Roller Coaster Returns
By Liz Ann Sonders, Brad Sorensen & Michelle Gibley
April 27, 2012
After an extended, and almost unprecedented period of relative calm, resulting in robust stock market gains from October 2011 through March 2012, we have seen some volatility return. Concerns over global growth have reemerged as Chinese economic data has disappointed, the European debt crisis again is gaining headlines as the merits of austerity are being questioned, and US economic data has been less impressive.
Volatility has picked up
Source: FactSet, Chicago Board of Trade. As of Apr. 24, 2012.
One potential benefit of this rise in consternation has been the long-awaited correction in stocks that many had been calling for. In fact, we have been comforted by numerous investor sentiment readings now showing elevated bearishness (remember that investor sentiment is a contrary indicator). The American Association of Individual Investors’ (AAII) bull ratio recently moved decidedly below the 50% mark for the first time in 2012. The percentage of respondents saying they are bearish has moved from just under 28% to nearly 42% between April 4 and April 11; and the percentage of bulls dropped to 28% from over 38% over the same time period. We believe this change in sentiment was needed in order for the market to reestablish a sustainable uptrend going forward.
The recent mild increase in volatility again reminds us that it's important to maintain a long-term focus and to maintain a diversified portfolio. It's vital that investors review their portfolio holdings on a regular basis, while also looking at how correlations among asset classes change over time. A well-diversified portfolio in one year may not be nearly so two years later, even if the positions are roughly the same—the interaction between asset classes changes over time. One final note on portfolio construction: The drumbeat of bearish bond commentary has grown over the past month as yields remain near record lows. While we again remind investors that investing in bonds for speculative or capital appreciation purposes has become more risky; it is also true that for diversification, income, and capital preservation purposes, bonds will still have a valuable place in many portfolios. Again, balance is the key.
Macro concerns again trumping micro story
Investors' attention is again focused on the macro rather than the micro over the past couple of weeks—the height of first quarter earnings season. The reporting period has been much better than expected, although admittedly from a lower bar—83% of companies have beaten expectations so far, which is an all-time record high. But market reactions to good reports have been more muted relative to the punishments doled out to those that disappointed. It appears Chinese developments, European debt and growth concerns, and some softening in US economic data has led to increased volatility.
In the United States, the economic expansion continues, but we may be in yet another soft spot. This isn't surprising given the likely pulling forward of some economic activity that was influenced by the unusually warm weather during the winter months. We believe this is a relatively modest and temporary phenomenon and that activity will again pick up in the coming months. Concern has grown that 2012 will be a repeat of the previous two years when the market declined beginning in April on softening economic data after decent starts to the year. We believe the story is different this time as jobs, lending and housing have improved and inflation has eased, allowing global central banks to keep policy loose; leading to our view that history won't repeat this year.
Recently, we've seen regional manufacturing surveys disappoint, although remaining in territory depicting growth. The Empire Manufacturing Index fell from 20.2 to 6.6 and the Philly Fed Index dropped to 8.5 from 12.5. Encouragingly, the employment expectation component of Philly Fed jumped six points to its highest level in a year, while March retail sales increased 0.8%, above estimates, indicating that the American consumer remains engaged. Commodity costs have also leveled off recently, which should help to bolster discretionary income.
Lower commodity prices should help consumers
Source: FactSet, Standard & Poor's. As of Apr. 24, 2012.
Despite this still-positive picture, recent job and housing data has weakened a touch. The March payroll report disappointed despite the unemployment rate dropping and recent initial jobless claims have crept a bit higher. We remain relatively unconcerned given that seasonal adjustments around the Easter holiday can be difficult and the level still remains well below the key 400,000 number. Jobs are a vital cog in the economy and we believe that increasing retail demand and a declining ability of companies to squeeze additional productivity out of existing workers should allow for continued improvement on the labor front.
Housing has very likely been affected by the weather. We believe the housing market continues to show improvement but were disappointed by the recent data releases that showed existing home sales fell by 2.6% and housing starts dropped by 5.8%. However, the forward looking building permits number rose 4.5%—boding well for future activity. And, even within the disappointment there were glimmers of positive news as the drop in starts was almost entirely attributable to the volatile multi-family component falling 16.9%. Finally, inventories continued to decline—existing homes on the market are down 22% relative to a year ago.
The Index of Leading Economic Indicators (LEI) rose for the sixth straight month, although upcoming seasonal adjustments suggest an upcoming weaker report. And, one odd note on the auto sector. We’ve noted the sharp rebound in auto sales and the resulting contribution to economic growth, but that could be in near-term jeopardy due to a potential shortage of a resin known as nylon-12 used in brake and fuel systems. The potential shortage comes as a result of a chemical plant explosion in Germany that is expected to take production offline for at least three months. Auto executives have expressed serious concern.
Fed holds but continues to confound
The recent Fed meeting provided few surprises as interest rates remain near zero and questions regarding future potential monetary operations remain. We continue to hope that the Committee will lean toward more normal monetary policy going forward but they do appear willing to up the ante and provide more stimulus if economic conditions deteriorate.
The Fed will likely keep its ammunition at the ready due to the potential hit to the economy that is currently scheduled to come at the beginning of 2013 in the form of massive tax increases and blunt-force spending cuts. We remain hopeful that something will be worked out to minimize the potential impact but are concerned that the current political environment does not lend itself to any easy compromise solution.
