Market Snapshot: Risks Abound....For Now
With Liz Ann Sonders, Chief Investment Strategist, Charles Schwab and Company
July 2012
Transcript
LIZ ANN SONDERS: Hi everybody. Welcome to the July Market Snapshot. I’m Liz Ann Sonders, and it is a pleasure to have this opportunity to share with you Schwab’s insights on the economy, the markets, and the key drivers behind them. As always, if you have any questions about the contents of this presentation, please ask any Schwab representative.
So, today, I want to talk a little bit about the economy and the markets in a global context. I do want to point out, though, that I’m taping this video on the first day of the two-day European Summit, so my comments will not include any reaction to what came out of that summit, even though you will watching this after we know the details. And thanks, as always, for tuning in. Let me start where I often do, with a comparison of the economies’ and the markets’ pros and cons.
So let’s starts with the cons, because I think the negative case is certainly the most vocal one right now. And I’ll talk about several of these, including the fiscal cliff that we’re dealing with, the European debt crisis and the related recessions in much of the Euro Zone area. Obviously, a relatively weak spate of economic reports in the US calling into question the recovery. We have our own debt crisis. We’re in the midst of a debt deleveraging. We seem to have an increase in volatility that’s not quite as troubling as last year, but certainly not helping the psyche of individual investors. Concerns about the Fed, what did they do recently with the extension of Operation Twist, I’ll talk about. And then, of course, we have a very heated election season. But, as always, I think you have to take an objective look at the environment and try to point out where there are some bright spots, and there are some. Because of the recent volatility and the recent correction in the market, sentiment has become very pessimistic. That’s actually a good contrarian indicator. Inflation has plunged, which frees up global central banks to ease. Still a tremendous amount of corporate cash on balance sheets, still healthy earnings, and then we’ve got the recovery in housing, which we touched on last month, also manufacturing renaissance, surging domestic energy production, falling energy prices that are feeding into consumer pocketbooks, and very inexpensive valuation on forward earnings. So I want to talk about those individually, as well.
Well, as Yogi Berra once said, ‘It’s déjà vu all over again, and unfortunately we’re dealing with the third consecutive mid-year slowdown in the economy, with notable weakness among the jobs indicators, which I’ll talk about. And I think contributing to the weakness both in jobs and more broadly is the structural change in the US economy. We have both private and public sector massive deleveraging, much of which is still ahead of us in the wake of the housing bubble having burst. In addition, I’ve talked a lot about sort of this muddle-through pace of growth that we have been in and I think we’ll continue to be in, and that’s simply not healthy enough to sustain better employment conditions. It also makes the economy more vulnerable to external shocks, including some of what I already mention, the Euro Zone crisis, the fiscal cliff.
So let’s dive into an economic analysis now, and start with the leading indicators for the US. These are the indicators that tend to give you a heads up about problems. And you can see in the second chart, which is the rate of change, that things have started to rollover a little bit. But do note that within recession periods—and a reminder, the green bars on any of my charts are officially-dated recessions—it is not unprecedented for the rate of change to start to decelerate. In terms of the first chart, which is just the level of the leading indicators, it shows we have not started to rollover. It also shows, though, and this is to no surprise, that this recovery has been fairly subpar, the leading indicators have not gotten back to their prior highs, and reflects this very weak pace of recovery, very muddle-through environment. Again, third consecutive mid-year slowdown, and it’s a slowdown from this muddle through this tepid pace. Recall back to mid 2009 when we opined that the recession was ending, which it did. We also opined that the recovery and expansion would likely look like a square root sign, so you get the V bottom and then flatten out. And I think we’re largely in that flattish type of environment. But in the midst of what has become a global slowdown, the US economy actually still looks pretty good in comparison.
So amid all the doom and gloom let’s try to remember what our economy has going for us in the United States that much of the rest of the world
doesn’t. We have an extremely flexible workforce, reasonably well capitalized banks, we have the world’s reserve currency, we have a very vibrant high-tech and innovative sector, we’ve got this new manufacturing renaissance, as I mentioned, a revival in housing, and then more recently the aforementioned plunge in energy prices.
