April 13, 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
- Economic data has softened a bit lately but still indicates growth in the United States. After a long stretch of relative calm in the markets, we've seen the markets pull back, possibly fulfilling the correction that was overdue. We believe the longer-term trend is higher but near-term risks continue to be elevated and earnings season could bring more volatility.
- After a couple weeks of shifting perceptions regarding what the Fed's next move may be, the minutes from the most recent meeting seemed to solidify the notion that another round of quantitative easing (QE3) is not in the offing. Although the stock and bond markets initially reacted negatively, we are heartened by the rhetoric.
- European debt fears have flared up again in Spain and Italy and we believe risks are elevated and may not be fully appreciated. Meanwhile, China's response to slowing growth has been surprisingly slow and risks of a misstep are rising, although we still remain optimistic in the longer term.
After the best first quarter stock performance since 1998, based on the S&P's 12% return, and the recent pullback in the markets, investors may be wondering what’s next. Can the market resume its move higher? Was the correction enough to heal overbought conditions and elevated investor sentiment? What will be the catalyst for the next move?
There hasn't been a shortage of commentary suggesting that a pullback in equities was overdue and needed for the next leg higher. But now that we've seen a pullback, concerns are suddenly growing that we could be in for an extended downturn. Although risks are elevated, currently we don’t believe the correction to-date represents a shift in the recent upward trend in stocks. In fact, we can look back at similar periods and find some heartening information. According to our friend Ed Yardeni at Yardeni Research there have been 17 times in the last 66 years that each of the first three months have posted positive S&P 500 returns. The average total yearly return for those 17 years was 20.2%, with none of those years posting a negative return. But with such a great head start, that might not be all that meaningful for the rest of the year. However, according to Ned Davis Research, there have been 11 instances since 1930 where the S&P 500 posted returns above 10% in the first quarter. The median return for the following three quarters was 6.95%, with all but two posting positive returns for that time period.
Additionally, the recent correction has helped push the Ned Davis Research Daily Sentiment Composite into excessive pessimistic territory, sharply reversing the overly optimistic sentiment seen just a few weeks ago. Negative investor sentiment has tended to be a contrary indicator and we believe is a positive development for the market as we move forward.
One more bit of historic data regarding the interplay between stocks and bonds. Bonds have had a decade-long run that has seen interest rates sink to historically low levels and we have warned investors that may be overallocated to bonds that a reversal to the mean may be in store. Capital appreciation on bonds is by definition capped as interest rates can only go to zero, which we’re not that far away from on Treasury securities. Furthering that warning, according to Bespoke Investment Group, when equities have outperformed bonds substantially (above 10%) for two quarters in a row, which just occurred and has happened nine previous times, the average equity return in the following quarter has been 4.6%, while bonds have averaged a decline of 0.5%. And we may be seeing that shift from bonds to equities begin as the week ended March 23rd, according to EPFR Global, saw outflows from long-term government bond funds of $1.01 billion, the largest amount on record (thanks to Barron’s for pointing this out). However, we must caution investors that are investing in bonds and bond funds for income purposes that they still remain the most appropriate predictable income investment vehicle in most cases, and the vast majority of investors should maintain at least some exposure to bonds based on income needs and risk tolerances.
Earnings to take the reins?
Recent US economic data has raised some questions among investors as to the sustainability of the economic expansion. We share some of those concerns as confidence remains tenuous, the political situation is messy, the European debt crisis rages on, and Chinese growth has slowed. But we maintain confidence that the economic expansion is continuing and should continue for the foreseeable future. The Institute for Supply Management's (ISM) manufacturing survey rose to 53.4, with a reading above 50 indicating expansion. Additionally, the employment component moved to 56.1 from 53.2, and while new orders dropped slightly, it still remains solidly above 50. The service side of the ledger also continues to show expansion as the ISM Non-Manufacturing Index posted a reading of 56.0.
