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January 27, 2012
The absence of the regular daily triple-digit moves in the Dow that characterized 2011 to start the year has felt a bit strange to investors who were getting used to the elevated volatility. However, recent action is more indicative of the way markets usually perform, and has contributed to nice equity gains so far in 2012. Additionally, it appears that at least some of the market attention has been taken off of the European debt crisis and we have seen some of the highly-correlated, risk on-risk off trades that dominated recently dissipate.
Source FactSet, Standard & Poor's, Reuters. As of January 25, 2012.
We continue to believe that an increased focus on the United States, both at the economic and corporate levels, bodes well for the stock market's potential to extend gains as we go through the year. There remain risks, especially in Europe, but the willingness of the European Central Bank (ECB) to extend three-year loans to banks with very attractive conditions appears to have reduced the fear of a near-term financial disaster. But caution and a well-diversified portfolio are still in order as the future remains uncertain and US Treasuries continue to trade near record low yields, indicating continued concern among investors.
Additionally, in the near term, a pullback could be in order. As we all know, nothing goes up in a straight line, and according to the Ned Davis Research Crowd Sentiment Poll investor sentiment is creeping toward the extreme optimism zone, which is typically a near-term bearish indicator. Another measure of sentiment—short interest on the NYSE—is at the lowest point in a year, which could remove some of the fuel from a potential near-term rally. However, despite the recent improvement, both the Conference Board’s Consumer and CEO Confidence surveys remain in pessimistic territory; which have historically been strong contrarian indicators for stocks.
Confidence remains low but has improved slightly as the string of positive economic data continues to roll in. Manufacturing continues to lead the way as the (NY) Empire Manufacturing Index moved to a nine-month high, with both new orders and employment jumping. Additionally, industrial productions showed a nice 0.4% gain, while capacity utilization rose to 78.1% but remained 2.3% below its 1972-2010 average, indicating continued mild inflation over the next several months. And we have pointed out in various publications, such as Liz Ann’s "True Reflections…on 2011 and 2012" article, inflation is an important determinant of economic growth, potential market gains and valuations. We received more encouraging news on the inflation front as the Producer Price Index (PPI) fell 0.1% month-over-month (m/m); and the Consumer Price Index (CPI) was flat m/m, and fell to a 3.0% year-over-year (y/y) rate from 3.4%. At the core level, which excludes food and energy, the CPI remained at a benign 2.2%, and appears poised to head lower in the coming months.
The biggest economic surprise of the first half of this year may be the potential for housing to cease being a negative drag on economic growth. We recently saw the National Association of Homebuilders' (NAHB) Index improve to a level not seen since June of 2007, and while we saw housing starts dip 4.1% in December, it was largely due to a reversal in an extremely strong reading of multi-family starts in November. In fact, single-family starts moved to their highest level since April of 2011, when the market was supported with government incentives. Liz Ann also details other potential positive developments in the housing market in her "Rock Bottom: Housing May Have Already Hit It" article.
Earnings season has also contributed to the mosaic being built for investors. Expectations for the fourth quarter had been ratcheted down considerably over the past several months; typically a good sign for the market during earnings season as potential disappointments may be sufficiently priced in. Thus far results have been mixed, but continue to show increasing demand and economic activity, while uncertainty at the corporate level remains elevated. However, bank loans have increased slowly, which indicates some level of increased confidence, while consumers are also starting to borrow more, suggesting demand is improving modestly.
Source: FactSet, Federal Reserve. As of January 25, 2012.
Confidence also appears to be a key priority for the Federal Reserve and they hope to engender more by improving communication with the investing public. Following their most recent meeting where they extended the time period that rates are likely to be exceptionally low through "at least late 2014," they published explicit forecasts for short-term rates, how long they expect them to remain at record low levels, and when they may start to raise rates again. We appreciate improved communication, but are slightly concerned that making such specific forecasts may tie their hands, biasing the Fed to stick with their forecasts, rather than quickly react to ever-changing conditions. Read more details on the Fed happenings in Liz Ann’s "Journey to the Center of the (Fed’s) Mind" article.
For now, monetary policy remains unabashedly accommodative and will continue to be for some time. This provides some measure of certainty to businesses looking to potentially borrow to expand business, but could delay activity as businesses rest with comfort that rates will remain low for quite some time.
Congress has returned from its holiday recess and one of the first orders of business will be the debate over the payroll tax cut extension at the end of February. We expect an extension, but not much beyond that. In an election year, it's traditionally tough to get much done; and with today's level of contention, even more so. Serious problems still need to be dealt with and the election results will go a long way in determining the course of the country in the coming years, but any substantial action will likely be on hold until 2013.