But let’s compare the US economy to the rest of the world, and one way to do that on a nice monthly basis is to look at something called PMIs, Purchasing Managers’ Indices. It’s a measure of the manufacturing side of the economy. In the US, the most popular version of that is the ISM. But PMIs are done across the world, and there’s a lot of similarity in how those surveys are administered. So it gives you a real quick actual in-the-moment look at what’s happening in the economy. And what you’re seeing in this chart is six months worth of data, the last six months worth of readings on PMI for the Euro Zone, China, Japan, and the US. And what you see here is a bit of a breaking away from the pack in terms of the what the US economy has been doing, relative to, say, the Euro Zone economy. And, by the way, that 50 line going across, that tends to be the demarcation point between expansion and contraction. So no big surprise, the biggest weakness in the Euro Zone with much more deterioration recently, and much greater strength in the US.
Now, since we highlighted the significant weakness in the Euro Zone economies, let’s have a look at the latest key statistics in the Euro Zone. And, remember, again, I’m doing this report before we’ve had the results of the European summit. But, clearly, one of the problems that Greece, maybe less in the spotlight right now, we are now dealing with larger countries, Spain and Italy, that are very much in the spotlight. And as a proxy for what’s happening there, you can look at the 10-year bond yield. And in the case of Spain, we have seen that recently jump up to about 7%, which is considered a real danger zone. A little bit less of a near-term risk in Italy, but this is one of the things that has caused big problems, because of the inability for the country to finance these very huge deficits. Now, again, I don’t know what will happen out of the summit. It will have concluded by the time you have viewed this. Our hope, and we have been stating this in various reports and on these videos, is that policymakers move toward a recapitalization of not only the Greek banks, but maybe also the Spanish banks, possibly via the bailout fund, which is the EFSF, European Financial
Stability Facility. We also hope to see a move toward a more comprehensive plan for a Euro Zone banking union. That would be initially, hopefully, in conjunction with a true fiscal union that would include mutualization of debt across nations. Now, again, maybe upon watching this, the markets have been pleasantly surprised by the outcome of the summit, but at this stage in the game, we’re not holding our breath.
So let’s review the economic transmission in terms of the Euro Zone economies’ deep recessions, and let’s look at the world’s two largest economies, the US economy and the Chinese economy. In terms of exports to the European Union, the broad 27-member union, you see we’ve seen much more weakness in terms of China’s exports to the European Union, less of a decline for US exports. And that’s helped keep the US economy relatively afloat compared to others, partly because close to 5% of China’s GDP is exports to the European Union. We’re only 2% of US GDP is exports to the European Union. So it’s not blinders on to what ails Europe, but it’s having less of an impact on the US economy relative to some others.
Now, contributing to the deep recessions in the Euro Zone is the significant contraction in lending, and of course access to credit. So they’ve got a real credit crunch there, and this is a problem not going away and likely to worsen in the near-term. So we’ve seen lending to non-banks within the Euro Zone actually come close to negative territory, and we would not be at all surprised to see that continue to deteriorate. And that is obviously causing major problems, not only for the European community, but also for those countries that trade a lot with Europe.
Now, we do think the European Central Bank, ECB for short, will have to step up and expand its balance sheet further than they already have, as well as hopefully unleashing looser monetary policy. Now, so far Interbank’s spreads remain fairly tight. The ECB has said it will support any major bank in the region under threat of a bank run, but we still think they need to do more. The ECB has proven itself to be less pro-growth than the US Fed, and we think will continue to lag the curve and remain more reactionary. Now, we do think eventually European stocks could react very favorable, probably some big rallies, but only if and when the ECB moves decisively to monetize Euro Zone debt. But the environment until then, we think, will remain highly volatile, and that’s why we continue to suggest that investors underweight Europe.
So when you look at the European Central Bank’s balance sheet compared to the Fed’s balance sheet, you can see with their recent lending facilities, that balance sheet has picked up significantly, not quite to the same degree that the Fed has expanded its balance sheet through QE-1 through QE-2, and, again, we think the ECB is going to have to do more.
Now, let’s go back to the US Fed. You know, the Fed has not been shy with additional ease, the latest, again, being the extension of Operation Twist through year-end. As a reminder, Twist has the Fed selling its shorter-dated Treasury security in order to buy longer-dated treasuries, and the effect is that it’s a compression on long-term borrowing rates. It doesn’t expand the Fed’s balance sheet, like QE-1 and QE-2 did earlier. It just changes the maturity structure. Now, many are now looking for QE-3 from the Fed because of the weakness in the economy, and we do believe they will deliver if there is not a pick-up in economic activity in short order. Now, one of the possible reasons the Fed opted to extend Twist most recently versus announce QE-3, is both due to the diminishing marginal returns of additional quantitative easing, but also the fact that lending has picked up nicely from its lows. So let’s look at both of those factors.
