by Mark W. Riepe, Schwab Center for Financial Research
What's an investor to do in the face of a soft domestic economy and an uncertain outlook abroad? Kathy Jones, Schwab's fixed income strategist, and Michelle Gibley, Schwab's director of international research, shared their thoughts with Mark Riepe.
The US economy
Q (Mark Riepe): What should we make of Friday's US unemployment numbers?
Kathy Jones: The unemployment report was a disappointment. The numbers indicate that economic growth is soft and employment growth is stagnating in the United States. The bond market, which had sold off in response to the earlier good news out of Europe, rebounded on the unemployment report. The figures seem to indicate the likelihood of continued low inflation.
- The number of jobs increased by only 96,000 in August, less than the 130,000 jobs anticipated and well below the more than 200,000 jobs indicated by the ADP survey. The previous two months were also revised downward, taking away another 41,000 jobs.
- The underlying figures were soft as well. The workweek declined by 0.1 hour to 34.4 hours, average hourly earnings were flat for the month and are up only 1.7% year to year, and factory payrolls declined by 15,000.
- Although the unemployment rate declined to 8.1% from 8.3%, that was only due to a drop in the size of the labor force. In fact, the labor-force participation rate fell to a 31-year low of 63.5%. The unemployment rate has been greater than 8% since February 2009, the longest stretch above 8% since 1948.
Q: Could unemployment data influence the Fed's decisions on further stimulus?
KJ: The Fed considers unemployment figures to be very important, since the goal of full employment is part of the Federal Open Market Committee's mandate. But we think a single number is not likely to alter its view significantly. We think the Fed was already poised to provide more stimulus based on recent statements focusing on the sluggish pace of US economic growth as well as downside risks from Europe and the approaching "fiscal cliff" of possible higher taxes and spending cuts in the United States early next year.
In the minutes of the July Fed meeting, the Fed stated that easing would be warranted unless the incoming data pointed to "a substantial and sustainable strengthening in the pace of economic recovery." Fed Chairman Ben Bernanke followed those statements with a recent speech in Jackson Hole that defended the Fed's extraordinary policy moves over the past few years and pointed to the benefits of quantitative easing. We believe more policy initiatives are likely from the Fed.
Q: Could a quantitative easing plan by the Fed be tied to an employment target of some kind?
KJ: We think the Fed will probably try to avoid targeting a level of unemployment because it limits its room to maneuver by making policy too formulaic. Moreover, there's a lot of statistical "noise" in the employment figures from month to month, and the figures are often heavily revised later on. Nonetheless, it seems clear that the Fed believes unemployment greater than 8% is too high and that it isn't a structural problem, i.e., a mismatch between skills and the labor force, but instead is due to weak economic growth.
Q: Would the Fed's most effective stimulus tool be a promise to hold down rates for a longer period?
KJ: Holding rates down even longer is one possibility and could be an effective tool. It's one of the easier policy options to implement, and it may also be one of the least controversial moves the Fed could make at this point (although it would likely still be criticized by some).
The Fed will release revised economic and interest-rate projections at this week's meeting, and it's possible that it could extend its expectation for rates to remain low into 2015; however, that would be based on input from the various members of the Federal Open Market Committee.
Fixed income investing
Q. How can investors go about building a fixed income portfolio these days?
KJ: We believe a few basic strategies could help investors in the current low-interest-rate environment:
- Stay invested. Earning income even at low rates is better than sitting in cash with money that isn't needed to meet near-term expenses. It's unpredictable when the interest-rate environment is going to change, but few would have guessed in 2008 that yields would still be this low in 2012. In our opinion, it could take a while before interest rates rise substantially.
- We generally favor laddered bond portfolios to help manage interest-rate risk, targeting an intermediate-term average duration (a calculation used to estimate how a change in interest rates will affect the price of a bond or bond portfolio1) of about five to seven years, depending on an investor's risk tolerance and when the money is needed.
