Schwab Market Perspective: Missing the Forest for the Trees?
October 28, 2011
In investing, a danger is getting caught up in day-to-day, hour-to-hour developments. And typically, it's the negative news that gets the majority of the attention from the media. Looking at the bigger picture is important for investors that have longer-term horizons.
The market continues to be at the mercy of developments out of Europe, with much of the recent focus on Greece. Discussed in more detail below, Greece itself is a relatively small country in terms of economic size and importance, but is getting the lion's share of media and market attention. Its importance is heightened due to it's interconnectedness with other European nations, but overemphasizing its problems can obscure the bigger picture solutions that are being formatted. But even the broader European focus has largely seemed to overshadow developments in the United States, which remains the world's largest economy.
Economic data also supports a modestly improving picture. Although the NY Empire Manufacturing Index remained in negative territory, important subcomponents including orders, employment and shipments all moved from territory depicting contraction to expansion. Another regional manufacturing survey, the Philly Fed Index, surged from -17.5 (which shocked markets two months ago) to 8.7, a six-month high; while new orders, shipments, capital expenditures, and employment all either remained in or moved into positive territory. Additionally, industrial production moved higher by 0.2%; durable goods order ex-transportation surprised significantly on the upside; and the Index of Leading Economic Indicators moved higher by 0.2%, the fifth-straight monthly increase. Finally, third quarter real gross domestic product (GDP) came in at 2.5% growth, up from 0.4% in the first quarter and 1.3% in the second quarter, further helping to dispel fears of a renewed recession. While encouraging, we continue to believe business confidence needs to strengthen in order to really get the economy moving in a sustainable way.
In response to these concerns, the Fed adopted "Operation Twist" at its most recent meeting, attempting to bring down longer-term mortgage and Treasury rates. So far, the impact hasn’t been felt as mortgage applications actually fell by close to 15% a week ago and are now at a 15-year low; and longer-term interest rates are now higher than when the program was announced. But, although there appears to be increasing dissention within the ranks of the Federal Open Market Committee (FOMC), the majority still seems ready to attempt to do more if they deem it necessary. The Fed appears unconcerned about stoking inflation, despite the headline Consumer Price Index (CPI) rising by 3.9% year-over-year, and the core rate at the upper end of their implied preferred range of 2.0%. Despite these readings, we too remain relatively unconcerned about inflation in the near term. We've seen commodity prices move lower recently, which should alleviate pressure on the headline rate, while continued high unemployment, minimal wage gains, and capacity utilization of 77.4% (still 3% below its 1972-2010 average) should keep inflation relative low.
Although a recent University of Michigan survey reminded us that the government is doing little to help confidence, as the ratio of those thinking the US government was doing a good job versus a bad job fell to a record low -53%, we do believe they will manage to cobble together some sort of agreement that avoids some of the more draconian outcomes currently predicted. However, any chance of a long-lasting, credible, plan that stimulates growth, cuts spending, and lowers debt before the 2012 elections seems slim at best.
Italy is in focus due to its large debt load. At 1.9 trillion euros ($2.6 trillion) Italy has the world's third largest bond market; behind the United States and Japan. It represents nearly 120% of Italy's GDP. Italy needs to continually raise vast sums of money to roll over maturing debt. If they are unable to find investors willing lend at reasonable interest rates, its debt would likely be too big to bail out. Lastly, with growth nearly stagnant, Italy needs changes to the status quo to put its financial future on a sustainable path.
Reforms in Italy needed to both reduce spending and spur growth are similar to changes needed in many of the "Club Med" countries: overhaul the pension system, reduce the protection from new entrants in certain "closed" professions, and reduce red tape. The World Bank ranks Italy 87th globally in its latest ease-of-doing business survey and 158th in terms of enforcing contracts. Markets question Italy's resolve to adhere to an austerity plan and implement reforms. Infighting within Prime Minister Berlusconi's fragile coalition government, allegations of corruption and scandals, and reversals of prior promises undermine confidence as well.
Italy's situation is not entirely dire though—it should not be considered the next Greece. Italy suffers from liquidity concerns due to low confidence; not from questions about solvency. Unlike Greece, Italy has a primary budget surplus; a surplus before debt payments; as well as high percentage of domestic, long-term holders of its debt, and long debt maturities. This suggests that any crisis should be slow to develop. We believe that Italy, like governments of other peripheral nations, will likely eventually come to grips with tough decisions. If the current government doesn’t make good on its promises, markets and constituents could force a change in leadership.
