June 13, 2014
Key Points
- Equities crept higher during the "sell in May" time period and it appears investors may be finally buying into the U.S. economic improvement story. Extremely low volatility has some concerned about complacency among investors.
- The U.S. economy is lifting meaningfully off the very weak first quarter, with the possibility of self-sustaining growth in our sights. The Fed's tapering of QE should continue, and talk is now turning to the next step in monetary "normalization."
- The European Central Bank's recent actions weren't game changing but should help bolster the recovery. Meanwhile, China is attempting to thread the needle between much-needed structural reforms and short-term growth.
Streamers and party hats have been absent but records continued to be broken by major market indicies over the past couple of weeks. However, stocks are only up marginally on the year and action has been noticeable muted; with tight ranges, low volume and record-low volatility, leading to questions of whether the recent "rally" is sustainable.
Exogenous, unexpected events are always possible and the time period elapsed since the last true correction (>10%) on the S&P 500 has been 33 months (August 2011), which has some convinced a fall is inevitable in the near future. We don't discount the possibility, but corrections have historically occurred every 30 months on average, so we're not necessarily stretched. Our friends at Bespoke Investment Group note that two recent stretches without a correction were more than twice as long as we're looking at now (March 2003-October 2007, and October 1990-October 1997). Worries about investor complacency, as seen in the continued low levels of volatility as represented by the VIX, soothe our concerns a bit, as the number of folks worrying about investors not worrying says to us that complacency may not be quite as high as thought.
The May time period represented an elevated risk for the market due to both the "sell in May" phenomenon and the historical tendency for a mid-year correction during midterm election years. And while the possibility still exists, market action is encouraging to us. Some of the high flying names have corrected without causing overall market problems to a great degree. In addition, we've started to see more cyclical areas of the market perform better, and yields on Treasuries have moved off their recent lows—both indications to us that investors are starting to believe in the improving economy. A correction remains possible and summer trading can sometimes be a bit distorted, but we believe the trend in equities will continue to be generally higher.
Economy picking up steam
Supporting that view is the improvement in the economy, with multiple indicators showing expansion and the increasing possibility of a self-sustaining expansion. Railcar loadings have increased and bank loans are growing, indicating both improving demand and loosening credit markets.
Lending is improving
Source: FactSet, Federal Reserve. As of June 9, 2014.
Additionally, May auto sales posted robust gains to levels not seen since before the financial crisis began in 2008. And while first quarter gross domestic product (GDP) was revised into negative territory, much of the reduction was attributed to an inventory drawdown, much of which may be rebuilt in the next quarter or two. Our friends at Cornerstone Macro Research point out that inventories have subtracted significantly from GDP five times during the current recovery (prior to this year's first quarter), and in the following quarter they have provided a boost to GDP growth four out of those five times.
Other indicators are also pointing to improving growth as the Chicago Purchasing Manager's Index rose to 65.5 from 63, while the national Institute for Supply Management's (ISM) Manufacturing Index continued to rise to 55.4, up from 54.9.
Manufacturing continues to improve
Source: FactSet, Institute for Supply Management. As of June 9, 2014.
Representing a larger portion of the economy, the ISM Non-Manufacturing Index rose to 56.3 from 55.2.
The job market also continues to improve as initial jobless claims, a leading indicator, hover around the 300,000 level. That is considered relatively healthy and down nicely from this time last year; with the four-week moving average now down to levels last seen in 2007. And the Bureau of Labor Statistics reported that 217,000 jobs were added in May, while the unemployment rate stayed steady at 6.3%. It's taken awhile, but employment has now exceeded the highs seen prior to the recession.
Housing continues to be a concern, although housing is now only about 3% of US GDP; down from over 6% during the housing peak. But that doesn't mean it's not important for both activity and confidence. Housing may remain in pause mode, but a sharp acceleration seems unlikely. Lumber orders have fallen recently, and according to Cornerstone Macro, since 1996 lumber orders have had a 97% correlation with housing starts. After sharp gains over the past few years, affordability is down, but remains relatively high. It appears that the housing market is trying to find its long-term trend after so much volatility over the past six years.
Fed focus shifts
The Federal Reserve seems set to continue to reduce its quantitative easing program over the next several meetings, with purchases likely to conclude before the end of the year. Attention and discussion is now turning to what the next "normalization" step should be. Some members believe they need to let the balance sheet decline before embarking on rate hikes, while others take the opposite approach. At this point, no decision appears imminent and the conditions in the economy will likely determine how and when the next step will be taken.
Don't fight the European Central Bank (ECB)
Unlike the United States, Europe's response to the crisis lacked the firepower and urgency of the Federal Reserve, and was derailed by the euro zone sovereign debt crisis. The continued half-hearted policy to stimulate growth has helped result in a rebound that has been lackluster and subject to downside risk due to bank deleveraging and the threat of deflation.
Bank balance sheets in the eurozone contracted by nearly 20% in 2013 due to the anticipation of the ECB's comprehensive assessment in 2014—where banks face changes to standardize accounting across the euro zone and increased capital requirements by the third quarter of 2014. Deflation, or a broad-based decline in prices, is a risk because falling prices could become self-fulfilling if people postpone purchases on the expectation that prices will be lower in the future. Inflation of just 0.5% in April was far below the ECB's target of "at or below 2%."