First, lending. This is total loans and leases out of commercial banks. And you see when QE-1 ended, they were still plunging, deep in negative territory. It was kind of a lay-up that we would get QE-2. When QE-2 ended, lending growth was still negative, but well up off the bottom, and now we’re pretty nicely into positive territory, so I think that is one of the reasons. I also mentioned, diminishing returns, so let’s look at that as it relates to the stock market.
The dark shaded areas on this chart represent the phase of QE-1, then the shorter phase of QE-2, and then most recently, Operation Twist. Now, the stock market action is not the only measure of the success of what the Fed does, but I just thought this was an interesting analysis showing from trough to peak in and around these three various easing phases you’ve seen a diminishing return in terms of impact on the market, and that may have come into play in terms of their thinking, as well.
Now, one of the troubling things about the Fed’s extension of Operation Twist is that it adds another layer of uncertainty as we approach year-end. We now have both a monetary cliff because Operation Twist expires at the end of the year, and this fiscal cliff with which to deal. So here’s a table of this so-called fiscal cliff, which is a combination of everything that is set to expire, or kick-in in the case of spending cuts at year-end. So I thought this was an interesting table that bank credit analysts put together because it not only looks at just the straight numbers in terms of the drag on the economy, and if everything happens as scheduled it’s close to a 4% hit on the economy, which more than wipes out all the growth that we have had. However, if you look at the various election scenarios that they put out there, the actual hit to the economy is something quite a bit less. Now, I’m not going to opine on what scenario unfolds here, and these numbers inevitably will be off, but the actual hit almost regardless of what happens in November is going to be lower. The problem, of course, is that even at a lower hit to the economy it still wipes out a good chunk of the amount of growth that we have had. So this will continue to be a huge issue until year-end, both for the psychology of investors, as well as for the economy.
Now, going back to what I mentioned about diminishing return from additional monetary ease, we actually think more fiscal support is needed. And by that I don’t mean traditional fiscal stimulus. There appears to be more traction and bipartisan support for a Simpson-Bowles-type approach, a full-on approach, comprehensive, detailed for dealing with this debt crisis that we have here in the US. And I think were we to get on that path and have it look likely that something would happen either around the election or shortly thereafter, I think that would take a lot of the risk off the table for the US economy and markets, but we’re not holding our breath pre-election.
Now, lest you think this entire video will be nothing but depressing statistics, let’s find and talk about some of the bright spots. Now, I mentioned the plunge in commodity prices and fairly resilient stock market. You’ve got better housing data, low debt service ratios for consumers, so stress on the consumer, which is the big driver of the US economy has actually eased quite substantially. So this is an index, the Consumer Stress Index, I’ve shown this in the past, that I created quite a few years ago, that combines everything from what the stock market is doing, to job growth, to
incomes, home prices, oil prices, medical inflation, overall household liabilities, and food inflation, all combined into a single index. And this is one of those charts where when it’s going up, it means stress is going up. When it’s coming down, stress is going down. So this is one of those charts where down is good, up is bad. So you see a real significant decline in stress on the consumer based on so many of these things, forces, working in favor of the consumer. So that’s the good news.
But I think one of the reasons why consumers remain troubled even though we have some of this stress easing, is in a unique way of looking at what may be affecting psychology of the consumer, and that is the volatility in net worth. We know net worth is not the number we have in our checkbook that we pay attention to on a day-to-day basis, but given that the stock market and housing are two big components, what has happened is in the last 10 years or so, the volatility in that net worth, the swings up and down have really blown-out relative to the long-term norm. And I think maybe without realizing that is having an affect consumer psyche, partly due to the fact that we had a stock market bubble that popped in 2000, and then, of course, the housing bubble that popped in 2007, the two biggest components of net worth.
Now, also weighing on consumer psyche has been the latest job data, but it’s important to put that into historical context. I’ve shown this chart before. The first part of it looks at initial unemployment claims, which is one of the key leading indicators for the economy. It’s the number we get out on a weekly basis every Thursday. This first chart looks at a four-week average, which is a common way of looking at this measure, and it shows the recent big drop in claims. By the way, as a reminder, this is one of those charts where down is good, up is bad. You want to see declining initial claims. And it to some degree mirrors what we saw when we came out of the early ‘80s back-to-back recessions, as you can see here. Now, in the second chart, it’s just simply the unemployment rate. And what I did with those dotted lines is I showed the peak in the early 80s, very similar to the peak more recently in the recession in claims, a similar trajectory down. At the point we hit relative to the early 1980s where we have been recently, the drop, the related drop in the unemployment rate was very consistent. What I want to point out, though, is look at what happened after that big whoosh down in initial claims after the early ‘80s recessions. We went through a period of flatter, choppy pattern, not only coming out of the early ‘80s recession, but the 1991 recession. The same thing happened coming out of the 2001 recession. So I’m not here to say the jobs environment is perfectly healthy, but this kind of steadying out, leveling out, a little bit of volatility with kind of a flattening trend is not all that unique relative to history. So it’s always important to put that into context.