Another victim of the prolonged debt crisis is the eurozone economy broadly, as European banks could limp along. To achieve the higher capital ratios mandated as a part of the "recapitalization plan," European banks could sell assets or reduce dividends, diluting equity holders. And there is potential for increased demand for claims on collateral (bank assets).
In addition to economic headwinds, we've kept our neutral intermediate-term view on European stocks believing that there may be more downside risk to eurozone earnings estimates than elsewhere globally. Third quarter earnings season may bear this out, as only 52% of European companies reporting through Oct. 26 beat earnings estimates, well short of the 72% rate in the United States, per Bloomberg.
Big picture implications from the eurozone debt crisis could shape investment philosophy for several years. In an era of painful debt reduction realities in many developed economies, there is the potential for uncertainty to result in more frequent and shorter business cycles, while pressuring economic and earnings growth.
Alternatively, emerging markets could grow in relative investment attractiveness. Emerging market economies tend to have lower debt levels. Additionally, generally younger demographics create a lighter burden on public finances and potential for more output. Meanwhile, expectations for emerging markets are low, with valuations at the lowest levels since 2009. Emerging market stocks came under pressure earlier this year amid monetary tightening headwinds; and further intensified with market volatility and concerns over a hard landing in China.
We believe a hard landing in China would probably need a US and global recession to occur, and policymakers have many levers to arrest a slowdown. While Chinese officials have yet to decisively move away from inflation vigilance, they have started to sound a more conciliatory tone. They are talking about support for small businesses; adding jobs as an explicit priority for the first time in recent history; reduce fuel prices; and making bank stock purchases.
A shift in policy bias in China could be nearing and fulfill the last condition needed for emerging market stock outperformance, as cited in Emerging Markets: A Bright Spot?
Visit http://www.schwab.com/public/schwab/resource_center/expert_insight/investing_strategies/international for more international perspective.
Key Points
- Earnings season was good and economic data in the United States has shown signs of improvement. Although we don't believe we'll see robust growth in the near future, we do believe the economy is improving. But investors appear to be unconvinced that the picture may be brightening.
- Headline inflation continues to run higher than we'd like to see but we don't believe sustainable price gains are likely. The Fed continues to be extremely accommodating, seemingly more concerned about the potential for deflation.
- Although Greece has garnered the headlines, Italy has the potential to be a much bigger problem. There are positive signs of progress in Europe and a tentative agreement has been reached, but hopes for a true long-term solution remain thin. Conversely, Chinese growth, while slowing, is likely to suffer no worse than a soft landing.
The market continues to be at the mercy of developments out of Europe, with much of the recent focus on Greece. Discussed in more detail below, Greece itself is a relatively small country in terms of economic size and importance, but is getting the lion's share of media and market attention. Its importance is heightened due to it's interconnectedness with other European nations, but overemphasizing its problems can obscure the bigger picture solutions that are being formatted. But even the broader European focus has largely seemed to overshadow developments in the United States, which remains the world's largest economy.
US growth improving and recession risk is ebbing
We are seeing signs of better growth that we believe is supporting an upside breakout of the recent range-bound equity market. But despite a nice rally in the markets since the beginning of October low from just under 1100 on the S&P 500, investor sentiment remains quite dour. The Ned Davis Research Crowd Sentiment poll does show improving confidence, but it remains in the "extreme pessimism" zone, which contrarily bodes well for the potential of a continued move higher in equities.Investors appear unconvinced despite recent rally
Source: FactSet, Standard & Poor's. As of Oct. 20, 2011.
We are now well into third quarter earnings season and it has been better than anticipated. The vast majority of companies reported both bottom- and top-line results that met or beat expectations, while outlooks were mildly optimistic. Demand has held up relatively well, and companies continue to hold their costs down and maintain solid balance sheets. After factoring in the latest results and guidance, valuations are attractive, especially relative to bonds.Economic data also supports a modestly improving picture. Although the NY Empire Manufacturing Index remained in negative territory, important subcomponents including orders, employment and shipments all moved from territory depicting contraction to expansion. Another regional manufacturing survey, the Philly Fed Index, surged from -17.5 (which shocked markets two months ago) to 8.7, a six-month high; while new orders, shipments, capital expenditures, and employment all either remained in or moved into positive territory. Additionally, industrial production moved higher by 0.2%; durable goods order ex-transportation surprised significantly on the upside; and the Index of Leading Economic Indicators moved higher by 0.2%, the fifth-straight monthly increase. Finally, third quarter real gross domestic product (GDP) came in at 2.5% growth, up from 0.4% in the first quarter and 1.3% in the second quarter, further helping to dispel fears of a renewed recession. While encouraging, we continue to believe business confidence needs to strengthen in order to really get the economy moving in a sustainable way.
