What’s going on out there? Should you react to the turmoil and
market volatility? At least one well respected Strategist, Liz Ann
Sonders of Charles Schwab & Co, believes the picture in 2012 is different
from 2011 (for the better), but confidence remains key.
market volatility? At least one well respected Strategist, Liz Ann
Sonders of Charles Schwab & Co, believes the picture in 2012 is different
from 2011 (for the better), but confidence remains key.
Here We Go Again….or Not?
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co,
Inc.; Brad Sorensen, CFA, Director of Market and Sector Analysis; Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
May 11, 2012
Concerns are rising that 2012 may be a repeat of the previous two years. The
picture is different, but confidence remains key.
Key points
• Softer economic data has prompted concerns that the market may be headed for a summer swoon—similar to the previous two years. We believe the backdrop is decidedly different (and better) this time around but investor and business confidence will continue to be important.
• Some appear to be hoping for weaker data in order to spur the Fed to enact another round of quantitative easing (QE3). We believe the bar is much higher and that the Fed should look to return to a more normal monetary stance. Complicating the overall picture and the Fed’s job is the coming “fiscal cliff” out of Washington at the end of this year.
• The political situation in Europe has injected even more uncertainty into an already tenuous environment. Public cries for a reduction in austerity, despite many proposed measures not taking affect yet, raises questions as to the sustainability of the eurozone as is. Spending cuts are important, but must be accompanied by serious structural changes that encourage growth and innovation to provide hope for the future.
We’ve seen this movie before … or have we? After starting out the previous two years in a positive direction, stocks experienced disappointing downturns beginning around this time of each year and continuing throughout the subsequent summers. Recently we’ve seen economic data soften, global concerns rise, Treasury yields fall, and stocks correct, prompting more questions as to whether we’re seeing a very unwelcome sequel. We believe not.
Before getting into why we don’t believe we’re in store for Summer Swoon III (a sequel, like many, that no one wants to see), we want to again point out that trying to time the market is largely a losing game for investors. And we also continue to remind investors that sticking to a disciplined long-term plan is key, rather that chasing crowd psychology or past returns. We’re reminded of the continued chasing mentality that almost inevitably leads to disappointment as
ISI Research reported that bond mutual fund inflows were at a record high during the first four months of the year, while equity fund outflows were the third largest on record.
Currently, investor apprehension is rising, indicated by increasing volatility and a stock market in correction mode, as the possibility of a replay of the previous two years is considered. However, we believe there are several important fundamental differences that help to support a renewed market advance before too long. First, we aren’t dealing with any major natural crises such as the Japanese earthquake and tsunami we saw last year; or the spike in food inflation
that unleashed the “Arab Spring.” In fact, commodity prices are largely moving lower, allowing central banks around the world to ease monetary policy, as we’ve seen in Brazil, Australia, and India among others. And while there are still major concerns regarding the debt crisis in Europe, discussed in further detail below, the European Central Bank (EC
has made moves that indicate they will be aggressive to preserve some semblance of stability in the European markets. Finally, in the United States we’re seeing further signs of housing stabilization, a
has made moves that indicate they will be aggressive to preserve some semblance of stability in the European markets. Finally, in the United States we’re seeing further signs of housing stabilization, acontinued improving job situation, and a rebound in auto sales, which is now a larger driver of GDP than residential investment. But there’s the impact of “muscle memory” given the past two years’ volatility; and perception can become reality. There is a risk that investors increasingly lose confidence in the economic recovery, pressuring stocks, and causing businesses to again pare back. In the short term, market performance can have more to do with sentiment than fundamentals, again illustrating the folly of short-term timing.
Temporary Softness or a New Trend?
Data has been mixed lately, with regional manufacturing surveys largely disappointing: the Chicago PMI fell to its lowest level since November 2009, although remaining in expansionary territory and the Dallas Fed Index slipped into negative territory. The national index provided more encouragement as the ISM Manufacturing Index rose to 54.8, the best level since June 2011, while the forward looking new orders component rose to 58.2, the best level since April
2011. This is distinctly better than the trend in most global PMIs. However, more concern came in the form of the ISM Non-Manufacturing Index, which softened to 53.5 from 56. But while the important service sector showed some softness, we continue to see consumers improve their balance sheets, which should help to support spending going forward.