The job picture got a little murkier with the latest report. Although ADP reported that March private payrolls expanded by 209,000 positions and February was revised higher, the Labor Department said that only 120,000 jobs were added, below expectations and contributing to the pullback in stocks. Positively, the unemployment rate dropped to 8.2%, still elevated but well off its high. Leading indicators of job growth such as initial unemployment claims continue to suggest that the March reading may prove to be an outlier and/or a natural pullback after the strong weather-related gains in the first two months.
In fact, the improving job picture appears to be bolstering the consumer, as retail sales numbers have been relatively positive and we’ve seen auto sales continue to rebound after a sharp drop-off.
Auto sales indicate increased confidence
Source: FactSet, U.S. Bureau of Economic Analysis. As of April 10, 2012.
And we'll be getting more information at the corporate level over the next several weeks as first quarter earnings season heats up. There appears to be more uncertainty heading into this season than we've seen recently, but we have seen analyst forecasts revised higher recently. This reporting season could provide the next near-term catalyst for the markets as some positive surprises and commentary could provide further fuel, while disappointment could move stocks lower. One advantage we may have is that expectations entering the season appear relatively low, with Yardeni reporting that as of April 6 analysts are expecting S&P 500 companies' earnings to only grow 2.4% over last year, which would be the slowest rate since the third quarter of 2009, providing the opportunity for upside surprises. Additionally, according to Strategas Research Partners, the negative-to-positive preannouncement ratio was 3.0 for the first quarter and they note that when the ratio has been above 2.1, the stock market in the month after the end of the quarter has risen 2.2%, while declining 0.3% when the ratio is below 2.1. One thing we'll be continuing to watch will be commentary surrounding the massive cash that being stored on balance sheets and how it may be used in the future.
Corporate liquidity near an all-time high
Source: FactSet, Federal Reserve. As of April 10, 2012.
Fed continues to confound
The above chart helps to illustrate why we believe that another round of quantitative easing (QE3) seems unnecessary. There is plenty of liquidity in the economy and pumping more in would seem to us to do little good. It appears the Federal Reserve may be starting to move toward that view as well, or at least they're becoming more confident in the economic recovery. The recently released minutes from their March meeting indicates that there isn't much appetite on the Committee for QE3. Although stocks and bonds had an initial negative response, much like a child wobbling on a bike after a parent lets go for the first time, we believe Fed support needs to slowly be withdrawn so the economy can ride on its own.
European debt risks flare up
Contrarily, The European Central Bank (ECB) appears anxious to shove its kid on a bike as soon as possible with lagged and tepid responses to the ongoing debt crisis. That said, its three-year loan liquidity injections early this year did buy time for banks and governments and reduced the imminent threat of a banking system collapse. However, the sugar high may have lulled investors into a false sense of security, as the eurozone debt crisis was merely put on pause.
While it may be an oversimplification, the elevation to a crisis situation boils down to confidence. Loss of confidence can become a self-fulfilling prophesy, as we witnessed with Lehman Brothers in 2008. Therefore, in order to maintain investor confidence, European policymakers have to continue to make progress toward reducing deficits, meeting fiscal targets, making structural changes to provide a foundation for growth, and implement backstops in case things deteriorate.
However, instead of making progress, confidence is being slowly eroded by backward moves:
- In Italy, Prime Minister Mario Monti’s labor reform proposal has been watered down.
- France’s presidential election on April 22 and May 6 could result in a change of leadership to presidential candidate Francois Hollande, who has pledged to renegotiate the eurozone fiscal pact.
- Greece’s general election, which could occur around May 6, could result in a weak coalition government, increasing the possibility of missed quarterly bailout funding targets.
- Even the Netherlands, considered a core country and a strong proponent of fiscal discipline, admitted it too would run afoul of the European Union’s 3% deficit target in 2012, resulting in the need for austerity cuts.
