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December 2, 2011
Macro factors have continued to dominate market action. Europe continues to move closer to a true crisis, a potential deficit deal in the United States went nowhere, and there are signs that the global economy is slowing down, with many European countries slipping into recession. However, as the crisis has intensified we’ve seen increased action, from coordinated intervention by global central banks to a loosening of monetary policy in China. These are likely only band-aids and don’t necessarily clarify the endgame for the eurozone. It is possible that an escalation in the crisis will ultimately force even more decisive action that remains lacking.
Especially in volatile periods it’s essential you match your asset allocation targets to your risk tolerance and that you have a diversified portfolio, even given elevated correlations. Dramatic market swings have become the norm, but we continue to believe that stocks are under-owned by investors generally, and offer an inflation hedge far superior to government bonds. As we’ve also witnessed this week, the expectations bar has been set quite low and with even marginally better news, the market can stage impressive rallies, catching many investors off-guard.
Mostly better US economic news has taken recession risk down meaningfully over the past couple of months. October's reading on "core" retail sales (ex-autos) rose 0.7%, which was the largest gain in seven months as consumers continue to spend at a pace that belies the weak confidence data.
Source: FactSet, Federal Reserve. As of Nov. 25, 2011. * CPI-deflated.
And more support for the consumer could be developing as the job market appears to be improving modestly. The most recent JOLTS (Job Openings and Labor Turnover Survey) report released by the US Department of Labor shows that at the end of September job openings were at their highest level since 2008. Additionally, jobless claims, a key leading indicator, have now moved below 400,000 on a four-week moving average basis, which is often considered a dividing line between a stagnant job market and an improving one. The ADP Private Payroll report showed a 206,000 job gain in November, well above estimates and the best reading since March 2010. And November’s broader job report showed that the US economy added 120,000 jobs and that the unemployment rate moved to 8.6%, the lowest rate since March 2009.
The positive data extends to the corporate side as well. Headlining the mostly upbeat data was the latest Index of Leading Economic Indicators that rose by 0.9%, the sixth-straight monthly increase. The internals of the report were even more encouraging as nine of the index’s 10 sub-components moved higher, the first time that has occurred since May of 2003. Additionally, industrial production rose 0.7% in October, while the Chicago PMI rose to 62.6 from 58.4, a seven-month high, and the new orders component rose to its highest level since March at 70.2. The national Institute for Supply Management’s (ISM) Manufacturing Index helped confirm this positive momentum by rising to 52.7, the highest level since June, while new orders also rose to 56.7 from 52.4. Perhaps most encouraging is the uptick we saw in the NFIB (National Federation of Independent Business) small business confidence to a three-month high.
We tend not to mention Gross Domestic Product (GDP) revisions too often as they are backward looking reports and the stock market is a forward looking mechanism. However, the recent revision of third quarter GDP from 2.5% annualized growth to 2.0% actually sent some encouraging signals about the fourth quarter. The downward revision was largely attributable to a decline in private inventories, which took away 1.55 percentage points away from the overall GDP number. We believe this portends higher growth in the current and perhaps future quarters as businesses have to restock severely limited shelves in order to keep up with what appears to be improving demand.
Events in Washington continue to compete with European developments to frustrate investors' ability to gain some clarity. The headline recently was that the so-called "supercommittee" failed to come to a deficit reduction agreement by the November 23rd deadline. The result is that the original $1.2 trillion in cuts over the next decade that was agreed upon in August as part of the debt ceiling compromise are still scheduled to begin in 2013, with a heavy emphasis on defense and health care spending. These so-called sequestrations were designed to be so offensive to both sides of the aisle that they would have no choice but to come to an agreement—clearly not the case.
While initially somewhat disappointing to some, their failure has some benefits. The deals they were trying to cobble together were nowhere near the $4-5 trillion in cuts likely needed over the next decade to make an impact on the country’s fiscal health. The United States still has time to address burgeoning debt and deficits as servicing costs remain relatively low due to extremely low interest rates. But time is running out. While the ratings agencies made no changes to the US debt rating following the failure of the supercommittee, the outlook would likely deteriorate if a more substantial agreement is not reached relatively soon after the 2012 elections.
Source: FactSet, U.S. Bureau of Economic Analysis. As of Nov. 25, 2011.
A more urgent near-term concern is the potential expiration of the payroll tax reduction from 6.2% to 4.2% and expiring unemployment insurance. With economic data showing fledgling improvement and the unemployment rate still elevated, it seems unlikely that politicians would want to impose what amounts to a tax hike on most. Should Congress fail to act to extend the reduction, it would amount to roughly $110 billion being taken out of the general economy, which would likely reduce already sluggish GDP growth in 2012 by approximately 0.5-1.0%.
