Teetering on the Edge?
By Liz Ann Sonders, Brad Sorensen, Michelle Gibley
October 12, 2012
- Concerns about a possible US recession remain elevated in light of the pending "fiscal cliff," resulting in some lackluster stock market action. We believe the market needed to digest recent gains and remind investors that equities typically climb a "wall of worry."
- The fiscal cliff and uncertainty around tax and regulatory policy appear to be influencing business decisions to the detriment of economic growth. The Fed is aggressively trying to fight these powerful headwinds, but its ability to make a large impact may be limited.
- While worst-case scenarios for Europe may have been taken off the table by the ECB, Spain's reluctance to ask for aid is causing consternation. And although we see continued weak growth in China, signs indicate the global slowdown may be turning around.
Stocks have taken a breather over the past couple of weeks, following impressive gains this year. As we've seen throughout this year, stocks often climb a "wall of worry" and we believe the path of least resistance for stocks longer-term remains up. There remains ample cash on the sidelines, investor sentiment is not much worse than uncertain, and the Federal Reserve remains aggressively easy. We suggest using pullbacks to add to positions as needed to bring or keep equity allocations in line with long-term goals. Since 1925, the S&P 500 has risen more than 12% during the first three quarters of the year (as it did this year) 31 times, according to Ned Davis Research (Oct. 12, 2012). The median gain for the fourth quarter in those instances has been 4.9%, and the S&P 500 finished in positive territory 81% of the time in the fourth quarter.
Third-quarter earnings season is upon us and expectations have been relatively dour, with analyst expectations for earnings growth falling to -2.1% from +6.6% at the start of the year, according to Wolfe Trahan & Co. (Oct. 3, 2012). Additionally, according to Strategas Research Partners (Oct. 2, 2012), for every five earning pre-announcements for the quarter, roughly four have been negative, which is the highest ratio since the third quarter of 2001. Lowered expectations, however, can lead to better performance. When the pre-announcement ratio has been above 2.1, the average monthly gain in the month following quarter end has been 2.1%, while when it has been less than 2.1, stocks have actually fallen 0.2% (according to Thomson Research (Sept. 30, 2012)). Company outlooks for the coming year will be of utmost interest, and we believe that estimates for the fourth quarter and 2013 should come down, which could cause volatility in the near term.
US economic growth remains sluggish and recession risk is rising as the fiscal cliff approaches. We've heard major multinational companies, especially those involved in shipping and delivery, express elevated concern about global economic growth. Recent reports also indicate that businesses are holding off on capital spending. We continue to hear anecdotal reports that executives are waiting for the election results and some resolution to the fiscal cliff before making major spending decisions. Unfortunately, their concerns about growth can be self-fulfilling, as decreased demand can lead to economic contraction.
We continue to believe that we'll avoid a recession in the near term, although fourth-quarter growth could be weak. We were encouraged to see the Institute for Supply Management's (ISM) Manufacturing Index move back above 50, to 51.5, after being below the dividing line between expansion and contraction for three months. Even more encouraging was the new orders component, which jumped 5.2 points to 52.3, while the employment component rose to 54.7. The weightier ISM Non-Manufacturing Index came in at a better-than-expected 55.1, up from 53.7, while new orders rose to 57.7. Additionally, auto sales continue to improve and are up roughly 65% since the lows in 2009, according to ISI Research.
Auto sales continue to improve
Source: FactSet, U.S. Bureau of Economic Analysis. As of Oct. 8, 2012.
Stronger auto sales are adding heft to consumer spending, which is vital to the US economy. Retail sales improved by 4.8% in July and 6.1% in August, according to Thomson Reuters, and the important holiday season is expected to generate a 4.1% rise in sales from the year before, according to the National Retail Federation. This is not robust, but also is not indicative of a recession. Along with improved balance sheets and a better housing market, the consumer is helping support economic growth.
Consumers continue to reduce debt
Source: FactSet, Federal Reserve. Includes mortgage and consumer debt, auto lease payments, rental payments, homeowners insurance, and property tax payments. As of Oct. 8, 2012.
The jobs picture also doesn't indicate robust growth, but it doesn't indicate a recession either. ADP reported that private payrolls rose by 162,000 in September, while the Department of Labor said 114,000 jobs were added, although readings for the previous two months were revised higher and the unemployment rate, tied to the "household survey," fell to 7.8%, its lowest level since January 2009. In support of the lower unemployment rate, jobless claims fell sharply in the latest week, albeit from a large revised adjustment emanating from a single state.
Election and fiscal cliff now in focus
With the election less than a month away and the fiscal cliff looming at the end of the year, markets appear to increasingly have their eye on Washington. The partial paralysis evident by businesses poses a further risk to the economy but there remains a possibility of "uncertainty fatigue." At some point, business leaders may grow weary of restraining themselves due to tax and regulatory uncertainty, and "animal spirits" and pent-up demand could win out.
Eurozone less pressing, but unsolved
A more severe debt crisis persists in the eurozone. The lifeline from the European Central Bank (ECB), in the form of potential purchases of sovereign debt, has bought time and, in our view, reduced extreme downside risks. The ECB, however, cannot act alone—countries must ask for assistance. Since this requires committing to unpopular austerity measures and oversight by outsiders, it's natural for countries like Spain to drag their feet.
