Shifting Winds-Turbulence Ahead?
March 30, 2012
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, Director of International Research, Schwab Center for Financial Research
Key Points
- Treasury yields have moved somewhat higher, while stocks have largely continued to rise. Some recent correlations appear to be breaking down, which could lead to some increased volatility but we remain relatively confident in the equity market. Perception as to the next potential moves by the Federal Reserve appeared to be shifting, but Chairman Bernanke reiterated their easy monetary stance. Uncertainty is rising and the Fed’s goal of increased clarity through more transparent communication is under increased scrutiny.
- Liquidity concerns in Europe have eased but economic risks remain elevated, while Spain and Italy face deal with their ongoing debt crises. Meanwhile, fears remain about a hard landing in China, although we have a more sanguine view.
Are we starting the return to a more "normal" market environment? It's too early to tell but we are beginning to see lower volatility and asset class correlations. Contributing to this more stable environment is a shifting of Fed expectations and increased investor confidence about US economic expansion. However, we acknowledge that such a shift will likely cause some near-term turbulence in the market, especially given elevated bullish investor sentiment (a contrarian indicator). The market has also become technically extended after its roughly 30% rally since early October 2011, and could be due for a breather. Additionally, an uncertain earnings season is approaching, oil prices continue to be concerning, and the siren song of "sell in May" is likely to be heard again. We believe any consolidation is likely to be shallow and could bring back some of the "wall of worry" that the market loves to climb.
One of this year’s earlier trends had been stocks moving higher, but Treasury bond yields remaining near record lows, indicating both continued concern about the sustainability of the economic expansion, and the confidence that the Federal Reserve would continue its extremely accommodative monetary stance for the foreseeable future. Recently, we’ve seen Treasury yields move up from those record lows, while stocks continued to move higher. This could be the beginning of a shift in investor attitudes as confidence in the economic expansion may be growing leading to skepticism that the Fed can maintain its current policy stance through 2014.
Yields Move Higher—For Positive Reasons
Source: FactSet, Federal Reserve. As of Mar. 27, 2012.
While it's too early to say this is the start of a trend of yields moving inexorably higher, it does appear that the retail investor could begin to shift some assets from bond funds and cash into equities. This could feed the next leg up in the equity rally.
Economic Transition
Part of the impetus behind the retail investor warming up to equities may be the improvement in economic data—especially as it relates to jobs and housing. But here too we may be entering a transition phase as year-over-year comparisons become more difficult and substantial gains become harder to come by. Housing data continues to be mixed and although initial jobless claims recently hit their lowest level in three years, the pace of the recovery in jobs could slow. This could contribute to near-term volatility, but we do believe in the sustainability of the economic expansion, which should help to support equity prices through the balance of 2012.
Jobs picture continues to improve
Source: FactSet, U.S. Dept. of Labor. As of Mar. 27, 2012.
Housing is not off to the races and likely won’t see a sharp bounce off of the bottom, but we are seeing encouraging signs. Although existing home sales fell 0.9% month-over-month in February, it was still the best February reading in five years and sales were up 8.8% over a year ago. Meanwhile, housing starts fell 1.1% but forward-looking building permits rose 5.1%, to the highest level since October 2008. And while housing remains extremely affordable based on historical levels, mortgage rates have moved modestly higher. Somewhat counter-intuitively this could contribute to further improvement of the housing market as the prospect of rates actually moving higher may push potential purchasers who had been sitting on the fence toward action.
Other economic data continues to show growth in the economy, although there are some potential chinks that we are watching closely. The Empire Manufacturing Index moved to its highest level since June 2010 while the Philly Fed Index rose to its best reading since April 2011. However, the forward looking new orders component of both reports moved lower. While not overly concerning yet, it’s something we’re keeping an eye on.
Additionally, the Index of Leading Economic Indicators rose 0.7% in February, marking the fifth-straight month of improvement. The National Federation of Independent Businesses Index moved higher, indicating improving small business confidence. Finally, retail sales moved 1.1% higher; while ex-autos and gas they moved 0.6% higher and the previous month was also revised upward, indicating the American consumer continues to spur activity.
Fed Stance Shifting?
This continued improving data may be contributing to a shift in the perception of the future of Fed policy. While the recent Fed meeting kept policy the same and continued to predict near zero interest rates through at least late 2014, they did upgrade their outlook of the economy slightly. Also, several Fed members have said they believe higher interest rates may be needed sooner than currently officially predicted. The fed funds futures market has the first rate hike coming at least six months before the end of 2014. And finally, during Chairman Bernanke’s recent testimony on Capitol Hill, he did nothing to indicate another round of quantitative easing was in the cards, leading investors to believe the Fed's confidence in the economic expansion may be growing. However, in a subsequent speech, he reiterated his belief that the economy and job market would continue to need Fed assistance, throwing a little more uncertainty into the equation. We are encouraged at these glimmers of hope and believe that a return to more normal policy sooner rather than later would be appropriate.
