Looking Back to Look Ahead
By Liz Ann Sonders, Brad Sorensen & Michelle Gibley
December 15, 2012
- Markets have been more focused on short-term forces; not least being Washington and the fiscal cliff negotiations. But taking a step back and gaining some longer-term perspective can help investors better weather short-term volatility.
- Even beyond the fiscal cliff, Washington and fiscal policy will likely remain in focus next year. Monetary policy is also front-and-center with the Federal Reserve maintaining its extremely accommodative policy; and is now targeting specific economic conditions instead of providing calendar guidance.
- Europe managed to make it through the year in one piece, but challenges and risks remain. Meanwhile, China may be embarking on a new reality and Japan could be increasingly in the investment discussion.
Note: Due to the upcoming holidays, the next scheduled Schwab Market Perspective publication will be January 11, 2013.
1,258: That's where the S&P 500 stood to start the year. We're now looking at gains, as of the writing of this article, of over 13% over the course of 2012—not bad based on history. But that doesn't tell the whole story. And it's from the more in-depth look at 2012 where we believe we can gain some lessons to use for investing in 2013 and beyond.
8.5%: That was the first reading on unemployment for 2012. We've managed to work that down to 7.7% after 146,000 jobs were added during November. It's moving in the right direction, but still well up from the ~ 4% levels of the late 1990's. This illustrates the importance of looking at trends rather than absolute levels. Virtually nobody is happy with 7.7% unemployment, but the fact that the trend is in the right direction helped to support the positive move in stocks for the year.
Jobs trending in the right direction
Source: FactSet, U.S. Labor Dept. As of Dec. 10, 2012.
Looking ahead, jobs will likely continue to be in focus and the outcome of the current Washington negotiations could impact the direction we're headed in the near future. But we continue to see signs that consumer demand is decent, as evidenced by improving auto sales and positive retail sales numbers reported by the National Association of Retailers. With plenty of cash on companies' balance sheets, we believe that hiring could accelerate moving into next year if some certainty is provided to businesses through a credible plan to deal with tax policy, spending cuts, and deficit reduction.
Oh, what a year!
This year the market focused on certain major events almost solely at times. From the European debt crisis, to the US Presidential election, to the current focus on the fiscal cliff; markets have traded on the ebb and flow of news regarding each situation. And from the media coverage you would think chaos was a key characteristic of 2012. But it wasn't. And that may be an important lesson to take from this past year. The market, and the broader economy, especially in the United States, have exhibited remarkable resiliency. There will likely continue to be inevitable stomach-churning pullbacks, but we believe in the long-term success of equities; especially to beat inflation over time.
At Schwab we do not believe in market target-setting. We don't believe it serves individual investors well as every year there are many unforeseen events that can impact the economy and the market over the course of a twelve- month period. Who could have predicted the way the European situation played out, or the impact of Hurricane Sandy in the northeast, or how Middle East tensions would develop, or even how the current fiscal cliff negotiations come to conclusion?
There is virtually no doubt that the United States, regardless of the outcome of the current fiscal cliff negotiations, will undergo some form of fiscal tightening in 2013. The net is that there will be at least some drag on economic growth. But there are always many factors influencing economies and markets that can serve as fiscal tightening offsets; and psychology always plays an important role. For example, while negative initially, the impact of Hurricane Sandy to start 2013 could help to offset some of the fiscal drag as the rebuilding kicks into high gear. And depending on how the cliff in resolved, or not, businesses with more certainty could begin to invest in delayed projects, which could also be a boost to the economy.
Finally, housing now appears to be firmly in recovery mode and we believe there remains ample pent-up demand that should contribute to continued housing growth; which could also offset some of the impact from tightening on the fiscal side.
Housing recovery continues
Source: FactSet, U.S. Census Bureau, National Association of Home Builders. As of Dec. 10, 2012.
There are other drags of note though. Chief among them in our mind is the lack of focus on growth-oriented policies by policymakers. The regulatory burden continues to increase and the Affordable Care Act has been mentioned by numerous executives as impacting their decisions on expanding business and adding to payrolls. We believe that growth is the missing element in many of the ongoing discussions in Washington, despite it being one of the major things that has differentiated the US economy from the rest of the world.
Fed appears locked in
The Federal Reserve continues to do everything in its power to foster economic growth, and it seems unlikely to change that stance in the near future, despite the evidence that its impact may be diminishing. Most recently, the Fed replaced the expiring "Operation Twist" with additional purchases of long-term Treasury securities in the amount of $45 billion per month to start 2013. That will be in addition to the $40 billion of mortgage-backed securities (MBS) they are buying through QE3.
The Fed did surprise the market a bit by moving to economic targets versus calendar targets when noting how long the current policy will stay in place. Specifically, it appears any form of tightening won't occur as long as inflation stays below 2.5% and the unemployment rate above 6.5%. We don't believe the unemployment target is commensurate with the extreme monetary policy and there are risks at staying at the party too long, but 2013 looks to be shaping up similarly to 2012 on the monetary policy front.
Europe still a risk, but less so
The eurozone also went on a wild ride in 2012, with Greece receiving a second and third bailout, and fears of a Greek exit. The European Central Bank (ECB) undertook several non-standard measures, beginning with several long-term refinancing operations (LTROs). However, the ECB's real influence came during the summer, with ECB President Mario Draghi's "do whatever it takes" to save the euro comment; and subsequent announcement of potential bond purchases through Outright Monetary Transactions (OMT). The OMT provides a safety net that significantly reduces the possibility of a break-up in the euro and associated downside risks, in our opinion.
