Looking Past the U.S. Election, Looking Past Wait-and-See (Sonders)

October 26, 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
by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key Points

• The market appears to be in a "wait-and-see" mode in advance of the elections, but looking beyond November 6^th is important for investors. The election is only one piece of the puzzle, and certain aspects of the political landscape likely won't be much clearer after Election Day.
• Earnings season has been somewhat disappointing, even though there was a relatively low bar to hurdle. We see more signs that the slowdown in the United States may be ending, however, with strength in housing particularly noteworthy.
• European policymakers continue to drag their feet, although there is likely some comfort that the ECB has attempted to take the worst-case scenarios off the table. Chinese growth remains sluggish and despite the possibility of a near-term rally, longer term pressures remain.

As for the election, it appears likely that party leadership in Washington will continue to be split. The House is likely to remain under Republican control, while the White House and Senate are very close calls. Assuming no single-party sweep, some measure of gridlock could remain regardless of who wins the presidency. Regardless of how the election turns out, uncertainty regarding both the fiscal cliff and long-term debt and deficit reduction plans will likely remain.

In spite of the election uncertainty, the coming fiscal cliff, continuing dithering in Europe, the slowest rate of growth in China since 2009, and tensions rising in the Middle East, the stock market continues to be near five-year highs—despite the recent pullback. Notably, the weakness over the past couple of weeks appears to have worked off some of the excessive optimism (a contrarian indicator) that had developed. According to Ned Davis Research, as of October 23rd, sentiment had moved into the neutral zone from the extreme optimism zone, which we view as a positive development to set up the market for another possible move higher.

Are the clouds parting?

Third-quarter earnings season has thus far somewhat disappointing despite relatively low expectations. Companies have mostly met or exceeded bottom-line expectations but revenue growth has been more disappointing. This is not surprising given the global slowdown over the past several months. With continued massive corporate cash balances on the sidelines, however, a few small holes in the dam of continued cautiousness could lead to the floodgates being opened. Animal spirits continue to be a potential powerful force behind the economy that could be unleashed if some uncertainty wanes.

Helping push businesses in that direction could be improving US financial conditions; characterized by easier credit access and a more receptive equity market. One broad measure of financial conditions comes from the National Financial Conditions Index, released by the Chicago Federal Reserve, which is now showing its lowest (most attractive) reading since June 2007.

Financial Conditions Support Business and Consumer Expansion

Source: FactSet, Chicago Federal Reserve. As of Oct. 23, 2012.

After the economy again flirted with stall speed for the third consecutive year, there are signs that the mid-year slowdown may be coming to an end, and growth may accelerate. The manufacturing sector, for example, saw a sizable midyear slowdown, with the Institute for Supply Management's Manufacturing Index falling into territory depicting contraction. The most recent reading, however, was above the key 50 level and some regional surveys also are showing further improvement. The Empire Manufacturing Index, although still in negative territory, rose to -6.16 from -10.41, while the Philadelphia Fed Index moved into positive territory for October by posting a reading of 5.7 after -1.9 in the previous month. Additionally, industrial production for September rose 0.4%, after falling 1.4% in August, while capacity utilization ticked up to 78.3% from 78.0%—all marginal improvements but moves in the right direction.

More important may be the improved health of the consumer. Data from September started with a bang as retail sales posted a surprising jump of 1.1% month-over-month, while excluding autos and gas, the gain was still a solid 0.9%. Heading into the critical holiday shopping season, we view this positive momentum after a negative reading in the summer as a good sign; and reflective of much-improved consumer confidence and sentiment. Additionally, gasoline futures prices, according to ISI Research as of October 18, are down about 20 cents, which could provide a further boost for consumers.

Retail Sales Rebound?

Source: FactSet, US Census Bureau. As of Oct. 23, 2012.

The recent strong housing trends are likely also boosting confidence. While the housing market is still not robust in an absolute sense, it appears the upward trend is too strong to ignore. New-home sales jumped another 15% in September to their highest level since July 2008, while the more forward looking building permits reading kicked 11.6% higher, also the best level since July 2008.

Finally, the National Association of Homebuilders' Housing Market Index (HMI) rose to 41, which, while still below the level of 50 that indicates more builders view sales conditions as good than poor, is the best reading since June of 2006. The recent year-over-year percentage increase in the HMI has been at record highs. And while probably not strong enough to overcome a potential fully loaded fiscal cliff should it come to fruition, housing improvement in our view can help the economy in many ways. It can help further solidify banks' balance sheets; provide confidence to consumers as houses are typically their largest asset; allow people to relocate for a better-paying jobs; and help the construction industry as more homes are built.

With the Federal Reserve continuing to explicitly target the housing market through the buying of mortgage-backed securities via its latest round of quantitative easing, it should help to keep mortgage rate at or near record lows for some time.

Eurozone muddles through

Faced with even greater challenges, the European Central Bank (ECB) has been able to thwart worst-case scenarios in the eurozone and buy time with the promise of potential sovereign-bond purchases. This has resulted in relief in peripheral government bond markets, benefitting Spain in particular. Spain's fundamentals, however, continue to worsen. Home price declines have accelerated, falling 2.4% in the third quarter from second quarter and bad loans have risen to a record 10.5% in August from an upwardly revised 10.1% in July. Banks are reining in activity, meanwhile, after deposits fell 8.7% from a year ago in August, and bank loans dropped 5% in August versus 2011.