Consumers’ debt position is much improved
Key to consumer spending continuing to hold up is likely the continued improvement in the job market, which has been in question lately. Jobless claims started to creep higher before experiencing a relatively sharp reversal recently and remaining well below the critical 400,000 level. However, payroll growth continued to be disappointing as a soft reading for March was followed with another one in April. We saw ADP report a mere 119,000 private jobs were
added, while the Bureau of Labor Statistics (BLS) reported that nonfarm payrolls expanded by a weak 115,000 positions; although the previous two months were revised higher. The unemployment rate fell to 8.1% due largely to a drop in the labor participation rate, which now stands at 63.6% — the lowest level since 1981. We do want to temper any great concern at this point with the reminder that these numbers are lagging by nature, and that some softness was expected due to the unusually warm previous months that likely saw some job additions
pulled forward. Also, perhaps somewhat counter intuitively, first quarter productivity falling by 0.5% on an annualized basis could portend good things for job additions as it appears that companies may be largely unable to squeeze any more out of current workers, and may be forced to hire in order to meet even modestly increasing demand. Helping to support that potential demand is a modest improvement in credit availability from banks, pushing more consumer spending. Note in the below chart that it’s a year-over-year percent change therefore even though the line for willingness has moved lower-it still indicates and increasing willingness over last year to make consumer loans.
Easing standards could help support demand. Hope for more Fed action?
We continue to be somewhat surprised that many market participants appear to be hoping for another round of quantitative easing by the Federal Reserve. First, we believe that data would have to get substantially worse than the relatively neutral picture we’re currently seeing, not a great development. And second, we are highly skeptical of the actual effectiveness of QE2. There continues to be enormous amounts of money in the economy that remains sidelined.
Getting that money to work is the key, not adding more liquidity to the already existing massive pile. Down the street in Washington, however, we are much more concerned about the potential for a big hit to the economy due to the so-called “fiscal cliff.” This is scheduled to occur at the end of the year and presently represents approximately $410 billion in tax increases and roughly $120 billion in spending cuts, which would represent about 3.5% of US gross domestic product (GDP) according to Strategas Research Partners. The market appears to be hoping that Congress and the President will come together in a lame duck session following the November elections to forestall at least a portion of the scheduled actions. We remain concerned about their ability to get anything substantial done and believe this is one of the biggest current risks to our relatively optimistic outlook. This concern was reinforced by Federal Reserve Chairman Bernanke recently saying that, “The size of the fiscal cliff is such that there’s no chance the Fed could have any ability whatsoever to offset that effect on the economy.”
Growth needs to accompany austerity in Europe
Falling off a cliff doesn’t begin to describe the ongoing problems in Europe and recent events have demonstrated the unpopularity of austerity. The adjustment to living within your means requires difficult choices and takes time – there is no magic cure. However, Europe’s problems are exacerbated by low (or negative) underlying growth, as well as a common currency and monetary policy that applies to countries possessing differing outlooks. Politics have added uncertainty, which will likely stay elevated for the foreseeable future for the
following reasons:
• In France, we believe newly-elected President Hollande could be a negative for the French economy, and his presence could exacerbate near-term concerns regarding the eurozone debt crisis. Hollande’s ability to govern will be subject to the outcome of parliamentary elections on June 10 and 17, where anti-austerity sentiment could remain elevated. However, longer-term, campaign promises have to contend with reality, and Hollande may be forced to soften his anti-austerity stance.
• Greece remains highly uncertain. Fractured voting on May 6 likely results in the inability to form a government, which could bring another election in mid-June. The next vote could become a vote on staying in the euro, with the possibility of a better outcome. While the May quarterly bailout funding from the European Financial Stability Facility (EFSF) has been authorized, further aid for Greece could be withheld until guarantees of commitment to austerity are received; and because fiscal targets have likely been missed with economic growth below expectations. There could be renewed calls for Greece to exit the euro as the year progresses.