The eurozone debt crisis is in much more urgent need of near-term action. The crisis is multi-faceted:
Banks and sovereigns are linked and the possibility of a weakened European banking system and its implications on the real economy is a theme we’ve been discussing since April. The crisis is hurting European banks in a vicious circle. Government debt holdings on bank balance sheets have fallen in value, creating the need for more capital; but the ability to access funding is weakened due to the crisis of confidence.
Since raising capital is difficult under these conditions, the risk is that banks rein in their operations by reducing lending, or deleveraging. Already banks are indicating they are tightening their lending standards in anticipation of actions needed over the next six months.
In an effort to protect capital, stronger banks have been hoarding cash, resulting in liquidity drying up and weaker banks becoming more reliant on the European Central Bank (ECB) for funding. Concerns recently began to spread and impair the functioning of both a German bond auction and the ECB’s weekly bill operations.
Global central banks acted to improve access to dollar funding in late November, equating to a move to ease European bank funding concerns; hopefully slowing the pace of bank deleveraging and reducing the possibility of a bank failure.
The central bank coordination only partially addresses the banking side of the crisis. On the sovereign debt front, little progress has been made because the size and details of bailout and support mechanisms thus far have lacked credibility.
The million dollar question is whether there will be a "bazooka" to fight the crisis; a reference to former US Treasury Hank Paulson’s 2008 description of the Treasury’s "weapon." The ECB could provide this bazooka by announcing the intention to purchase large amounts of sovereign debt. Purchases thus far have been labeled “limited” and any injection of money into the system is systematically removed through a process called “sterilization.
* Rebased to Jan. 5, 2007 = 100 Source: FactSet, Federal Rreserve, European Central Bank, Bank of Japan. As of Nov. 29, 2011.
Factors influencing ECB inaction and ways the ECB could get around these barriers:
There are big hopes for the European summit on Dec. 8-9, where plans to move toward closer fiscal union are expected to be discussed. The hope is that the Germans and the ECB will relax their opposition to large scale unsterilized purchases, as enforcement of fiscal discipline could give them cover to change their stance.
The crisis has proven to be anything but predictable because elected officials don't always act in ways that are the most conducive to the functioning of the market and real economy. We worry about stubbornness to backstop anything beyond banks. Without a "bazooka" the vicious cycle could remain in play: weak sovereigns hurt banks, in turn undermining the health of sovereigns. This could create the need for a reactive, rather than proactive response—cleaning up the mess after it happens—which can be more costly than addressing the problems upfront.
However if the "bazooka" is found, it could result in a powerful rally in markets. We caution investors about the risks of making big bets in this type of environment. Rather, elevated market volatility can be taken advantage of to manage around your long-term asset allocation plan.
While a recession in Europe is more a question of “how steep” rather than "if," we are less concerned about a hard landing in China.
Growth in China is slowing and China's exports in September and October have already been hurt by the slowdown in Europe. Additional pressure on the Chinese economy has come in the form of reduced access to credit and the reduction of infrastructure spending. Lastly, while housing sales have dropped off, construction has continued, but we expect this to wane in the future.
However, there are still ways China’s growth will be supported in the future:
The most significant signal for a return to growth in China was the easing of the required reserve ratio for banks at the end of November. This is a sharp turnaround from a prior focus on inflation, with the reduction in both commodity prices and global economic growth estimates giving the Chinese central bank the leeway to ease monetary policy. As a result, the lending freeze is likely to thaw; and while near-term growth will continue its downward momentum, it will provide a stimulus for future growth.
Significantly for investors, Chinese stocks tend to move in anticipation of policy moves. Chinese stocks have underperformed other global markets since late 2009 in anticipation of tighter financial conditions, but have recently moved sideways, believing tightening would not continue. Now that policymakers have made a decisive move, it is possible Chinese stocks could begin to outperform the global benchmark. Read "China Fear is a Potential Opportunity" for more.
Source: FactSet, Shanghai Stock Exchange, People's Bank of China. As of Nov. 29, 2011. * Indexed to 100 as of January 1, 2008. A larger/smaller number above 1 denotes greater outperformance/underperformance of the Shanghai Composite Index relative to the MSCI EAFE Index.
Please visit www.schwab.com/oninternational for more international perspective.
The MSCI EAFE® 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 500® 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.
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