These continued threats to growth resulted in the ECB announcing a package of historic measures at its June meeting: cutting interest rates, including setting a negative deposit rate; suspending the sterilization of the Securities Market Program (SMP); and launching a 400 billion euro four-year Targeted Long-Term Refinancing Operation (TLTRO) aimed at providing non-mortgage, private sector loans. The ECB bought time with this package, which has the potential to keep economic growth in motion and stave off deflation. However, these measures aren't a game changer, and with growth at such a low rate, the ECB may need to eventually embark on a broader QE program.
Eurozone lending bottoming?
Source: FactSet, European Central Bank. As of June 9, 2014.
Positively, lending is already showing signs of bottoming and the TLTRO is more likely than the original LTRO to boost lending because cheap money is guaranteed for 3-4 years. Additionally, the divergence in policy of the ECB relative to the Fed could relieve some of the upward pressure on the euro. The first rate hike in the United States could be brought forward if the strengthening of economic data continues, while the ECB has virtually guaranteed low rates for longer, pushing out the time to the first rate hike in the euro zone. A move lower in the euro would benefit earnings of exporters and economic growth.
We believe that the eurozone's recovery will continue and that easier access to credit due to bank recapitalizations as a part of the ECB's comprehensive assessment will eventually feed through to better earnings. Meanwhile, we believe euro zone stocks are attractively priced and solid dividend yields will pay investors to wait. We remain bullish on European equities.
Tight conditions in China still squeezing growth
In contrast to the eurozone, credit in China continues to tighten, crimping economic growth. The credit slowdown is a consequence of a period of excess and is likely to continue as policymakers realize the old economic model of debt-led investment was producing smaller returns and was unsustainable. As a result, policymakers have cracked down on speculative activities, and initiated a reform plan intended to produce more sustainable, albeit slower, growth in the future.
Chinese credit continues to slow
Source: FactSet, Bloomberg, People's Bank of China, National Bureau of Statistics. As of June 9, 2014.
Slowing growth is to be expected, but the near standstill in the property market could mean a deeper slowdown and is the biggest risk we are monitoring. The Chinese property market shifted to oversupply due to an increase in completions in late 2013, combined with cash flow constraints for property developers this year. Developers began to slash prices to unload inventory to meet cash flow needs, in turn freezing buyer confidence and new construction.
As a result, floor space available for sale through the first three weeks of May increased by 34% year-over-year, home prices fell on a month-over-month basis for the first time in 24 months in May, and new construction starts dropped to a seven-year low. This is having a knock-on effect of slowing local government revenues and infrastructure spending. Meanwhile, the Chinese government's corruption crackdown has resulted in some paralysis at the local government level, as mid-level officials are reluctant to spend or act in fear of making a mistake and the attendant reprisal.
The good news is that China's policymakers are reacting, ordering banks to loosen lending standards for first-time buyers and easing purchase restrictions in some cities. While the inventory of homes available for sale has increased, household formation can soak up inventory in a relatively short time. The sideways movement in the property developer stock index confirms our view that a crash in the property market does not appear imminent.
Targeted stimulus measures have been announced in other areas as well:
- Fiscal spending by local governments pulled forward
- Targeted reserve requirement rate (RRR) cuts for qualified banks
- Increased railway spending
- Tax breaks for small businesses
- Injections of liquidity into the interbank market
Critics indicate the stimulus is a shift away from reform, but the evidence doesn't support this view. Reforms continue at a fast pace, particularly for the financial system. Important announcements so far this year include: freeing deposit rates in two years, allowing the issuance of preferred shares, drafting regulations to allow local governments to directly issue bonds, and allowing cross-border investments between the Shanghai and Hong Kong stock exchanges. While these expanded forms of funding, or stimulus via reform, don't provide an immediate payback, they improve the sustainability of growth longer-term.
We believe China's slowdown isn't over and more growth scares are possible, but we also don't feel a crisis is likely. Chinese policymakers have plenty of ammunition to fight a plunge in economic activity, and policy is loosening. The recent decline in the Chinese currency could boost earnings later this year, creating the potential for upward earnings revisions and an eventual rise in the stock market.
Meanwhile, Chinese stocks are pricing in a lot of bad news, and we believe the risk/reward is favorable for owning Chinese stocks within a market weight to emerging market stocks overall. Read more in Why New Reforms Make Chinese Stocks Attractive.
Read more international commentary, including our recent article 4 Mistakes to Avoid in International Investing at www.schwab.com/oninternational.
So what?
US stocks should continue to move generally higher although activity may remain sluggish through the summer and the possibility of a correction is elevated as per both seasonal/election cycle tendencies and elevated optimistic sentiment. The U.S. economy should help support the market as signs are increasing that we may be entering the long-waited for self-sustaining expansion. The ECB's actions weren't game changing but are helpful and European equities look attractive, while we believe the worries over a Chinese slowdown are overblown.
