By Liz Ann Sonders, Brad Sorensen, Michelle Gibley
November 9, 2012
- The election results are in, removing at least one area of uncertainty from the equation. Challenges and questions remain and the election did not alleviate uncertainty about the "fiscal cliff;" but we believe there is the potential for upside surprises that could set the stage for a renewed equity rally.
- For the near term, economic data in the United States may take a back seat. With the focus on the political process and upcoming data likely influenced by the devastating storm in the northeast, getting a clear view on the economy may be difficult.
- Growth around the world appears soft, but some pockets are more encouraging than others. China is going through a leadership transition of their own but problems continue to plague Europe.
It feels to us a little like the day after Christmas, with all the presents opened and the excitement diminished, and now facing a mound of discarded wrappings and a pile of bills to deal with. The seemingly endless campaign season and subsequent election is now complete but major challenges and questions remain, illustrated by the sharp drop in equities immediately following. Most pressing is the pending "fiscal cliff" approaching at year end, and the clean up and reconstruction from Hurricane Sandy. This appears to be a somewhat unique circumstance in history, when a lame duck Congress has such important business to get done before adjourning for the year. With no action on the cliff, the current trend of modest economic growth could likely be negatively offset by the cliff's impact and cause a recession. However, with a modest agreement to forestall most of the cliff, equities could breathe a sigh of relief and find their rally legs again.
We may have a bit of a tailwind behind equities as short interest (constituting bets against the market) on the NYSE was relatively high according to BCA Research as of October 29th; which could provide some fuel for a move higher. Additionally, according to our friends at Bespoke Investment Group, the market historically performed modestly better during Novembers in election years than non-election years. Over the past 100 years, the Dow has averaged a gain of 0.83% in November during Presidential election years, and a gain of 0.66% in all other Novembers. It's not something we would build an investment case on, but another piece to the puzzle.
Economic data about to get murky
A much bigger piece to the puzzle is how the US economy is developing. The largely completed earnings season left much to be desired. According to Strategas Research Partners, as of October 30th, a little over half of the S&P 500 had reported, with 63% of companies beating earnings guidance—roughly in line with history. But, only 37% of companies beat on the revenue line, indicating cost controls are continuing; but growing sales remained challenging. We believe the corporate sector can pick up relatively quickly should confidence increase, and an agreement on the fiscal cliff could go a long way toward achieving that.
Beyond that, recent economic data indicates the consumer continues to hold up relatively well, and business activity appears to be rebounding at least modestly from the summer slowdown. After a substantial downturn during the financial crisis, we've seen consumer spending resume its uptrend, as we believe some pent up demand and improved balance sheets, along with lower energy costs and an improving housing market, help to fuel the consumer.
Consumer looking resilient
Source: FactSet, U.S. Bureau of Economic Analysis. As of Nov. 6, 2012.
And while the job market remains sluggish, modest improvement continues, with ADP reporting 158,000 private sector jobs were added in October and the Labor Department showing 171,000 jobs were added in the most recent month, while previous months were revised higher. The unemployment rate held most of its surprising drop from last month by only gaining 0.1% to 7.9%.
The job picture is improving…slowly
Source: FactSet, U.S. Labor Dept. As of Nov. 6, 2012.
Additionally, we continue to see housing numbers improve, as the Case-Shiller Index showed prices rose 0.5% in August, which was the seventh consecutive month of improvement. Continued strength in housing and job growth should boost consumer spending, the backbone of the US economy.
And after the summer slowdown, we are seeing some signs of life in the economy. The Institute for Supply Management (ISM) Manufacturing Index rose to 51.7 from 51.5, which marks the second straight month in territory depicting expansion, after three months below the key mark of 50. And the much bigger service side continues to grow as the ISM Non-Manufacturing Index posted a reading of 54.2, down from the previous month's 55.1, but still well into territory depicting growth.
In the coming weeks, the data may become more challenging to read as we deal with the impact from the storms hitting the northeast. Initially, data will likely take a hit as the disruption and damage done to such a major part of the country is likely to have an impact on the overall economy. But then we could see a boost in some numbers as reconstruction and recovery begins. Netting it out, we believe the overall impact of the storms will be slightly negative to the economy, replacing structures that were already existing doesn't do much to improve productivity and uses resources that could have been used for potentially more economy-enhancing purposes. It's the old "broken window" theory—if the activity that came from destructive events was really beneficial to the economy, it would also make sense to go around breaking random windows because it would provide jobs to those that replace windows and economic growth…but of course that's not the case.
This only adds to the challenges facing the Fed as it continue to implement its third quantitative easing program of purchasing mortgage-backed securities in an attempt to bring down the unemployment rate partly by further stimulating the housing market. With the likely murkiness of incoming data, the Fed may not move at their December meeting. But remember, "Operation Twist"—where the Fed buys long-term securities and sell short-term securities in an attempt to further drive down longer-term yields—is scheduled to conclude at the end of the year. Just allowing it to stop could be viewed as a form of tightening, and we don't believe that's the message the Fed wants to convey, so some action is likely. They will also be keeping an eye on the fiscal cliff negotiations and may feel forced to do even more should an agreement be elusive.
Despite divergences, global growth holding on
Like the United States, developed economies globally are struggling to contain fiscal spending and government debt, resulting in bumpy and uneven growth resulting in below average global output.
Global economies deviate
Source: FactSet, Bloomberg. As of Nov. 6, 2012.