Europe’s debt crisis merely on pause
The second Greek bailout was completed on March 20 with markets hardly batting an eye. But the eurozone sovereign debt crisis is far from over—it is merely on pause and there is still risk of future outbreaks.
Where could sovereign debt concerns arise?
- Greece and Portugal could need additional bailouts;
- Ireland could ask for debt forgiveness to bolster a public vote for the fiscal pact;
- France’s general election could result in a change of leadership from Sarkozy to Hollande.
However, we feel these potential events are unlikely to result in a broad contagion outbreak. On the other hand, Spain and Italy have the ability to heat up concerns and risk aversion due to their large debts and economies. Italy’s economy has grown less than the eurozone average over the past decade and reforms are needed to improve competitiveness and enhance growth prospects. Italian Prime Minister Monti needs to keep making progress to maintain investor confidence, and watered down labor reforms may not have a lasting effect.
However, Italy has some positive attributes, including a wealthy private sector with a per capita net worth more than three times higher than the other European peripheral countries, according to BCA Research, giving them the ability to fund debt locally. As such, Italy’s debt tends to be in stronger, longer-term, hands. Additionally, Italy has a primary budget surplus – a surplus before debt payments – as well as long debt maturities.
Spain's housing bubble still deflating
Source: FactSet, S&P/Case-Shiller, Bank of Spain. As Mar. 27, 2012. Indexed to 100 = 1/1/1996.
Spain on the other hand has a more uncertain and risky outlook. While Spain’s current government debt load is smaller than Italy’s as a percentage of gross domestic product (GDP), it has an elevated deficit, high and rising unemployment and a housing bubble that is still deflating. A risk is that the large amount of private sector debt could incur more losses for banks, potentially requiring cash infusions from the government. Additionally, instead of making deficit-reduction progress, Spain has backpedaled; now targeting a higher deficit to end 2012 than envisioned a few months ago.
Positively, European policymakers are doing their part to contain risks, from the European Central Bank's three-year loans and Germany's recent willingness to combine the temporary European Financial Stability Facility (EFSF) with the longer-term European Stability Mechanism (ESM) that comes into effect in July. However, an even bigger firewall may eventually be needed.
Europe dragging down global growth
The lingering effects of the sovereign debt crisis on the European economy continue. The renewed downturn of eurozone purchasing manager indexes in March indicate the economy is still fragile and it could take some time before growth reaccelerates. A hobbled European banking system remains at the heart of the slowdown. Bank balance sheets likely don't have enough excess capital to expand lending and banks have responded by tightening lending standards. Lending is the lifeblood of economic growth and a severe reduction in lending is likely to restrain activity.
In terms of investment implications, the outlook for European stocks is mixed. Valuations appear attractive and we believe correlations will decline and investors will differentiate across markets. Markets with stronger economies such as Germany could do better, while those with weaker economic outlooks, like Spain, could lag. The Italian stock market falls in the middle, as a negative economic outlook is offset by high private sector wealth.
Should we worry about China?
There are plenty of bearish stories about China these days and China remains a puzzle to many. The lack of transparency and the view that news is filtered and managed helps fuel the fears.
We believe the truth lies somewhere between the bearish and bullish case. We still believe that a hard landing is unlikely and that markets are at times over-reacting to data that is really not new news. Examples include the 7.5% growth target for 2012 when the Five-Year Plan issued a year ago envisioned a 7% rate over the full period; and comments from BHP Billiton that demand for iron ore would drop to single-digits, which was not significantly different than what they had said in the past.
Even reports that China's manufacturing purchasing manager index (PMI) is in contraction territory are a misnomer. The PMI survey is a diffusion index—a reading below 50 indicates more people say things are slower versus last month than faster—in other words, below average activity. In a fast growing economy such as China, this does not necessarily equate to a contraction.
Manufacturing in China slowing
Source: FactSet, Markit. As Mar. 27, 2012.
We have believed for some time that China's economy would continue to slow, but that a sharp drop in inflation and money supply would allow stimulus to be enacted that could reaccelerate growth later in 2012. However, we are discouraged by so far modest policy easing amid signs of accelerated slowing.
In particular, the report that profits for Chinese industrial companies fell 5.2% during the first two months of 2012 was worse than we expected. Granted, this figure was after profits gained 34.3% a year earlier and is during a seasonally weak period, so it may not be a lasting trend, but is concerning.
The Chinese government typically takes gradual moves, but the slow pace of response while economic data is moving faster indicates the government could slip behind the economic momentum, then struggle to gain ground. China’s economy is now the second-largest globally and is becoming tougher to micro-manage – the risk of a policy mistake is growing. We’re not ready to change our view as we believe we’re still in the early innings of the slowdown, but have a wary eye on policy response.
An event that could have longer-term implications is the coming political changeover at year's end. Concerns have arisen after the party chief in Chongqing, one of China's biggest cities, was sacked in March. This is the highest level official removed in over two decades. There appears to be increasing strains within the Communist party about whether to move toward reforms or tighten control. We'll be monitoring this over the coming year.
Read more international research at www.schwab.com/oninternational.
Important Disclosures
The MSCI EAFE® 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 500® 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.
