Schwab Perspectives: Shifting Sentiment
Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and
Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
May 27,Ā 2011
Key points
- Economic headwinds are causing growth expectations to be reevaluated, resulting in choppier action in a majority of asset classes, including stocks. This trend seems likely to continue in the near-term, with uncertainty somewhat elevated over the next few months.
- The Fed is moving steadily closer to ending its purchases of Treasuries but we donāt believe itās a major market event. Normalization of monetary policy still seems slow in coming, while a game of brinkmanship in Washington has the potential to rattle markets, although we believe QE2 ending on schedule is nearly certain.
- Europe's debt crisis continues to plague the eurozone. Solutions appear to be limited and agreement is still anything but assured. Meanwhile, China's slowdown is also weighing on investors, but we donāt believe a hard landing is in store.
There has been a downshift in economic growth lately that has caused markets of all types to gyrate. Commodities moved sharply lower before rebounding modestly; Treasury yields have moved even lower; the dollar has shown some strength; and stocks have been more volatile, but have still moved in a roughly sideways fashion. While disconcerting, this type of action is to be expected as some of the "dollar carry trades" unwind and investors adjust to a slower growth phase.
This is an excellent example of why investing with a short-term view can be so difficult. Investing has to be viewed through a longer time horizon with objectives and risk tolerances well established ahead of time. We believe that the most likely path of the stock market over the next few months is sideways, although there is certainly the potential for sizable moves in both directions depending on news flow. We remain confident that the longer-term trend in the stock market is higher, while bond prices are likely to head at least somewhat lower (resulting in higher yields) over time.
Data tells a story of deceleration
Recent economic data has been somewhat weaker. Regional manufacturing surveys dropped sharply last month, although they are notoriously volatile and mostly remained in expansion territory. Industrial production was flat in April, versus expectations of a gain of 0.4%, while capacity utilization fell 0.1%, and remains 3.5% below the 1972-2010 average. These indications of a slowdown in growth has been confirmed by Treasury yields moving lower, indicating growth concerns trump inflation. It is a bit surprising that investors continue to loan to companies and the government at such low rates; locking in a low return if held to maturity and the potential for somewhat worse results if rates start to move higher. Investors who have over-weighted fixed income may do well to take some profits and look to have a more balanced portfolio.
It's easy to get mired in the disappointing. Growth has indeed slowed and concerns are justified, but the majority of indicators still indicate economic expansion. Additionally, there have been several external factors we believe have impacted data temporarily. The Japanese natural disasters disrupted supply chains that are starting to come back online, while extreme weather impacted production and distribution in the United States. Further, the spike in oil prices above $110 per barrel seemed to have a large affect on sentiment among businesses but we have seen that improve with the recent weaker oil price. And while the Index of Leading Economic Indicators fell 0.3% in April, it was only the second negative monthly reading since March of 2009, and we believe it will resume its positive trend in May as some of these temporary factors dissipate.
LEI dip likely temporary
Source: FactSet, U.S. Conference Board. As of May 23, 2011.
Employment conditions illustrate some of the aforementioned distortions. Jobless claims had moved steadily higher over several weeks recently, moving well above the 400,000 level considered key in indicating an improving job market. However, we maintained that a majority of those gains were likely unsustainable as they were impacted by the late Easter holiday, weather, and several other temporary events and we have seen claims again start to move lower again. The job market likely remains key to further improvement in the economy, as increased confidence in job prospects leads to increased spending, greater demand, and even greater hiring. We have seen nascent signs of more rapid improvement, but still want and expect to see more hiring.
At this point, an improved jobs picture seems to be the only thing that may help the struggling housing market. Housing starts were down 10.6% in April; permits were down 4.0%; and existing home sales were down 0.8%āall confirming the year-over-year median price drop we saw in existing homes as foreclosures and other distressed sales continue to plague the market. The silver lining is that mortgage rates remain extremely low, pricing is more attractive, and the impact on the US economy of housing has dropped substantially. We continue to believe the healing of the housing market is going to be a multi-year process, but a more rapid improvement in job growth would likely accelerate that development.
Commodity action helps out Fed, debt drama continues
With an eye on the still-lackluster housing market, the Fed continues to buck the global trend and maintain its extremely easy monetary policy; again reiterating that QE2 will be completed in full and rates will be on hold for an "extended period." The Fed has maintained their belief that the headline inflationary pressures remain temporary in nature, and the recent action in commodity prices likely bolsters their case.
Commodity action means easing inflationary pressures
Source: FactSet, Standard & Poor's. As of May 23, 2011.
Readings on inflation are measured in terms of changes in price over time. Therefore, commodity prices donāt necessarily have to fall further to cause more moderate inflation readings; they simply have to stop going up. With some recent strength in the dollar, and global central banks tightening monetary policy, we believe that commodity prices are likely to remain relatively flat or even fall a bit further in the near term. With headline inflation likely to ease, and core inflation still tame, with excess capacity still ample and virtually no wage growth; the Fed will likely feel little pressure to accelerate its path toward normalization in the near term.
In contrast, the pressure in Washington continues to rise as the debt ceiling has now been reached and no agreement to raise it appears imminent. As noted before, the Treasury has various accounting "tricks" it can use to move the reckoning date into at least early August, but the closer we get, the more jittery markets may become. We have little doubt this will come down to the last few days, but are also quite positive that the United States will not default on its debt. But the struggle over this relatively routine maneuver illustrates the fight for the 2012 budget is likely to be a bruising one.