But due to the size of its economy and debts, weak economic outlook and banking system, Spain is the elephant in the room that cannot be ignored. Eurozone debt concerns flared up after Spain announced it would miss its 2012 deficit target.
The Spanish economy has an uncertain and risky outlook as evidenced by unemployment still rising from an already high 24% and a housing bubble that is still deflating. Additionally, private sector debt in Spain grew dramatically during the housing boom and the risk is that Spanish banks could face more problems in the future because losses on private sector debt are likely to rise. As a result, bank problems could be inherited by the sovereign, because banks could need government aid.
The interaction between the economy, the banks and the sovereign can feed off each other and exacerbate the situation, and it may take only a minor deterioration in one or two areas for a negative spiral to take effect in Spain. We believe Spanish banks likely need more capital as a buffer, but we don’t believe Spain’s government is in imminent need of a bailout. However, markets are nervous that Spain’s situation could deteriorate, necessitating a bailout over the next couple years.
Eurozone concerns remain, particularly for Spain
Source: FactSet, iBoxx. As of Apr. 10, 2012.
We are discouraged that the combination of deterioration in Spain and the ECB reiteration that emergency measures are temporary has been able to have such a large impact on Italian yields. While the region's bailout funds were somewhat boosted by combining the temporary European Financial Stability Facility (EFSF) with the longer-term European Stability Mechanism (ESM) for a year, an even bigger firewall may be needed.
Global growth moderating
The focus on austerity in the eurozone misses the need to foster the absent ingredient- growth. Economic releases over the past month have shown a generalized renewed economic weakness in Europe and continued declines in credit indicate growth will be difficult to achieve.
Meanwhile, the Asia/Pacific region is also under downside pressure. As discussed later, China’s economy continues to soften. Many Asian nations have close ties to the Chinese economy, and a slowdown in commodities and goods exports to China is reducing their growth.
As for Japan, the world's third largest economy, economic data has been mixed. Japan's leading index has continued to trend higher and there has been a recent rebound in machinery orders. However, Japanese household spending remains weak and despite an increase in the Bank of Japan's (BoJ) asset purchase program in February, money supply dropped in March, and the quarterly Tankan survey showed business confidence has failed to improve. In contrast to the BoJ holding off on new measures in its April meeting, we believe the BoJ needs to do more and make good on its promise of pursuing “powerful easing” to create inflation and weaken the yen.
Likewise, somewhat disheartening is a slight change in tone by central banks elsewhere. For example, despite downside risks to economic growth, the Reserve Bank of Australia and the ECB also held off on easing at their recent meetings amid signs of inflation picking up. We believe inflation pressures will continue to ease globally as we move through the year, as food prices have fallen and oil prices could have downside risks as global growth slows and geopolitical pressures ease. This could give central banks more leeway to ease in the future.
China continues to slow, but crash unlikely
We believe markets had been underestimating the risks in Europe and over-emphasizing the possibility of a hard landing in China. Growth has slowed, but has defied the bearish calls for a crash. However, monetary easing has been disappointingly slow. We had believed that a sharp drop in inflation and money supply would allow stimulus to be enacted sooner. Typically an economy needs growth in money supply and lending to grow. Money supply has been growing at a slower pace than nominal economic growth, pressuring economic growth.
China likely slows amid modest money supply growth
Source: FactSet, National Bureau of Statistics of China, People's Bank of China. As of Apr. 10, 2012.
* Excess liquidity is M2 money supply less nominal GDP
The Chinese government is playing a balancing game that has increasing risks of missteps. We are encouraged by early signs of a reacceleration in lending that could boost economic growth. Elsewhere, the government is trying to reduce imbalances in the economy and transition away from dependence on exports as well as building factories and infrastructure. While removing imbalances may be good over the long-term, the ability of the government to micro-manage an economy that is now the world's second largest is becoming more difficult. Real progress toward a transition is likely to require tough political decisions and reforms, and miscues could make for a bumpy ride.
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.
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