Liz Ann Sonders: Investment Outlook (July 1, 2011)

Dealing with Debt

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

July 1, 2011

Key points

• Global governments are dealing with rolling debt crises, which are translating to shaky investor confidence. We are concerned that many of the solutions being proposed will weigh on growth prospects, but are hopeful about short-term resolutions that restore business confidence and lead to more investment and hiring.
• The economic sluggishness globally continues, largely affected by short-term factors. We believe a rebound is likely in the second half of 2011, but are wary of policy mistakes and weak confidence. The Fed continues to hold steady, keeping short rates near zero and likely reinvesting maturing Treasury securities after QE2 ends.
• Greece passed the austerity package required to get short-term funding but much more is needed. And while the focus has been on Europe, it may be time to start paying more attention to the Asian region.

Debt concerns have combined with soft economic data to weigh on markets and we’ve seen a bit of return to the "risk on, risk off" trade that dominated 2010. We believe this is a relative temporary phenomenon that should start to reverse toward the end of summer, but there are growing risks. Tenuous confidence among businesses and investors could again be shaken depending on how the debt crises are dealt with or if the economic soft patch lasts longer than we currently believe.

Small business confidence is tenuous

Source: FactSet, Natl. Federation of Independent Business. As of June 27, 2011.

For now, we continue to have a relatively optimistic view of the latter half of 2011, with stocks setting up for a potential rally. Corporate balance sheets remain flush with cash and earnings continue to hold up remarkably well, although we’ll get another update on that during the upcoming second quarter earnings season. Additionally, much of the bad news seems to be "known" and may already be reflected in stock prices, setting up the possibility for upside surprises as some of the temporary burdens begin to ease. Finally, investor optimism has taken a blow from the recent action, which is typically a contrary indicator—a potential good sign for the market in the coming months.

Debt decisions key
The focus has been largely on the European debt crisis, which is detailed below, but the US debt situation continues to add to uncertainty. We certainly don't believe that there is any real risk of default by the United States due to not raising the debt ceiling, a view confirmed by the continued extremely low yields of Treasury securities; but we are concerned about the deal that may be made in Washington. It appears highly likely that the agreement will involve at least an agreement to cut spending by approximately the amount of the boost to the debt ceiling—likely somewhere around $2 trillion. Spending needs to be cut, but details are important including the timing of the cuts and whether there's a bias toward budget gimmickry. If too much cutting is pushed out into future years, any short-term benefits to the recovery would be offset by longer-term continued uncertainty.

However, that risk can be softened by the US economy growing at a more rapid rate, much as we saw during the early 1980's recovery. Government policies that add uncertainty into the market and stymie risk-taking and innovation only make the future bill more difficult to pay. At Schwab, we have long been advocates of free markets and capitalism as the solution to many of the perceived problems in the world. Increased regulation and government interference has already started to weigh on business and we believe is a large contributor to the reluctance of companies to put their massive cash balances to work. Uncertainty and concern over the health care bill and resultant costs, regulation on interchange fees in the financial sector, environmental decrees that raise the cost of doing business, and an uncertain tax policy as we continue to deal with our debt all contribute to business uncertainty. A more globally competitive tax policy, a rollback of some of the more egregious regulations instituted recently, more certainty with regard to the health care law and the new financial derivative regulations, and cuts to spending on entitlement programs would help. It’s important to convince businesses and ratings agencies that our country is on the right track in order to accelerate economic growth over the next several years and bring down the unemployment rate; while repairing housing, and increasing growth and tax receipts. This would result in a more tenable debt situation at both the Federal and state levels.

Soft data continues- transitory?
Uncertainty over the US government's actions in advance of the August 2 debt ceiling expiration, combined with soft economic data contributed to the recent market correction. Regional manufacturing surveys have dipped into negative territory, jobless claims remain stubbornly above the key 400,000 level, and housing continues to scrape along the bottom. However, all has not been negative as the Index of Leading Economic Indicators rebounded strongly, gaining 0.8%, inflation remains relatively low, and the yield curve remains historically steep, which has typically been a good indicator of future economic growth.