Eurozone debt worries linger
Such events are unsettling in the United States, but circumstances in the eurozone are even more complicated given diverse economies with independent national budgets using a common currency, the euro.
The situation in the eurozone has heated up because Greece has not met its fiscal goals agreed to in its bailout plan for the third quarter in a row. Due to Greece's missed fiscal targets, cash may be running low. Without either a restructuring or additional funds, Greece could default if it runs out of cash to fund interest or principal payments due this summer.
Therefore, investors increasingly view a restructuring as a necessity. Restructuring can be done either by extending maturities (also called a "soft" or voluntary restructuring, or re-profiling), or reducing principal (involuntary). Bondholders would take losses in an involuntary scenario, while receiving reduced payments each year in a voluntary scenario. Complicating matters, the European Central Bank said it may pull funding for Greek banks in the event of a restructuring.
While Greece itself is a small portion of the global economy and debt markets, markets are skittish about the broader implications of a Greek restructuring or default due to the interconnectedness of the eurozone banking system, as well as the risk of contagion to other countries. In May, leading French bank Credit Agricole had its credit rating downgraded due to its Greek exposure, and Moodyās warned that a default by Greece could result in credit downgrades in other peripheral nations.
We think policymakers will provide Greece with more money, but writing a new adjustment plan will be a tough sell. Voters in fiscally prudent eurozone countries have already pushed back, unwilling to pay for bailouts in fiscally weak countries, and have ushered in political changes. These changes have increased uncertainty over bailout responses, as well as fiscal spending plans. Government uncertainty was cited in both Italyās and Belgiumās lowered sovereign credit ratings outlooks in May; and investors are concerned that new off-balance sheet liabilities for Spanish local governments may come to light under new leadership.
Why eurozone debt matters
We believe the inability of eurozone policymakers to speak and act with unity is creating an ongoing eurozone debt hangover. With eurozone debt concerns continuing to hit headlines, what does it all mean?
Our attention on eurozone sovereign debt ultimately relates to the European banking system due to cross-country holdings of debt. We are concerned European banks could recoil from lending, the lifeblood of economic growth. Eurozone banks may either lend conservatively to preserve capital or raise lending rates. The first quarter Europe Bank Lending Survey showed a tightening in credit standards and banks expect further tightening. A eurozone bank CEO recently said that many eurozone banks are facing higher funding costs due to the sovereign debt crisis, often higher than the companies they lend to, which is "clearly unsustainable." Unlike in the United States, European companies are more reliant on bank loans than capital markets for funding.
Sovereign debt concerns hit European banks
Source: FactSet, STOXX. As May 24, 2011.
European bank stocks have sold off due in part to these worries. A reduction in eurozone economic growth due to a moderation in lending would subtract from global growth. As a region, the eurozone ranks as the second-largest economy, only slightly smaller than the US economy, and roughly twice the size of Chinaās.
China slowdown worries arise
China's growth tends to evoke strong emotions in both bulls and bears, and a likely slowdown in growth will result in bears becoming more vocal. Concerns have shifted from growing too fast and the risk of inflation, to slowing too much. We believe the truth will likely fall somewhere in the middle.
A number of factors point to a potential slowdown, including a slower rate of money supply, a slump in property sales, declines in commodity imports, a moderation in purchasing manager indexes, and the reduction of global growth estimates. Access to credit has tightened with reports that small businesses are having difficulty obtaining loans, banks are competing for deposits, interbank rates are increasing and some property developers are paying steep premiums in non-bank channels to access capital.
Regardless, economic growth in China is estimated by the Bloomberg survey of economists to remain above 9% for 2011. Prior periods of sub-8% growth, the range at which a hard landing is considered a risk, have coincided with global recession or major external shocks. We donāt see a hard landing in Chinaās economy as likely, as detailed in our China bears and bulls article.
However, it will likely take several months before markets get confidence on whether Chinese policymakers have been able to engineer slower inflation without overly threatening growth.
Do international issues matter to US investors?
US investors may wonder how much eurozone debt, the quake in Japan, or a slowdown in China matters. Indeed they do because the globe is more interconnected than ever before and events overseas could reduce global growth. If global growth is reduced, corporate earnings in the United States could also be reduced, although still post solid growth in 2011. Of S&P 500 Index companies reporting foreign sales, roughly 45% of revenues and 40% of net income is from international sources, predominately Europe.
In terms of broader implications, a slowdown in China is a risk to commodity prices. Chinaās slowdown will likely be concentrated in construction on infrastructure and housing, which constitutes nearly 50% of Chinese economic activity. China represents roughly 40% or more of global consumption of cement, iron ore, coal, steel, aluminum and copper.
China slowing, will commodities follow?
Source: FactSet, Shanghai Stock Exchange, Commodity Research Bureau. As May 24, 2011.
While Chinese shares may have discounted slower growth, and the Chinese market tends to be a leading indicator of global growth, commodity prices could ease. Read more in our article on the breakdown in commodities.
However, we believe a Chinese construction slowdown could be short in nature due to the Chinese governmentās affordable housing program, which seeks to build 10 million new homes in 2011, and China, as well as many other emerging nations and Japan, have further infrastructure building plans.
Visit www.schwab.com/oninternational for more international perspective.
Important Disclosures
The MSCI EAFEĀ® 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 MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
The S&P 500Ā® index is an index of widely traded stocks.
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.