Small business confidence better, but still too low
Source: FactSet, Nat'l Federation of Independent Business. As of Oct. 20, 2011.
Murky jobs picture, but maybe better than portrayed
Improving employment growth continues to be the focus of both the Federal Reserve and the government, and we are seeing nascent signs of improvement. Initial jobless claims continue to hover around the 400,000 level; various surveys, as mentioned above, indicate improving employment conditions; and the often-ignored JOLTS (Job Openings and Labor Turnover Survey) report showed that at the end of August there were 3.1 million job openings, up 200,000 from a year ago and 944,000 greater than the trough seen in July 2009. While the long-term unemployment rate is far too high at over 6 million, that number has remained relatively stagnant over the past year.Fed continues to swing away
The Federal Reserve continues to be concerned with the over 9% unemployment rate and the still moribund housing market that appears to be, at best, bouncing along the bottom. Although new home starts jumped by 15%, permits were down 5% and both of those number were greatly affected by the volatile multi-family component. Additionally, existing home sales fell.In response to these concerns, the Fed adopted "Operation Twist" at its most recent meeting, attempting to bring down longer-term mortgage and Treasury rates. So far, the impact hasn’t been felt as mortgage applications actually fell by close to 15% a week ago and are now at a 15-year low; and longer-term interest rates are now higher than when the program was announced. But, although there appears to be increasing dissention within the ranks of the Federal Open Market Committee (FOMC), the majority still seems ready to attempt to do more if they deem it necessary. The Fed appears unconcerned about stoking inflation, despite the headline Consumer Price Index (CPI) rising by 3.9% year-over-year, and the core rate at the upper end of their implied preferred range of 2.0%. Despite these readings, we too remain relatively unconcerned about inflation in the near term. We've seen commodity prices move lower recently, which should alleviate pressure on the headline rate, while continued high unemployment, minimal wage gains, and capacity utilization of 77.4% (still 3% below its 1972-2010 average) should keep inflation relative low.
Washington continues to underwhelm
Focus will likely return to Washington over the next month as the debt Super Committee's deadline for coming up with a deal approaches. Early reports are that there’s little positive movement toward a deal that both sides can agree on. But in addition to the fact that most deals like this get done at the last minute and we are hearing rumblings that a "grand bargain"-type deal is not out of the question.Although a recent University of Michigan survey reminded us that the government is doing little to help confidence, as the ratio of those thinking the US government was doing a good job versus a bad job fell to a record low -53%, we do believe they will manage to cobble together some sort of agreement that avoids some of the more draconian outcomes currently predicted. However, any chance of a long-lasting, credible, plan that stimulates growth, cuts spending, and lowers debt before the 2012 elections seems slim at best.
Is Italy or Greece Europe’s weak link?
Across the pond, however, some progress was made on finding at least a temporary solution to the Greek debt problem. Although still short on critical details that could derail any feasible agreement, it appears that participants have started to realize the reality of the situation. The recent summit ended with private Greek debt-holders agreeing to a "voluntary" 50% haircut in the value of their bonds, while also announcing the bolstering of the European Financial Stability Facility (EFSF) and increased capital to the continent's financial institutions. However, where that money is coming from is unclear at this time—a major question still looming. Despite the vagaries, it is a glimmer of hope. Although global risks have intensified in recent months, a meltdown of the global banking system has significantly moderated in our view; with the mere acknowledgement and progress toward actions to fight the eurozone debt crisis. That said, the fallout from the crisis will likely continue, in three significant areas: Italy, the European banking system, and the overall eurozone economy.Italy is in focus due to its large debt load. At 1.9 trillion euros ($2.6 trillion) Italy has the world's third largest bond market; behind the United States and Japan. It represents nearly 120% of Italy's GDP. Italy needs to continually raise vast sums of money to roll over maturing debt. If they are unable to find investors willing lend at reasonable interest rates, its debt would likely be too big to bail out. Lastly, with growth nearly stagnant, Italy needs changes to the status quo to put its financial future on a sustainable path.
Reforms in Italy needed to both reduce spending and spur growth are similar to changes needed in many of the "Club Med" countries: overhaul the pension system, reduce the protection from new entrants in certain "closed" professions, and reduce red tape. The World Bank ranks Italy 87th globally in its latest ease-of-doing business survey and 158th in terms of enforcing contracts. Markets question Italy's resolve to adhere to an austerity plan and implement reforms. Infighting within Prime Minister Berlusconi's fragile coalition government, allegations of corruption and scandals, and reversals of prior promises undermine confidence as well.