Now, the next chart shows an interesting relationship between oil prices and economic surprises. I talked about oil prices, energy prices more broadly having come down quite a bit. Now, up until March/early April of this year, we had seen many of the economic releases underperform expectations because of what had been a huge surge in energy prices. We also know that the winter had extremely warm weather, so that gave a boost to the economy earlier in the year and we’re having some give-back there, as well. But higher oil prices in the first quarter, again, weighed on subsequent growth, and I think that’s one of the reasons why the more recent economic reports have been worse than expected. The good news, of course, is that oil prices have plunged, as have expectations for the economy. So I think this is setting up an opportunity for a turn toward the positive for economic surprises. So what the chart looks at is WTI crude oil price in orange, and that’s on an inverted scale, and then the CitiGroup Global Economic Surprise Index. It measures how economic readings are coming in relative to expectations. And you can see that those two track one another almost perfectly going back the last several years. And unless that becomes a huge divergence and we don’t continue to follow this pattern, the recent decline in oil prices suggests a turn in economic surprises.
And then, of course, housing has become a much brighter light. Now, I discussed this in more detail in last month’s Market Snapshot, but I want to highlight it again, because in the case of this, my favorite housing indicator, the Real Mortgage Rate, it has continued to improve. And this is an update from last month. So what the Real Mortgage Rate is, is it takes the nominal mortgage rate, the 30-year fixed mortgage rate, minus the rate of appreciation or depreciation in home prices, equals the real mortgage rate, kind of like real GDP is nominal growth minus inflation equals the real rate of growth. So what you see is from a… going back to that point circled number 1, that was the peak in the housing market, which was the bottom, not coincidentally, in the real mortgage rate, where you had a 6% 30-year
fixed mortgage rate minus a 17% rate of appreciation in homes got you a negative 11% real mortgage rate. No wonder why we had a bubble. You could borrow at negative interest rates, borrow at 6 to buy an asset appreciating at 17%. Fast forward to the point circled number 2, right in the depths of the recession, after the housing bubble had burst, mortgage rates have come down to 5%, but now you were subtracting 17%, ironically, at the bottom in terms of house price depreciation. So 5 minus a negative 17 was plus 22. You had no hope for a recovery in housing with 22% real mortgage rates, because even though mortgage rates in nominal terms have come down, the asset you were borrowing to buy was still plunging. Fast forward to today, we’ve now got a 4%, actually a sub 4% 30-year fixed mortgage rate, but we’re now subtracting positive appreciation again for home prices. So the real mortgage rate is actually negative 4%. That’s a pretty healthy environment.
Now, also, last month, I highlighted not only record affordability, but supply and demand fundamentals. Now, let’s look at those supply and demand fundamentals in a slightly different way. I just put this chart together not too long ago, and it shows net household formations, which are the purple bars versus housing completions. Now, you see the huge jump in net household formations in 2011. That’s after a steady, steady decline, and we know the reason for it. I’m sure a lot of you have maybe college-age kids that finished college and came right back to the nest because they either couldn’t afford it or opted not to try to go into the household formation mode. That is starting to reverse itself, yet the housing completions has continued to come down, and we’re now looking at a real mismatch between household formations and housing completions which suggests that homebuilding will need to accelerate to meet that demand.
Now, there’s also a key housing market index that was, frankly, one of the indicators that triggered us at Schwab to make a very, very pessimistic call on the real estate market in ’06, and subsequently the economy and stock market in late 2007. You know, we don’t tend to go out there with forecasts, and we didn’t really forecast, but it had become very clear to us that something was not right. Now, that indicator has been trending up recently and suggests a rebound in home sales further that actually should take us back to the pre-bubble era. So it’s the NAHB Wells Fargo Housing Market Index. It’s continued to move higher and suggests that home sales, total home sales, should continue to trend up. And that is a very clear basing that we saw in the last couple of years that is starting to move higher.