We are encouraged by the impact of the three-year loans provided by the European Central Bank (ECB) in its first long-term refinancing operation (LTRO) on December 21. By stepping in as a lender of last resort for banks, the ECB diminished the risk of another Lehman-style banking system collapse by easing the liquidity crisis (though not the solvency problems of many countries).
While there are still signs of dysfunction, such as the difficulty that Italy's UniCredit had accessing credit at the start of 2012, and near record high overnight bank deposits at the ECB of roughly 500 billion euros, there have been other areas of improvement. The ECB's move appears to have increased confidence toward banks. This has resulted in a decline in measures of interbank stress, US money market funds shifting back into short-term peripheral debt markets, a return of secured and unsecured new issuance for corporations, and a fall in short-term peripheral sovereign yields.
On the sovereign side, despite calls for the ECB to make large scale purchases of government debt, the lack of action by the ECB has the positive impact of keeping pressure on sovereigns. Bond markets want governments to provide credible plans and indicate willingness to commit to keep their promises; and ECB pressure is likely helping here. We're encouraged by the resolve shown by Italy's Prime Minister Mario Monti, representing the "big fish" country in the periphery, as well as progress toward closer fiscal union across the eurozone.
There is even acknowledgement by policymakers that austerity alone will not solve Europe's problems. As we've said, forcing more austerity on countries already suffering from a lack of economic growth is largely counterproductive. Growth initiatives must accompany austerity and are a positive, even if reforms take time to reap the rewards. While more needs to be done on the sovereign side, things are shifting in the right direction, and it is often the trend that matters to investors. However, risks remain, most acutely for Greece and Portugal, but we believe a disorderly default in Greece has a low probability of occurring.
We believe growth in Europe in 2012 will still be hampered. Banks need to strengthen their balance sheets; are facing an uncertain funding environment; and the possibility of higher losses on loans with the economic slowdown will force them to hoard cash. As access to credit is the lifeblood of growth, the eurozone economy is likely to be dampened because the reduction in lending that began in late 2011 is likely to continue.
Source: FactSet, European Central Bank. As of Jan. 24, 2012.
However, we are monitoring for signs that stock markets have priced in the risks, and believe the risk/reward may be shifting in a positive direction. We believe the worst of the bank deleveraging and fiscal austerity will hit in the first half of 2012 and upcoming ECB actions are likely to provide additional liquidity and could weaken the euro; both of which should stimulate the economy. Stocks tend to be anticipatory and at some point will likely "look across the canyon" to a potential growth rebound. We’re looking for positive reactions to negative news, such as we saw with the sovereign credit rating downgrades in January, and earnings season may provide additional clues.
Global growth slowed dramatically in the second half of 2011, illustrated by the decline of the JP Morgan Global PMI Manufacturing Index to just under the 50 level that separates expansion from contraction. Meanwhile, there were fears that the crisis in Europe could deteriorate to the point of a severe recession or Lehman-like banking system meltdown and pull down the rest of the globe with it.
Source: FactSet, Bloomberg. As of Jan. 24, 2012.
But the beginning of 2012 has given stock markets two gifts: the reduced risk of a Lehman-style event in Europe and prospects for an acceleration of global economic growth. Global manufacturing appears to have reaccelerated in December and we expect upcoming measures of activity in January to show a continuation of this trend.
Media and investor proclamations of an upcoming hard landing in China were rampant from last September on. In fact, an outflow of capital from the country contributed to a decline in China's foreign exchange reserves in the fourth quarter of 2011; the first drop in more than a decade. Contrary to fears, China posted strong growth of 8.9% in the fourth quarter. While growth is likely to slow further, we believe the peak of the monetary tightening campaign is probably in the rear view. Last year’s slowdown in both lending and inflation gives China's central bank leeway to ease policy. Official announcements have included a cut in banks' reserve requirements and a delay of tougher bank capital rules, and we've received other indications credit is loosening. Fiscal policy is also likely to add to growth. With policy likely at an inflection point, growth could reaccelerate in the second half of 2012.
The Shanghai Composite fell more than 20% in 2011, one of the worst performances among global equity markets. Ned Davis Research notes that the dividend yield on the MSCI China Index is about two standard deviations above its 16-year norm, "a degree of cheapness last seen in 2008." With so much negativity priced into the market, it is possible that with hard landing risks falling in our view, China's slowdown in 2012 could be less sharp than feared and stocks could outperform. See our China article for more on this topic.
Investors are likely familiar with the refrain "Don’t fight the Fed," wherein monetary stimulus is typically good for economic growth and stock market performance. This situation is occurring globally, with most central banks pursuing easy monetary policy.
As such, other stock markets globally are likely to benefit. Countries in which the reversal in inflation and monetary policy are likely to be the sharpest could outperform. This is a factor behind our positive outlook expressed in our emerging markets article and an upcoming article on Brazil. Read more international research at www.schwab.com/oninternational.
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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