The Spanish government's fiscal deficit target of 6.3% for 2012 may be missed and Spain's economy contracted in the third quarter for a fifth-straight quarter. Despite these negatives, Spain's government is projecting a 0.5% decline in gross domestic product (GDP) in 2013, smaller than the International Monetary Fund's (IMF) 1.3% forecasted contraction, and the Bloomberg consensus of a 1.4% decrease. A late-November election in the Catalonia region may be a referendum on secession, which could have negative consequences. Economic realities may thwart dreams of separation, however, and we view secession as a low-probability event.

In summary, because the relief in Spain's government bond market is based primarily on improved sentiment and not fundamentals, the country's bond market is vulnerable to renewed pessimism, making yields potentially volatile with a possible upward bias. It may take yields moving higher before Spain asks for aid. This may be greeted positively by markets, however, as it would remove an uncertainty.

Even Germany's economy struggling

Source: FactSet, IFO national Institute of Research, German Federal Statistics Office, Eurostat. As of Oct. 23, 2012.

While the ECB has taken the eurozone out of crisis mode, economic growth is likely to remain weak. Despite some improvement in September, a sustained economic recovery is not yet in view; even in Germany, viewed as an economic stronghold. German business confidence as measured by the Ifo survey dropped to the lowest level in more than two-and-a-half years in October, and the preliminary eurozone composite purchasing manager index fell to 45.8 in October, the lowest in more than three years.

While austerity in many countries is a headwind, we are also focused on the European banking system, which we still believe is in need of more capital. Germany, the Netherlands and Finland are resisting allowing the European Stability Mechanism (ESM) bailout fund to be used to recapitalize banks for "legacy" problems. These countries want the ESM to be used only for problems that occur after eurozone-wide bank supervision, which is not expected to start until sometime in 2013. Additionally, bank deleveraging has barely started—of the $2.8 trillion base case the IMF estimates that European banks need to deleverage from the third quarter of 2011 to the end of 2013, only $600 billion has been completed through the second quarter of this year. A hobbled banking sector is unlikely to expand lending in our opinion, which could keep a lid on economic growth.

While eurozone stocks have the potential for a "catch-up" rally, we urge investors not to be complacent about the risks—volatility could increase again and challenges remain. We outline our neutral stance on eurozone stocks in our article.

Has China bottomed?

Investors seemed to take solace from China's recent economic data, with China's third quarter GDP figure of 7.4% meeting the Wall Street consensus estimate, and data for September showing somewhat of a rebound in the economy. However, we are even more skeptical than usual about these government figures, with the trend being the main source of our consternation. We're taking our cue from commentary from companies, with the ISI Research company survey falling to levels not seen since 2009 and earnings reports from US multinationals indicating either uncertain or slowing outlooks in China.

China's bounce would be off a significant slowdown

Source: FactSet, national Bureau of Statistics of China. As of Oct. 23, 2012.

That said, there is some signs of inflection, and it appears that worst-case scenarios in China may have been averted. Glimmers of hope include an improvement in infrastructure construction, a bounce back in purchasing managers indexes (PMIs), money supply, rail volume and electricity consumption. Additionally, new stimulus could accompany the coming leadership transition that begins the same week as US elections.

We are concerned about the recovery in China, as we believe speculative excesses could make the recovery more difficult and slower than many expect. There continues to be the expectation of a turn in China just around the corner, with 19 of the 24 economists surveyed by Bloomberg forecasting a rebound in GDP in the fourth quarter, two expecting flat growth, and only three anticipating a further moderation. While past underperformance, a bottoming of economic data and new stimulus could result in a several-months-long rally in investments tied to China, we believe any rallies should be treated with caution. A difficult recovery and high expectations could present headwinds, and a rally in China-related investments may be short-lived. Read more in our article Is the Worst Over for China?

Global divergences

Preliminary readings on economic growth in October show divergences—a rebound in China and deterioration in the eurozone; while the United States is expected to have improved. Overall global economic growth appears tepid, however, but it's not falling apart either. Positively, central banks globally continue to have a bias toward easing monetary policy, with inflation generally subdued.

Does that mean investors should avoid international investments? We think not. Investing internationally still provides a diversification benefit for portfolios over the longer term and it is rare for a country to be the top stock performer for more than a year. Trends can change and markets can move in unpredictable ways, making an "all-in" into any one asset class a precarious proposition.

Read more international research at www.schwab.com/oninternational.

So what?

Earnings season in the United States has been disappointing and global economic growth remains slow. But there are signs of hope as US economic indicators have been trending higher; excessively optimistic sentiment has been worked off; and we're closer to a resolution of the election, and a potential fix to the fiscal cliff. We believe this is setting up for a renewed uptrend in stocks after some continued near-term volatility, but urge investors to maintain a diversified portfolio because no one can predict the future.