June 15, 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
- Equities bounced off of what appeared to be oversold conditions but although the US economy appears to be holding its own, a renewed sustainable uptrend may be hard to come by until some substantive policy actions are taken around the globe.
- Willingness to take action isn't a problem for the Fed, as reiterated by numerous Fed speakers in recent weeks, but we remain skeptical about the impact of a potential new round of quantitative easing, other than perhaps psychological. Conversely, the US government continues to dither, while the uncertainty surrounding the impending "fiscal cliff" is hamstringing investors and businesses.
- The time for decisive action in the eurozone appears to be quickly approaching as short-term solutions are no longer satiating the market. The ongoing crisis is affecting economies around the world and we remain cautious in the near term but believe emerging markets are still positive longer-term investments.
The oft-repeated phrase of "kicking the can down the road" may be coming to an end in the financial markets. Up to now, markets have been at least somewhat satiated by moves by US and European policymakers to temporarily avoid crisis blow-ups using short-term solutions. From a one-year extension of the payroll tax cut in the United States, to long-term refinancing operations (LTRO) in Europe, short-term fixes have to date prevented a calamity. However, it appears that time may be running short for those "solutions" to satisfy market participants. With each new "fix" the positive market bump appears to be getting shorter, with focus more quickly returning to the long-term challenges. So while we believe that the US economy will continue to muddle along, we are in the midst of the third consecutive mid-year slowdown in economic growth and it may be hard to get a reacceleration until we have some answers to these longer-term issues.
But that doesn't mean that investors should sit on their hands; action is required here as well. Elevated uncertainty can cause paralysis, but we believe it's important for investors to keep their longer-term financial goals in mind and rebalance portfolios as necessary. Judging by mutual fund flows, individual investors are quite hesitant to add to equity exposure, while continuing to shovel money into bonds. In the near-term that can be appropriate—to hunker down and wait, especially considering our view that the near-term looks challenging. However, equities remain reasonably valued in a longer-run context. In addition to low valuations, investor sentiment remains depressed (a good contrarian signal), earnings remain healthy, and corporate balance sheets look great. Conversely, bonds held for capital appreciation purposes rather than income look much less attractive to us. Yields on Treasuries remain at or near record lows and sentiment continues to be elevated. History has shown that markets revert to the mean at some point, which would favor equities over bonds after a decade during which fixed income took the crown.
We think the ride for the markets will remain volatile until there is more clarity on both the eurozone crisis and the fiscal cliff. We continue to recommend that investors underweight European equities, and look to add to high-quality US equity positions as needed on the inevitable pullbacks. And, for those investors that want to make more tactical tweaks to their portfolio given the current environment, we would point you to the recent changes in sector recommendations in Schwab Sector Views.
Expansion continues but confidence waning
The last couple of labor reports have added to consternation regarding the US economy and the sustainability of the expansion. And, with the first quarter gross domestic product (GDP) report showing anemic growth of 1.9%, it appears clear that we're starting to run dangerously close to "stall speed"—where the possibility of returning to a recession increases. We believe we'll avoid such a scenario, but risks have risen. Without more certainty on the tax, regulatory, and health care front, it's difficult to see businesses wanting to aggressively invest or hire.
Confidence still tepid
Source: FactSet, Natl. Federation of Independent Business. As of June 12, 2012.
Several key leading indicators haven't deteriorated to the same degree as some of the labor data. Jobless claims, although ticking up lately, remain below 400,000, while both Institute of Supply Management (ISM) surveys showed positive signs. Both remain in territory depicting expansion, with the Manufacturing Index slipping to 53.5 from 54.8; but encouragingly new orders rose to 60.1—a 13-month high. The Non-Manufacturing Index ticked slightly higher to 53.7; but again, here the new orders index, which tends to be forward looking, rose to 55.5 from 53.5. And, helping support demand going forward, we've seen oil and gasoline prices pull back, which should help to bolster discretionary income. Finally, confidence should also be buoyed at least modestly by trends in housing and the strength in domestic energy production.
Fed ready to act, government needs to act
Housing continues to be a primary focus of the Fed, and Operation Twist has helped drive mortgage rates to all-time lows. They are also focused on the labor market, believing that unemployment at 8.2% is too high, while the recent soft labor reports likely increased the chances of another round of stimulus. If the Fed opts for more easing, we think it will more likely come via an extension of Operation Twist versus a third round of quantitative easing (QE3). However, Fed chairman Bernanke admitted in his recent testimony before Congress that further action may have "diminishing returns."
Cash remains plentiful
Source: FactSet, Federal Reserve. As of June 11, 2012.
The potential for much more impact, as Chairman Bernanke readily admits, would come from a fiscally responsible and sustainable budget agreement that addressed both the looming "fiscal cliff" and longer term deficit challenges. Tax reform, entitlement reform and broad spending cuts could go a long ways toward really uncoiling some springs in the US economy, but unfortunately seems unlikely to be realized in 2012.
Europe needs to find union
But before we get to November, we can focus on elections across the pond. The fallout from the Greek election will be felt for some time. A potential Greek exit, detailed in two articles at www.schwab.com/oninternational, created market concerns about contagion spreading to Spain in particular.