Economic divergences remain, with the US economy a relative bright spot, China improving somewhat, and a renewed weakening in the eurozone. However, on a global combined basis, enough areas of growth have offset weakness, and the JP Morgan Global Composite Purchasing Managers Index (PMI) has stayed above the 50 level that separates contraction from expansion; coming in at 51.3 in October. Going forward, there are areas of risk as well as potential upside for global economic growth.
Fiscal cliff—in Japan?
Japan is also facing its own potential fiscal cliff. The two main political parties are in a stand-off regarding raising the government's borrowing authority ahead of auctions that begin late-November, with the LDP party hoping to force an election. The difference compared to the United States and eurozone is that Japan remains a net creditor to the world due to high levels of domestic savings. Meanwhile, Japan's economy is weakening, with industrial production plunging 4.1% in September; falling in six of the last eight monthly reports. The Bank of Japan has yet to be effective in creating either growth or inflation; pursuing a timid easing policy that likely needs to be more aggressive.
We have a cautious view on the Japanese stock market. There have been increased payouts to shareholders by Japanese companies recently, and there are signs of improvement in the real estate sector. But companies in the retail, machinery, automobile, travel and consumer electronic industries have fallen on hard times due to strained trade relations with China and a weak domestic economy.
Eurozone still problematic
Economic growth in the eurozone has yet to stabilize, and there are indications of a renewed deterioration. The eurozone composite PMI fell to 45.7 in October—the lowest level in more than three years—with a faster rate of contraction in both manufacturing and services. A level of 45.7 is consistent with an economic contraction at a quarterly rate of 0.5% according to Markit, the company that compiles the data.
Economic weakness isn't confined to the troubled peripheral nations…it's also ensnaring the core of Europe. The economic stronghold of Germany, with roughly 50% its economy related to exports, cannot hide from soft growth globally. German business confidence as measured by the Ifo survey dropped to the lowest level in more than 2½ years in October, industrial production fell for the second month by a larger than expected 1.8% month-over-month in September and factory orders plunged 3.3% month-over-month in September, led by a 4.5% decline in foreign orders. The Bundesbank, Germany's central bank, said the German economy may shrink in the current quarter.
While austerity in many countries is a headwind, we are also focused on the European banking system, where we still believe there is a need for more capital. Positively, banks' access to funding improved in the third quarter. However, some of this improvement is due to potentially unsustainable factors, including an increased reliance on short-term sources and funding from the ECB's Long-Term Refinancing Operations (LTRO) three-year loan program in some countries. European banks have also been able to report an improvement in capital ratios due to an increase in sovereign debt holdings, which are considered "risk-free" and result in lower reserve requirements. We agree with the International Monetary Fund's assessment that European bank deleveraging has barely started.
Eurozone credit crunch deepening
Source: FactSet, European Central Bank. As of Nov. 6, 2012.
A hobbled banking sector is unlikely to expand lending in our opinion, and a deepening credit crunch is likely to keep a lid on economic growth. Lending in the eurozone dropped 0.8% year-over-year in September, the most since October 2009. While large companies have been able to tap credit markets, access to bank loans for small and medium-sized companies, which constitute up to 70% of the eurozone economy, deteriorated in the six months to September. Meanwhile, overall credit standards tightened in the third quarter and rejection rates for corporate loans rose to 15% in October, the highest rate since 2009. Lastly, elevated lending rates in the periphery remain a problem.
The potential for bond purchases by the European Central Bank (ECB) has reduced extreme downside scenarios; but Spain and Greece remain vulnerable, which could create near-term volatility. Eurozone stocks have the potential for a "catch-up" rally due to past underperformance, but we urge investors not to be complacent about the risks as volatility could climb again and economic challenges remain. We outline our neutral stance on eurozone stocks in our article.
Short term, China could switch to a positive factor
There are early signs of a bottoming in China growth, and it appears the worst case scenario of a hard landing in China may have been averted. Glimmers of hope include an improvement in infrastructure construction, a bounce back in PMIs, money supply, rail volume and electricity consumption. However, the bottoming process could be bumpy, as there have also been signs of headwinds; with bookings for future exports at the semi-annual Canton Fair down 9.3% from the prior six months, and reports of increased inventories of inputs for construction materials.
The political leadership transition that began the first week of November could bring an increase in government stimulus, with infrastructure spending the target with the biggest and fastest potential impact. However, we are concerned about the recovery in China, as we believe speculative excesses could make the recovery more difficult and slower than many expect.
While past underperformance, a bottoming of economic data, and new stimulus could result in a several-months-long rally in investments tied to China, we believe the rally should be treated with caution. A difficult recovery and high expectations could present headwinds; and a rally in China-related investments may be short-lived. Read more in our article, Is the Worst Over for China?
The election is over but uncertainty remains as the fiscal cliff is looming. There are a myriad of possibilities regarding potential outcomes and we won't attempt to place odds on them all. Suffice it to say that we and the rest of the business world will be watching these negotiations closely. With elevated uncertainty, we continue to urge investors to take a long-term perspective and use pullbacks such as we saw the day after the election to add to equity positions as needed to keep allocations at targets and to maintain a diversified portfolio.
The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
The Institute for Supply Management (ISM) Non- Manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms' purchasing and supply executives, within 60 sectors across the nation by the Institute of Supply Management. The ISM Non-Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
The JPMorgan Global Composite Purchasing Managers Index (PMI) is an indicator of the combined economic health in both the manufacturing and services sectors, and on a global basis.
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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