Europe's confidence game slipping
As dire as the situation sometimes seems in American politics, we can always look to Europe for an example of even greater problems. Sentiment regarding the eurozone debt crisis was boosted by the double shot of European Central Bank (ECB) three-year bank loans and the perception of progress by individual country governments toward structural reforms and fiscal austerity. However, since the beginning of March, uncertainties have risen because governments have either been thrown into upheaval or backpedalled on deficit reduction and reform goals; and the major impact of the ECB's three-year loans has faded.
Spain in particular has been a focus, as it is viewed as too big to fail, yet also too big to bail out. Spain's situation can be thought of an inter-related four-legged stool of problems: a deteriorating economy, a housing bubble burst, a weak banking system and an elevated government deficit. When one leg of the stool deteriorates, the others feel the pressure.
The Spanish government's credibility has been called into question because it missed its 2011 fiscal deficit target by over 40%, with the deficit registering 8.5% instead of the 6.0% target. This increases doubts about the ability to slash the deficit in 2012 and 2013, not to mention what appear to be overly optimistic assumptions in the deficit reduction plans in our opinion. We don’t believe the situation in Spain necessitates an imminent bailout, but markets are nervous that the situation could deteriorate, necessitating a bailout over the next couple years.
The ECB's three-year loans, also known as their long-term refinancing operations (LTROs), reduced the threat of a global banking crisis in our view. While the money was partly credited with yields plunging on debt of weak countries, the effect on government yields is fading. It may sound like a bit of a shell game, but after posting peripheral debt as collateral with the ECB to receive money, some banks in the periphery used the LTRO money to buy more debt of their home countries. This negatively increased the ties between weak banks and weak governments.
Now, the ability to use LTRO money is running out due to banks’ capital rules. As such, the ability for Spanish banks, for example, to support Spanish government bond auctions, is waning. New bond issuance is increasingly dependent on foreign investors, at a time when foreign investors are increasingly shunning exposure to peripheral countries. The move in France and elsewhere toward policies that are unfriendly to businesses (banks and energy companies in particular), reject austerity, increase taxes on the wealthy and toward protectionism, are the wrong prescriptions in our view.
Additionally, the socialist way of life may need to be re-examined, because many governments need to reduce spending. Healthcare and pension programs take up a large share of spending, which is likely to increase as populations are aging. Tax rates are already high in many countries, but better collection and reduced complexity of tax laws could likely bring in more revenues.
The way out of the “austerity trap,” where weakening economic growth contributes to missed fiscal deficit reduction targets and new rounds of austerity, is growth. More concrete and aggressive policies need to be made to:
- increase flexibility of labor markets, and
- reduce restrictions on the ease of doing business.
Structural reforms will take time to reap rewards; however, we don’t see a magic cure in the short-term for the eurozone’s ailments.
Eurozone economic downside risk
In the meantime, transmission to the real economy of the eurozone sovereign debt crisis is to weaken the banking system. The LTRO money provided new buyers for maturing bank debt, with the ECB acting as a substitute for capital markets. However, as ECB President Mario Draghi recently said, "This is not capital," and “If banks don't have capital, (they) better raise it now."
The weak state of European banks has been a continued theme in our outlooks over the past year. The huge $2.6 trillion (2.0 trillion euro) balance sheet reduction over the next 18 months estimated by the International Monetary Fund (IMF) comes as little surprise to us. The IMF estimates that about 25% of this deleveraging will be accomplished by reducing lending, which is likely to dampen economic growth further. After improving for three months, the dramatic two-month falloff in the eurozone purchasing manager index (PMI) and continued reductions of economic forecasts indicate that Europe is likely to remain in recession territory and put some pressure on global growth.
European growth a continued drag
Source: Bloomberg. As of Apr. 24, 2012.
We believe the source of the recent downturn partly emanates from a further tightening of bank lending and we believe European banks, Spanish in particular, need additional capital.
China still has levers for growth
In contrast to Europe, China still has levers for growth and we believe a hard landing is unlikely. The manufacturing PMI remains below 50, but for a fast-growing economy, this means a weakening of growth, not necessarily a crash. Additionally, while economic growth in the first quarter of 8.1% was slower than expected, it certainly isn’t a disaster. The pace of monetary easing has disappointed the market, but the government may be pursuing a prudent strategy by allowing the air to come out of the economy a while longer, reducing imbalances in the structure of the economy.
The slowdown in the first quarter came primarily in two areas—exports and investment. While the Chinese government can’t do a lot to influence exports, it can influence investment spending. Property construction is likely to fall because the government is restricting growth. However, after a sharp falloff, there is likely an appetite to reaccelerate spending on infrastructure projects.
Contrary to concerns about too much infrastructure, in our opinion, China appears to be relatively underdeveloped, particularly in the inland provinces. The sharp increase in new loans in March is likely to reinvigorate growth, and we believe infrastructure spending is likely to benefit.
Surge in Chinese loans likely reinvigorates
Source: FactSet, Global Insight. As of Apr. 24, 2012. 1 quarter moving avg.
While second quarter economic growth could be weak again and hard landing fears are not likely to dissipate soon, sentiment is overly negative in our opinion. It is interesting to note that despite the rampant fears, the Shanghai Composite Index has outperformed over the past month.
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