- The fixed income core of the portfolio should be high-quality bonds, such as a mix of US Treasuries and investment-grade corporate and municipal bonds. For added diversification and income, we suggest putting up to 20% of the fixed income portion of a portfolio in more-aggressive strategies such as high-yield bonds, preferred securities or emerging-market bonds, provided that investors are comfortable with the added risks.
- Higher-coupon bonds can also be a good strategy to consider in a low-interest-rate environment. The added income can help reduce the volatility of the bond when rates do rise. Investors need to keep in mind that they’ll pay higher prices for higher coupons, all else being equal.
- Some allocation to inflation-linked bonds such as Treasury Inflation-Protected Securities (TIPS) can be a way to help protect against inflation longer term.
Q: Does the European Central Bank's (ECB) bond-buying program make investing in European bonds any safer?
KJ: We do not see a favorable risk/reward in European bonds. The countries considered safer have yields that are too low to take currency risk, while the countries with higher yields are still risky in our view. The bond-buying program doesn't address some of the problems in the European banking system or boost the amount of credit available to the economy.
The plan would lower the quality of the ECB's balance sheet. The bank removed the credit requirement for sovereign bonds used as collateral, which could mean deterioration in the credit quality of the central bank's balance sheet over the long term. The announcement did help bring down yields in European bond markets such as Spain and Italy, where there are concerns about those countries being able to finance their debt.
The plan entails the ECB buying short-term bonds in countries with elevated yields if the countries apply for help and accept the terms that the EU lays out, which are largely aimed at cutting spending and making structural reforms.
The ECB indicated that the bond buying would be "unlimited," but it also indicated that the market intervention would be sterilized, meaning that it will drain reserves by the same amount that it injects into the market.
On the positive side, the plan sends a signal that Europe is working on its problems and it should buy fiscally troubled countries some time to address their underlying economic problems. It also shows a commitment to the common European currency.
However, the ECB's move doesn't guarantee that long-term rates will remain low, nor does it eliminate the possibility that another country (beyond Greece) may need to restructure its debt. It also doesn't appear to do anything to boost economic growth, a key underlying problem for resolving some of the region's deficits.
Michelle Gibley: The ECB laid out the technical aspects of a sovereign-bond purchase program for Outright Monetary Transactions. The ECB justified the program by citing market dysfunction over concerns about the viability of the euro.
The plan requires participating countries to first officially ask for assistance and commit to deficit-reduction targets and structural economic reforms (known as conditionality). To the extent warranted by monetary policy, the ECB may buy the debt of these countries in unlimited amounts, up to three years in maturity, on secondary markets. Purchases will be "sterilized," meaning that injections of liquidity are offset by withdrawals via ECB issuance of short-term debt.
We view the plan positively because it differs from past actions. Insisting on conditionality is a positive as it keeps pressure on countries; the ECB's purchases won't be given seniority status; the break-up of the euro may be less in question (though not a zero probability); and the plan is stronger in our view because the ECB is acting as a buyer of last resort.
Challenges do remain. Eurozone banks need more capital; economies are struggling; and the euro faces longer-term risks, such as the need to move toward a banking union. Countries need to stay the course, which will be difficult.
Q: There's an important decision expected this week from Germany's Constitutional Court on the eurozone rescue fund. What's at stake and what's the significance?
MG: The German Constitutional Court is examining the legality of the permanent bailout fund (known as the European Stability Mechanism, or ESM) and Germany's involvement in the eurozone fiscal compact. The court is involved because, according to German law, the country needs to maintain control over its fiscal budget and can't be forced into long-term financing of the debts of other countries.
Many court watchers expect a positive ruling, which would allow the ESM to proceed, but the ruling is likely to be accompanied by conditions for the use of the ESM. For the temporary EFSF fund, the court attached the condition that the German parliament would vote each time the EFSF would be used. Other conditions could include limiting the ESM from increasing in size or turning into a bank holding company.
The court, however, could rule that the ESM is illegal, potentially resulting in turmoil throughout global financial markets because policy makers would have to go back to the drawing board to find a way to provide longer-term access to bailout funding.