Despite the relief in Spain's government debt market, it may still require a bailout. Since the relief is based primarily on improved sentiment, not fundamentals, Spain is vulnerable to renewed pessimism, making yields volatile with a possible upward bias. Yields may need to move sharply higher before Spain asks for aid. This could be greeted positively by the markets, however, because it would remove an uncertainty.
Meanwhile, the real economy in the eurozone still has headwinds, as European banks remain hobbled and likely still need more capital. While the permanent bailout fund—the European Stability Mechanism (ESM)—could recapitalize banks in theory, progress toward a eurozone-wide banking union, a precondition for any recapitalization, has stalled. Eurozone banks need to shrink their balance sheets (deleverage); with the International Monetary Fund (IMF) estimating the amount of deleveraging could be anywhere from $2.8 trillion to $4.5 trillion by the end of 2013, depending on policy-makers' actions. A hobbled banking sector is unlikely to expand, which could keep a lid on economic growth.
While eurozone stocks have the potential for a big "catch-up" rally, we urge investors not to be complacent about the risks—volatility could climb again and challenges remain. We outline our neutral stance on eurozone stocks in our article.
We've been noting the problem of high expectations for China since July, and our concerns have since intensified. We believe there is an increased chance China has a "hard" landing—where economic growth slows too much and feels like a recession. A hard landing may not show up in official figures, but could be felt in other ways. We believe the overhang of speculative excesses and a possible need to transition China's economic growth model could result in a difficult economic environment that could persist longer than most expect.
A major problem in China is the amount of speculative capacity in China. The belief by businesses that growth would stay robust and that any slowdown would be followed by a snapback resulted in sustained high levels of production and investment. In fact, after the global financial crisis, investment in new capacity grew at a faster pace than China's gross domestic product (GDP).
As a result, the IMF has estimated that utilization of production capacity in China was at 60% at the end of 2011, down from 80% before the global financial crisis ("IMF Country Report on the People's Republic of China, July 2012"). Since that time, new capacity in some sectors continued to be added in 2012, despite the slowdown.
We believe there could be fallout from excess capacity because we doubt economic growth will return to the high pace envisioned when capacity was put in place. The implications are many:
- Reduced need for spending to build new capacity;
- Price and profit pressure due to supply in excess of demand;
- Potential for a rise in bad loans for banks and an increase in accounts receivables for companies as cash flows decline; and
- Possible job losses for factory workers at plants with excess capacity.
We aren't suggesting a crash in China's economy and stimulus could reaccelerate growth in coming months. A new era of slower growth in China, however, could have profound implications for investors, reducing growth prospects for US multinationals, cutting demand for commodities over the medium-term, and lowering growth for emerging market economies as a whole. We remain cautious on both the Chinese and emerging market equities.
Global slowdown behind us or worsening?
Headlines don't always tell the whole story. While the IMF cut growth forecasts for most global regions in early October, there are signs of improvement under the surface. Global economic growth may be sluggish, but it's not falling apart.
Global economy may have improved in September
Source: FactSet, Bloomberg. As of Oct. 9, 2012.
Global purchasing manager indexes (PMIs) for September indicate the global economy overall may have improved during the month. A number of countries reported figures above the 50 level that separates expansion and contraction, and many economies posted slower rates of decline in September relative to August. Overall, the JP Morgan Global Composite PMI rose 1.6 points to 52.5 in September, on the strength of services, which added 2.0 points to 54.0; while manufacturing also improved, gaining 0.8 points to 48.9.
Global trade also remains subdued, but there is improvement here, too. In September relative to a year prior, South Korea's exports fell 1.8% and Taiwan's exports grew 10.4%; better than August's 6.2% decline and 4.2% fall, respectively. Elsewhere, leading indicators of global growth have also improved, with the Baltic Dry Index rising over 30% since mid-September, and the CRB raw industrials spot price index gaining 12% since end of July.
Developed market economic data better than feared
Source: FactSet, Bloomberg. As of Oct. 9, 2012
Meanwhile, expectations appear low and economic data have surprised to the upside in advanced economies. This mix of "better than feared" and the improvement in the data (even if still not rosy) has boosted stocks, as the trend is often more important than the level. Additionally, reduced extreme downside risks in the eurozone and global central bank liquidity have also helped.
There could be even more upside for global stock markets if economic growth continues to improve; although China's slowdown and subsequent recovery, as well as uncertainties with regard to the US fiscal cliff could mean a bumpy road ahead. China constituted roughly 10% of world GDP in 2011 but accounted for a larger percentage of growth in some sectors (for example, roughly 40% of some construction-related commodities). As a result, China's transition could create a multiyear shift in sector leadership, reducing prospects for some sectors, while creating new markets for others.
Read more international research at www.schwab.com/oninternational.
It appears to us that US growth remains in stall speed and recession risk is elevated heading into year-end thanks to fiscal cliff uncertainty. However, we are encouraged by some positive US and global economic data recently. After a period of lackluster action and amid continued investor skepticism, stocks have the potential to move higher as excessive optimistic sentiment is worked off, but volatility could rise as we head toward the end of the year. We continue to suggest investors maintain a diversified portfolio, add to stocks amid pullbacks as needed, and maintain exposure to fixed income securities for fixed payment needs.
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