So have things improved in the eurozone? Well, yes and no. European banks received the LTROs, which eased funding and liquidity pressures; but likely remain undercapitalized and in the early innings of deleveraging in our view. A eurozone banking union could help boost confidence in the financial system, but progress has been slow. Common supervision is unlikely before the end of 2013, and deposit insurance and a process to wind down insolvent banks don't appear on the drawing board. With the banking system still hobbled, lending could remain under pressure, and therefore economic growth could continue to struggle.
Depressed lending weighs on eurozone growth
Source: FactSet, European Central Bank. As of Dec. 11, 2012.
Fundamentals remain weak in Spain; with the economy still contracting, unemployment rising and the housing bubble still bursting. As such, its bond market is vulnerable to the whims of sentiment, keeping a bailout for Spain still a possibility. Political uncertainty in Italy is now in the mix, which could create several months of headline risk ahead of elections there if there are threats to dismantle reforms and austerity put in place over the past year. However, we don't believe Italy will be thrust into a bailout. Campaign rhetoric is typically toned down once new leaders come to power; as seen this past year in Portugal and Spain, and even Greece! However, anything is possible, particularly when it comes to politicians.
Economically, the slowdown that started in the peripheral PIIGS (Portugal, Ireland, Italy, Greece and Spain) has spread to the core of Europe, with even the stronghold of Germany possibly entering negative gross domestic product (GDP) territory in the fourth quarter of 2012.
However, there have been "positive" surprises in the eurozone. Overall economic growth hasn't fallen off the cliff, and reforms and austerity have started in many nations. Additionally, despite forces that suggest a pulling apart in the eurozone, policymakers have gone to great lengths to keep it together, as the Greek case illustrates. It appears the cost of a breakup is currently perceived to be too high. In 2011, UBS estimated that the unraveling of the euro could reduce Germany's GDP by up to 25% and cost every German up to 8,000 euros in the first year.
Europe's economy is likely to remain a weak link in 2013 and there is the risk of volatility returning. Therefore, while eurozone stocks have the potential for a "catch-up" rally due to past underperformance, we have a neutral stance, as outlined in our article.
China bottoming, but recovery could disappoint
China's economic slowdown in 2012 was sharper than expected and new stimulus lagged expectations. It appears China's government may be comfortable with slower growth, particularly as workforce expansion is slowing due to over 30 years of a one-child policy, reducing job creation needs.
However, China's economy appears to be bottoming, led by a pickup in infrastructure spending by the government. Infrastructure spending is China's "automatic" stabilizer – picking up when economic growth slows. We believe China's infrastructure still has scope to improve. However, we worry that a high reliance on investment (in factories, infrastructure, and real estate) in China's economy has created imbalances. Additionally, the fuel to fund investment could wane as local government revenue has fallen, and we're concerned about the sustainability of speculative lending used for investment, as we discuss in our article.
China's industrial production downshifted?
Source: FactSet, Nat'l Bureau of Statistics of China. As of Dec. 11, 2012.
We are also concerned about excess capacity as a headwind for China's recovery. Industrial production appears to have downshifted and we doubt production growth will return to the pace envisioned when capacity was put in place. Excess capacity could create a number of undesirable effects:
- Less need for investment in building new capacity;
- Price and profit pressure because supply exceeds demand;
- Declining cash flows, which increase the number of accounts receivable for companies and the potential for defaults on bank loans;
- Possible job losses for factory workers in plants with excess capacity.
China's new leadership will be transitioning the economy, with a goal of addressing income inequalities and improving the livelihood of the population. This will be a slow and lengthy process, but is likely to be accompanied by slower growth during the transition. We believe slower growth is the new normal in China.
The stabilization in China's economy could result in a several-months-long rally in investments tied to China, but investors may want to use caution. Excess capacity could present headwinds and China's export sector is vulnerable to slowing emanating from Europe and/or the United States. Rallies in China-related investments may be short-lived.
New Dawn in Japan?
A new theme for 2013 is likely the addition of Japan to the investment discussion due to a transition in leadership of both the government and central bank; with both possibly targeting a weaker yen. Japan's economy remains stagnant under the weight of deflation and government debt, and trade has shifted to a negative from a positive factor. The hope is that by weakening the yen and targeting inflation, exports and domestic growth will be stimulated.
The yen has already dramatically moved in anticipation of policy changes. While a sustained drop in the yen may help Japanese stocks, we believe Japanese companies need more than a weak yen as outlined in our article. Additionally, it remains to be seen whether Japanese policymakers have the willpower and ability to execute a weaker yen policy. In order to be successful, the Bank of Japan would need to "out-ease" the Federal Reserve, and "short yen" is already a crowded trade.
Read more international research at www.schwab.com/oninternational.
Looking back at the past year in order to learn and better prepare for the future can be a valuable exercise. As Winston Churchill said, "Those that fail to learn from history are doomed to repeat it." But we can also take a broader look back and see that the US economy, and the world as a whole, have experienced numerous phases that were at least as challenging historically. There is one thing that all crises have in common: they eventually end. Here's to a happy and successful 2013 for us all.
(c) Charles Schwab