Schwab Market Perspective
The How Matters
November 30, 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
- Market focus has clearly been on fiscal cliff negotiations. An agreement that averts the cliff would likely ignite a further near-term rally, but the ultimate solution and its components could have longer term consequences that may not be as market-friendly.
- US economic data has been impacted by Hurricane Sandy, but it appears modest growth is continuing; although business investment has fallen off. Housing continues to provide support and the Fed is staying the course.
- There are some signs of growth stabilization globally, notably in some of the emerging economies, including China. But the eurozone remains in a recession, while Japan recently dipped into one as well.
You can be forgiven if you are tired of the words "fiscal cliff" (we certainly are), but markets are focusing on little else. We've seen large swings in the major indices based on daily comments from politicians on the progress of negotiations, and that is unlikely to change until a resolution is at hand.
First, let's put some perspective on the term "fiscal cliff." We believe it would be better described as a fiscal slope. While the tax increases would kick in immediately, the spending cuts would occur over the course of the year; allowing at least some time for the economy to adjust. And it's important to remember that the economy doesn't operate in a vacuum. There will be other economic developments occurring that could exacerbate or serve to offset the impact. For example, if an agreement is reached—even if it doesn't appeal to all, as is most likely—at least some measure of certainty would be injected, which could free up businesses to make decisions they have been postponing as they waited for the rules of the game to be set. This appears to be a relatively large problem as The Wall Street Journal reported on November 19 that 50% of the 40 largest US companies have announced plans to curtail capital spending this year or next.
Businesses waiting for a resolution
Source: FactSet, U.S. Bureau of Economic Analysis. As of Nov. 23, 2012.
We believe that the market would rally nicely in the near term should an agreement be reached, but the how/what of the deal could have an impact on the markets and economy. We do hope the United States takes some lessons from Europe as they continue to struggle with burgeoning debt in several countries. While they have focused on austerity, growth promotion has largely been ignored. Economies can grow themselves out of a lot of problems and we believe that a deal here that reduced the incentive of risk taking by businesses or increased the costs of growth would be detrimental. We're already starting to see some evidence that some provisions of the Affordable Care Act may be impacting businesses' desire to expand. Many companies have indicated they may move employees below the 30-hour/week limit that would require them to provide insurance; while some small companies are weighing the cost of adding a 50th employee. A more competitive corporate tax code, rational regulatory oversight, entitlement reform, and reasonable spending cuts that solidify the US credit rating would help establish an environment where economic growth can be the most powerful solution to the US debt crisis.
Stormy data results in hazy view
The impact from Hurricane Sandy continues to influence readings as we saw retail sales fall in October with the National Association of Retailers attributing the decline to the impact from the storm. Additionally, industrial production fell 0.4% with the Federal Reserve estimating a negative 1% impact from Sandy. And, of course jobless claims have been elevated and home sales have impacted in the region as well. But moderate growth remains the trend; and the recent upward revision to third quarter gross domestic product to 2.8% was heartening. We also expect a post-Sandy boost to growth from the rebuilding efforts.
As noted, housing continues to recover, providing another leg of support to the economy and consumer confidence, particularly important in the midst of the holiday shopping season. Existing home sales rose 2.1% in October while the National Association of Homebuilder's Index's latest reading was 46, still below the 50 dividing line between conditions improving and deteriorating, but the highest level in six years. Additionally, housing starts, which can be a rough gauge of confidence among insiders in homebuilding, rose 3.6% in October to the fastest pace since July 2008; and pending home sales recently hit a five-year high.
Starts indicate improving confidence in the recovery
Source: FactSet, U.S. Census Bureau. As of Nov. 23, 2012.
Fed continues to fight the good fight
The improvement in housing is giving the Fed some comfort as it continues to implement its third quantitative easing program, involving the purchase of mortgage-backed securities in an attempt to bring down the unemployment rate and further stimulate housing. Next up is "Operation Twist," the program under which the Fed has been buying long-term securities and selling short-term securities in an attempt to further drive down longer-term yields. It is scheduled to conclude at the end of the year; but allowing it to expire could be viewed as a form of tightening, which various Fed speakers over the past month have indicated is not their desire; so some action is likely. The Fed will also be keeping an eye on the fiscal cliff negotiations and may feel forced to do even more should an agreement be elusive.
Europe's weak link(s)
In the eurozone, the lack of focus on growth in the name of austerity is negatively reinforcing a weak economic situation in the near-term. However, there are some reforms that could reduce labor costs and improve competitiveness, and open some "closed" professions to new entrants. These reforms could help over the longer-term, but they will likely take effect slowly. In the meantime, economies are contracting, people are losing their jobs, incomes are falling and confidence is weak—again, the how matters.
The banking sector is likely another headwind for growth in the eurozone. A key difference relative to the US banking system is the speed at which shortcomings are addressed. Banks in the United States started to receive capital infusions and write down assets within a year of the fall of Lehman, while banks in the eurozone are still likely in the early innings. According to the International Monetary Fund (IMF), of the $2.8 trillion base case the IMF estimates European banks need to deleverage from the third quarter of last year to the end of 2013, only $600 billion has been completed through the second quarter of 2012.