Now, the turndown in the housing index in 2006 nicely warned of a rougher stock market to come. So now let’s move on and talk about stocks, starting with the sentiment environment, an area as most listeners know, of market analysis that is near and dear to my heart. I pay a lot of attention to this. With the recent 10% correction that we got, sentiment went from being extremely optimistic into an extreme pessimism zone, maybe not quite as deep as I would have liked to see. And, a reminder, sentiment works in a contrarian way—the more pessimistic investors are, the better that environment for the stock market, because it usually means things have gotten washed out. You can see we’re now in the zone where the stock market has had close to double-digit returns. Looking at the… sort of the row up from that in the table, the good news is, is we appear to be accelerating from deep pessimism, and it’s that acceleration back into the neutral zone that has actually generated the best returns for the stock market going forth. None of these are forecasts, of course, but I actually like to see negative investor sentiment.
Now, most of the sentiment measures that I look at and most people look at, the indices, they simply measure attitudes of investors, but we also need to look at investors’ actions as a measure of sentiment. And when you look at mutual fund flows in and out of stocks, in and out of bonds, it is no big surprise, I’ve talked about this a lot, it is now reflecting extreme pessimism on the part of investors in terms of where they’ve been putting their money. And we’re in a zone now, again, of extreme pessimism that in the past, as you can see in the table, has been the zone in which the best stock market returns have been generated.
One other bright spot is the market’s valuation. On a forward basis, the S&P 500® is trading at only 12.8 times earnings, and that is well below the 16.8 long-term median for valuation. It doesn’t mean the market can’t go lower. This is not a perfect guide, but it certainly gives you some cushion in this highly volatile environment.
And I want to conclude with a final chart highlighting what I talked about in the beginning, which is that the US house is likely the best even if it’s in a
bad neighborhood, as so much as been discussed. So let’s look at the S&P 500 as a proxy for the US stock market relative to the MSCI Emerging Markets Index. Now, we’re fairly favorably disposed towards emerging markets, certainly over the non-US developed markets like Europe, but I actually think the US will continue to accelerate at least in relative terms from a performance perspective. And we may be in the beginning of another kind of bottoming-out here and a resurgence in relative performance of the US stock market compared to at least emerging economies.
So let me conclude and say that, look, the short-term clouds remain very dark. We have limited near-term support likely coming from policymakers, whether it’s here or in Europe, but the major factors that have underpinned the bull market in stocks in the last three years haven’t yet deteriorated such that it dents my longer-term optimism. I mentioned you’ve got central banks and developing economies beginning to unleash unbelievable monetary firepower. Commodity prices have come down, feeding right into the consumer. Interest rates remain at historic lows. Now, tail risks remain high for now, and that’s why we’ve been more cautious, but many are likely already priced into markets and expectations. Remember, neither get in nor get out. Questions I get all the time: ‘Should we get in?’ ‘Should we get out?’ Neither of those are investment strategies. Of course, nor is panic. So keep your emotions in check. Go back to the tried and true—diversification, rebalancing, reasonably long time horizons.
And, of course, we thank you for joining us for this Market Snapshot. As always, Schwab investment professionals can provide you with copies of today’s presentation, and you can find additional market commentary under the Market Insights tab on Schwab.com. Thank you.
DISCLOSURES AND DEFINITIONS
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions and estimates herein are as of the date of the material and are subject to change without notice at any time in reaction to shifting market conditions. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Examples provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain.
Diversification does not eliminate the risk of investment losses.
Indexes are unmanaged, do not incur management fees, costs and expenses (or "transaction fees or other related expenses"), and cannot be invested in directly.
The Citigroup Economic Surprise Index measures the amount that economic activity surprised or disappointed relative to analyst expectations. It’s defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance beating consensus. The index is calculated daily in a rolling three-month window.
The Morgan Stanley Capital International (MSCI) Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, 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 a capitalization-weighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their outstanding shares.
Asset Allocation - The strategy of spreading your investment funds across categories of assets such as stocks, bonds and cash investments to help offset risks and rewards, based on your goals, time horizon and risk tolerance.
Ned Davis Research (NDR) Crowd Sentiment Poll - Shows perspective on a composite sentiment indicator designed to highlight short- to intermediate- term swings in investor psychology. It's based on seven different individual sentiment indicators in order to represent the psychology of a broad array of investors.
Recession - As per National Bureau of Economic Research (NBER), a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
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