short-term rhetoric and provide some serious long-term plans that allow businesses to have more confidence in the future.
- European policymakers continue to delay any real action, increasing the risks of an escalation of the debt crisis. Meanwhile, China's slowdown will keep downward pressure on global growth.
Correlations among asset classes have risen again as trading appears to have returned to the "risk-on, risk-off" action so prevalent over the past few years. The eurozone debt crisis has been a primary driver as market participants add or subtract risk based on the latest news out of Europe. In fact, we've seen the correlation between the German DAX (their equity market) and the US Treasury market increase to nearly 100%, a strong indication that the greatest near-term risk may be a European implosion.
There is not much more clarity in the US economy as economic data remains soft-to-mixed and bickering in Washington continues, keeping confidence among consumers and small businesses near 2008 lows. But there's reason for optimism, especially for investors that keep a longer-term horizon in mind. American innovation, creativity, and entrepreneurship continue to be among our country's best assets. Businesses are extremely profitable, balance sheets are strong, and cash levels are massive. Business investment has been a bright spot in the economy and given that it's only running at a pace slightly above depreciation, there's likely significant pent-up demand building for when confidence returns. And consumers' balance sheets appear to be well-improved relative to the crisis levels of 2008. We continue to recommend investors use pullbacks to add to equity positions as needed to keep allocations line with targets; while looking to pare back any fixed income positions that may have become outsized.
Assessing the odds
One key to successful investing is balancing the potential risks of any certain investment with the potential reward. The goal, of course, is to add to those investments whose upside potential appears to most greatly outweigh the downside risk. Looking at the current markets, equities have traded in a relatively narrow range since the summer swoon and appear to be already pricing in a recession. Valuations based on historical means are relatively low as corporate profitability has remained healthy, while stocks have corrected.
A stronger message is emanating from fixed income, with Treasuries and high-grade corporate credit fetching near-record low yields. We believe this is a reflection of economic worries and foreign capital flows into US Treasuries, augmented by limited concern about inflation.
It remains our base case that the US economy remains out of recession territory, albeit in a low-growth phase for the foreseeable future. If we are wrong, stocks could have more downside. However, the upside to Treasury prices (and downside to yields) is severely limited. Yields can only go to zero, no matter how bad things get, and for much of the yield curve, we aren’t that far away.
But with so many negative headlines and dire forecasts permeating the news, it seems that any positive surprises could have a relatively large impact on markets. Case in point would be the initial strong reaction to the big drop in unemployment claims reported on September 29 and the upward revision to second quarter gross domestic product (GDP). While we aren’t forecasting a return to strong growth, the expectations bar has been set relatively low, a potentially good contrarian indicator for equities.
Corporate balance sheets remain flush with cash
Source: FactSet, Federal Reserve. As of Sept. 23, 2011.
* Cash includes: check deposits & currency, commercial paper, foreign deposits, money market funds shares, mutual funds shares, time deposits & savings, and govt. agency & Treasury securities.
Government continues to ding confidence, while the Fed works to offset the damage
The level of rhetoric continues to be elevated in Washington and the ongoing standoff in Washington is damaging the confidence of American businesses and consumers. It's not that gridlock continues, which is often viewed positively by the market. It's that many of the issues being discussed affect the ability of businesses to make long-term plans, while many of the decisions that have been made have been largely viewed as anti-business, particularly on the regulatory front.
We believe the error by both parties is in leaving long-term fixes aside for now in favor of short-term remedies. Numerous temporary steps have been tried, from "cash-for-clunkers" to home mortgage modifications and buyer tax credit; with few, if any, tangible results. We believe the latest round of proposals will have a similar impact.
Although we find it highly unlikely, an agreement between the two sides that resulted in a reformed, sustainable tax code, serious and practical entitlement reform, reasonable spending restraint, and a more friendly and globally competitive business environment would go a long way toward setting the economy on a sustainable growth path. The most effective and fastest way to solve debt problems is to grow your way out of them.
Fed contiues its efforts to restore confidence
The Federal Reserve continues to fight against this lack of confidence and announced its latest efforts at its last meeting through "Operation Twist." The Fed will be selling short-term Treasuries and buying long-term Treasuries in the hopes of flattening the yield curve and pushing investors and businesses to move out on the risk spectrum. They also announced they will be reinvesting proceeds from maturing mortgage-backed securities back into the same instruments in an effort to stimulate the housing market. We continue to have doubts that these moves will have a significant impact on the overall economy, as confidence has been meaningfully damaged, including about the Fed's policies.
The Fed can’t make people spend, borrow, or hire
Source: FactSet, US Bureau of Economic Analysis, Federal Reserve. As of Sept. 23, 2011.
* M2 velocity = GDP divided by M2.
Eurozone banks under stress, European recession may be next
Confidence continues to be undermined by the eurozone debt crisis; concern about the potential for Greece to default and contagion spreading to other "Club Med" nations; and losses on holdings of government bonds held on bank balance sheets. Anxiety has stressed European banks' dollar-denominated funding; prompting global central banks to coordinate access to such funding. Banks have become skeptical of lending to each other, resulting in rising interbank lending rates.
European bank stress up
Source: FactSet. As of Sept. 27, 2011. Europe Bank Stress=three month EURIBOR (Euro Interbank Offered Rate) minus three-month EONIA (Euro Overnight Index Average) swap rate. Eurozone banks under stress, European recession may be next