Q: What other events in Europe should investors be watching for in the months ahead?
MG: Several events in September and October could inject risk into markets, but the ECB's Outright Monetary Transactions plan could cushion the downside because the central bank appears willing to be a lender of last resort.
Independent audits of Spanish bank capital needs are expected in September. Spain's credit rating is under review by Moody's Investors Service and Standard & Poor's, with a decision expected before winter. Spain's debt could be downgraded to below investment grade.
Spain's funding needs pick up in late October. As the auctions to refinance existing debt approach, market pressure could increase and force Spain to make a decision. We believe there's incentive for Spain to ask for aid before the credit rating reviews and the auctions in late October, but Spain doesn't necessarily require aid at this point.
Greece could still exit the euro, but not yet. Policy makers are indicating that they're willing to negotiate, with a report due later in September from the commission overseeing the debt crisis and a decision on the next quarterly disbursement due in October. Fortunately, the ECB's willingness to be a lender of last resort has, in our opinion, reduced the risks of contagion to other countries if Greece does exit the euro.
Q: What's the overall outlook for Europe right now and what should investors do with eurozone stocks?
MG: We recently upgraded our view on eurozone stocks to neutral from underperform, as we believe the ECB's plan is a significant positive step that reduces extreme downside risks and due to significant underperformance by eurozone stocks over the past two years. While a large catch-up rally is possible, we believe challenges could limit the ability of eurozone stocks to outperform over the medium term.
We believe weightings in line with long-term asset allocations are appropriate for both eurozone stocks and, as an extension, the overall international asset class, due to the large weight of the region in the MSCI EAFE Index, which measures stock performance in developed markets outside the United States and Canada.
Performance over the medium term could be hindered, however, because challenges remain. Eurozone banks need more capital, economic growth will likely be subpar and longer-term risks to the euro remain, such as the need to move toward a European banking union. Additionally, countries need to stay the course, which will be challenging. A caveat: The German Constitutional Court ruling on Sept. 12 could change the outlook if the court rules that the ESM is illegal.
Q: Which individual European countries may present some positive near-term investing opportunities?
MG: While low-quality stocks in peripheral European countries may post the strongest rebound, we prefer staying with quality names in core countries, as we expect heightened risk to continue in peripheral countries. Within the eurozone stock index, the core countries of France and Germany have the highest weighting.
Germany has a relatively strong economy as well as an export sector that produces specialized goods and has solid brands, which puts it in a strong competitive position. During the second-quarter earnings season, 73% of companies in Germany's DAX Index beat sales estimates and 72% beat earnings estimates, indicating expectations may be low. Germany's stock market, however, has a high weight in cyclically exposed, export-oriented sectors (industrials, materials and energy) of 40%, meaning that it's still dependent on factors outside of the German domestic economy that move with swings in the business cycle.
France's economy has been more resilient than expected, but leading indicators suggest that it could still enter recession. Additionally, President François Hollande has proposed policies that appear anti-business and anti-competitive in nature. There may be opportunities in individual stocks, however, as many French companies in the consumer discretionary sector have strong global brands.
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1. Duration assumes a 1% change in the interest rate. For example, if a bond has a duration of eight and the yield to maturity for the bond moves by 1%, then the bond’s price is expected to go up or down by 8%. Does not consider the effects on price of any stated call features or other redemption provisions.
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.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Fixed-income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications, and other factors.
High yield bonds are subject to greater credit risk, default risk and liquidity risk.
Investments in foreign assets may incur greater risks than domestic investments. Investing in emerging markets may accentuate these risks.
Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
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 EAFE captures about 85% of the investable developed-markets universe excluding the United States and Canada. The index has been calculated since 31 December 1969, making it the oldest truly international stock index.
The DAX (Deutscher Aktien IndeX, or German stock index) consists of the 30 largest German companies in terms of order book volume and market capitalization trading on the Frankfurt Stock Exchange.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.