A eurozone banking union could help boost confidence in the financial system, but progress has been slow. Common supervision would be the first step, but appears a ways off, and deposit insurance and a process to wind down insolvent banks don't appear to be on the drawing board. With the banking system still hobbled, lending could remain under pressure, and therefore economic growth could continue to struggle.
Depressed eurozone lending a weight on growth
Source: FactSet, European Central Bank. As of Nov. 27, 2012.
In Greece, a third rescue has been negotiated, and Greece may recede from the headlines for a bit; but the "new" Greece debt deal may not be the last. Spain has benefitted from the sentiment boost of the safety net of potential European Central Bank (ECB) bond purchases, but fundamentals remain weak, leaving its bond market vulnerable to the whims of sentiment.
The ECB's safety net has resulted in some areas of economic stabilization in the eurozone, but there are still areas of deterioration. The first estimate of the eurozone's composite purchasing managers index (PMI) gained 0.1 to 45.8 in November, and business confidence in Germany and France rose. However, delving into the PMI components, new business growth fell at the fastest rate since mid-2009, inventories were worked down at the largest rate since Aug. 2010 (a detraction from economic growth), and the rate of job losses was the second fastest since Jan. 2010. While the PMI rose, the low level indicates the recession could worsen in the fourth quarter—eurozone GDP could fall as much as 0.5% according to Markit, which compiles the PMI survey.
Eurozone stocks have the potential for a catch-up rally due to past underperformance, but we urge investors not to be complacent about the risks—volatility could climb again and economic challenges remain. We outline our neutral stance on eurozone stocks in our article.
Japan in flux
Japan's economy continues to stagnate and the Bank of Japan (BoJ) has yet to be effective in creating either growth or inflation; pursuing a timid policy that likely needs to be more aggressive. An upcoming election on Dec. 16 could shift power to the Liberal Democratic Party (LDP), which has called for "unlimited" monetary easing, an inflation target of 2% and new fiscal stimulus. These measures could weaken the yen, which has already dramatically moved in anticipation, resulting in a Japanese stock market rally.
Sustained weakness in the yen could help Japanese stocks, but we believe more fundamental changes to Japanese corporate culture are required before we see lasting and meaningful improvements to the economy. We believe the Japanese stock market may have headwinds as we detail in our article.
Déjà vu in China
China's economy appears to be bottoming, with the government engineering a soft landing in the domestic sector. The recovery is being led by an uptick in infrastructure approvals and starts, and is spreading to related industries. Moreover, the stabilization in the global economy has been mirrored in China's exports and industrial production. However, the external sector (exports) remains vulnerable to Europe's weak economic situation and the possibility of slower growth in the United States due to fiscal headwinds.
Infrastructure spending is China's "automatic" stabilizer – picking up when economic growth slows. While this familiar refrain may concern some, we believe China's infrastructure still has room for improvement. China's government is transitioning to new leadership over the November 2012 to March 2013 period. The new government's vision is not yet known, but status quo is likely over the near term. A December planning session could reveal 2013 targets and there are hopes of reforms, but China usually makes measured, not radical moves.
We remain mindful of the role of expectations in stock market performance. In our view, optimism for an accelerated stimulus seems unrealistic now given the turn in the economy. Additionally, the Bloomberg consensus forecast is for 2013 GDP growth to accelerate to 8.1%, but government officials have given a 7-7.5% range. Some Chinese-related investments have bounced, but the rally may have headwinds, as investors are still marking down expectations. We find it interesting that foreign investors have fueled a rally in the H-shares stock market since September, potentially related to the Fed's QE3 as well as the turn in China's economic data, but local investors in the A-shares stock market have pushed the Shanghai Composite to the lowest level since Jan. 2009. Read more in our article.
Global economy stabilizing?
Global economic divergences persist; with the eurozone and Japan weak, the United States a bright spot, and China improving.
Global economies deviate
Source: FactSet, Bloomberg. As of Nov. 27, 2012.
Despite growth that is bumpy and slow, the global economy is relatively stable overall, with enough areas of improvement, such as in the United States, Canada, Mexico, Brazil, China and the UK, offsetting areas of weakness. In terms of international markets we view favorably, volatility related to the US fiscal cliff could provide investors opportunity in Canada and Mexico.
Read more international research at www.schwab.com/oninternational.
So what?
The market's gyrations and the media's incessant focus on the here and now can leave investors vulnerable to wild swings in sentiment. We believe it's important for investors to take a step back and understand the how and why of what is currently occurring. Presently, finding "solutions" to the US fiscal cliff and the European debt crisis are the focus, but the structure of those apparent fixes is important for investors to gauge as they will likely have longer-term impacts on the economy and markets. Although we urge investors to keep their long-term goals in mind, individuals who may be more concerned about the potential of a near-term selloff may want to consult their financial consultant or advisor about potential short-term hedging or tax efficient strategies to carry them through this elevated period of fiscal uncertainty.
Important Disclosures
The S&P 500 Composite Index® is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors. Manufacturing Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index includes the major indicators of: new orders, inventory levels, production, supplier deliveries and the employment environment.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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