• Ireland’s vote to ratify the eurozone fiscal pact on May 31 could be threatened by increased regional anti-austerity sentiment. Joining the fiscal pact is required to access to the longer-term bailout fund that starts in July, the European Stability Mechanism (ESM). Without the backstop of the ESM, investor concern could rise and hurt Ireland’s hoped-for return to capital markets later in 2012.
The French and Greek electorates voted against austerity, but absent reforms to improve potential growth, there are few alternatives to austerity. Economic growth in the eurozone is forecasted to fall 0.8% in 2012 and grow a mere 0.3% in 2013 according to the International Monetary Fund (IMF). In this environment, running fiscal deficits when debt is already elevated becomes unsustainable. As debt grows to elevated levels, investors require higher interest rates to compensate for the higher risk. As such, auster
ity isn’t a choice, it is a requirement. However, austerity needs to be accompanied by reforms to improve growth prospects.
ity isn’t a choice, it is a requirement. However, austerity needs to be accompanied by reforms to improve growth prospects.
Additional austerity and growth changes we favor include:
• Substantial labor reforms to allow businesses to adjust workforces to demand, which could improve labor productivity and economic growth.
• Reduce bureaucracy and regulations that hamper innovation by lessening the incentive to start new businesses.
• Tax reform – simplify regulations and improve tax collection. Tax cuts could improve compliance.
• Cut spending on social programs such as health care and pension systems that remain generous by US standards.
We view Hollande’s “growth” plan of fiscal stimulus for infrastructure spending as misguided, as it merely provides a temporary boost. As for monetary stimulus, the European Central Bank (EC remains constrained.
remains constrained.Weak European banks pressure economic growth
The ECB’s three-year loans to banks earlier this year staved off a global banking system crisis. The loans provided a new buyer for maturing bank debt, with the ECB acting as an intermediary, or substitute, for capital markets; but new capital was not injected into banks. Therefore, eurozone banks likely remain weakly capitalized for the problems in the region, and the IMF estimates eurozone banks need to reduce their balance sheets by $2.6 trillion (2.0 trillion euro) over the next 18 months, with about 25% of this achieved via reduced lending.
Spanish banks in particular are under the microscope due to a housing bubble that is still deflating while a recession deepens and unemployment at 24% continues to rise. Plans for government aid to Bankia—the second injection of public funds in two years—may validate concern that banks have overvalued real estate assets on their books. Estimates of Spanish bank capital funding needs range from 50 – 200 billion euros, with many converging on a 100 billion euros forecast that equates to 7% of eurozone real GDP.
As the Spanish government may not have the leeway in the bond markets to provide this amount of funding without risking a spike in interest rates and threatening its own solvency, outside help is likely needed. Solutions are limited though, as eurozone bailout funds are currently prohibited from direct infusions into banks. Any “bad bank” proposal to off-load bad loans from balance sheets likely needs to have credible loss estimates and be mandatory in order to provide a lasting shot of confidence. Meanwhile, Spanish bank equity is being diluted
by debt for equity deals.
European banks limit economic growth
A weak banking system is likely to rein in lending, the lifeblood of economic growth. This may already be playing out – the eurozone PMI in March and April reversed sharply downward, indicating Europe could continue to pressure global growth.
Global easing still ongoing
There are concerns about a repeat of 2011, but a key difference in 2012 is a nearly universal global downtrend in inflation. While last year, emerging market central banks had to raise rates to keep inflation under control, this year’s growth slowdown is accompanied by an inflation “green light,” with emerging market central banks joining developed markets in the rate cut party.
In just the past month, Brazil cut rates by 0.75% and India cut interest rates for the first time in three years. Additionally, Australia returned to easing after being on hold, and the asset purchase program by the Bank of Japan was increased.
Fall in food prices key for emerging markets
We believe inflation on a global basis will likely remain subdued this year. Food prices in particular have fallen, important for the growth economies in the emerging world, where food accounts for a disproportionate amount of the change in inflation. If inflation remains contained, central banks could to continue to provide stimulus, underpinning global economic growth.
Important Disclosures
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, J
apan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden,
apan, 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.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.