Italy's situation is not entirely dire though—it should not be considered the next Greece. Italy suffers from liquidity concerns due to low confidence; not from questions about solvency. Unlike Greece, Italy has a primary budget surplus; a surplus before debt payments; as well as high percentage of domestic, long-term holders of its debt, and long debt maturities. This suggests that any crisis should be slow to develop. We believe that Italy, like governments of other peripheral nations, will likely eventually come to grips with tough decisions. If the current government doesn’t make good on its promises, markets and constituents could force a change in leadership.
Another victim of the prolonged debt crisis is the eurozone economy broadly, as European banks could limp along. To achieve the higher capital ratios mandated as a part of the "recapitalization plan," European banks could sell assets or reduce dividends, diluting equity holders. And there is potential for increased demand for claims on collateral (bank assets).
Eurozone banks likely to rein in lending
Source: FactSet, European Central Bank. As of Oct. 25, 2011.
A weakened eurozone banking system is likely to reduce lending, the lifeblood of economic growth. Over the summer, eurozone banks started to tighten lending standards at the fastest pace since 2009, and indicated they expect tightening to worsen. In response, businesses could begin to protect cash by freezing or cutting employment, capital investment and discretionary spending, reducing production or reducing inventory.In addition to economic headwinds, we've kept our neutral intermediate-term view on European stocks believing that there may be more downside risk to eurozone earnings estimates than elsewhere globally. Third quarter earnings season may bear this out, as only 52% of European companies reporting through Oct. 26 beat earnings estimates, well short of the 72% rate in the United States, per Bloomberg.
Longer-term investment implications from the eurozone debt crisis
Investors likely have whiplash from month-to-month swings in sentiment regarding the eurozone debt crisis, but there are longer-term implications. In our opinion, the euro "experiment" of a common currency for countries with different cultures, economic make-up and growth, without fiscal union, is flawed. What may be needed is fiscal coordination on budgets, tax rates and collection; debt issuance; and enforcement of budget discipline. The adjustment to supra-national oversight is likely to be unpopular with constituents who may see this is as "taxation without representation." Social unrest and discord could continue to be a staple in the eurozone.Big picture implications from the eurozone debt crisis could shape investment philosophy for several years. In an era of painful debt reduction realities in many developed economies, there is the potential for uncertainty to result in more frequent and shorter business cycles, while pressuring economic and earnings growth.
Alternatively, emerging markets could grow in relative investment attractiveness. Emerging market economies tend to have lower debt levels. Additionally, generally younger demographics create a lighter burden on public finances and potential for more output. Meanwhile, expectations for emerging markets are low, with valuations at the lowest levels since 2009. Emerging market stocks came under pressure earlier this year amid monetary tightening headwinds; and further intensified with market volatility and concerns over a hard landing in China.
Are China fears justified?
Growth in China slowed to 9.1% in the third quarter from the 9.5% rate in the second quarter, hardly qualifying as a hard landing. However, due to lack of transparency and mistrust of government statics, it is useful to look at other proxies of economic growth. The HSBC survey of purchasing manager intentions of over 400 companies—a broader version than the government’s as it includes smaller companies—increased to 51.1 in September.Soft landing in China looks likely
Source: FactSet, Bloomberg. As of Oct. 25, 2011. Seasonal average over a six-year period excluding a one-year period from May 2008—June 2009. October data is preliminary.
Despite low 2011 figures, HBSC notes that a PMI reading as low as 48 is consistent with annual growth of 12-13% in industrial output and a 9% rate of increase in GDP. Other positive proxies of growth include healthy freight volumes and an acceleration of electricity output in September to 12.2% from 9.1% in August.We believe a hard landing in China would probably need a US and global recession to occur, and policymakers have many levers to arrest a slowdown. While Chinese officials have yet to decisively move away from inflation vigilance, they have started to sound a more conciliatory tone. They are talking about support for small businesses; adding jobs as an explicit priority for the first time in recent history; reduce fuel prices; and making bank stock purchases.
A shift in policy bias in China could be nearing and fulfill the last condition needed for emerging market stock outperformance, as cited in Emerging Markets: A Bright Spot?
Visit http://www.schwab.com/public/schwab/resource_center/expert_insight/investing_strategies/international for more international perspective.
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, 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.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
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