By Liz Ann Sonders, Brad Sorensen, Michelle Gibley
June 29, 2012
- Stocks have moved modestly higher and may now be in a relatively large trading range. The possibility of market moving events in Europe and the United States may keep investors cautious in the near term, not wanting to take a substantial bet one way or the other.
- US economic growth remains sluggish and is drifting dangerously close to stall speed. The Federal Reserve extended their Operation Twist program, and noted they are ready to do more; but we are skeptical that additional monetary easing will do the trick.
- Policymakers in Europe appeared to make some progress in the most recent summit, but much is left to be done and time is running out. Meanwhile, global growth is slowing and central banks are attempting to stem the decline.
We often hear the phrase "fat tails" in the investing world, which is actually hijacked from the statistics arena. It refers to the increased probability of an extreme outcome that breaks away from the normal pattern. While there is always that possibility in the market, there are a couple of issues investors appear to be zeroed in on that could determine the intermediate term direction of the market. First, there is the European debt crisis. We appear to be getting closer to a resolution one way or the other as the "buying time" fixes are having less and less impact. The fat tail outcomes involve a sustainable solution that keeps the euro intact and addresses the area's debt issues in a coherent and responsible way; in which case we believe stocks would likely shoot higher. Conversely, if the situation breaks down completely and the eurozone as we know it dissolves, it's likely that stocks will take at least a near term sharp downward turn.
Similarly, in the United States, if the upcoming fiscal cliff is resolved with a long-term plan that reduces deficit spending in a responsible way, investors would likely be quite enthused. However, should nothing be done and we go over the cliff, investor reaction in the near-term could be quite negative, as would the prospects for the economy.
It's important to note that these are still called fat tail possibilities, meaning that the tail scenarios may be more likely than normal, but still less likely than the middle part of the curve, which is typically where investors have to make their decisions. Certainly it's possible for investors to hedge their risk relative to the fat tail scenarios to some extent, but betting the farm on these low probability outcomes, one way or the other, is a dangerous strategy. For now, it appears that policymakers will continue to cobble together short-term solutions that will placate the market for shorter and shorter periods, allowing the market to rally, and then fall back on disappointments that the bigger problems still remain. A frustrating environment to be sure, and one that we believe argues for a bit of cautiousness within a diversified portfolio. We continue to believe investors should underweight European equities and use those dollars to focus on higher quality US stocks.
We did get "finality" in one area that was in question—the Supreme Court issued its ruling on the Affordable Care Act. While the full decision was a bit complicated, in essence, the law was upheld. The broad market largely ignored the decision and we believe that this decision is just the start of what will continue to be a hotly debated issue. Company certainty on health care costs appear to be no greater today, as the election looms and the possibility of repeal or substantial changes remains a central campaign theme for the Republicans.
Economic sluggishness concerning, but it's not time to panic
Contributing to our belief in volatile stock market action in the near term is continued evidence that US economic growth has downshifted marginally and is starting to creep dangerously close to so-called stall speed. For now the US economy is still growing although recession risk has risen.
Jobless claims, a leading indicator, remain below the key 400,000 level, which is encouraging and pointing toward continuing economic growth, but the trend has moved higher. Further, the recently released JOLTS (Job Openings and Labor Turnover Survey) report, which can also be a good indicator of the future direction of the unemployment rate, showed that job openings dropped from 3.7 million in March to 3.4 million in April, which was the biggest drop in almost four years.
JOLTS report indicated soft job market
Source: FactSet, US Dept. of Labor. As of June 25, 2012.
Additionally, the Philly Fed report fell to its lowest level since August of last year, moving to a negative 16.6, although this survey can be quite volatile on a month-to-month basis, while the Richmond Fed Index also fell into negative territory. These were not confirmed by other regional surveys, including out of Chicago and Texas, which both increased. In addition, the Index of Leading Economic Indicators (LEI), which has tended to be a good indicator of potential recessions, surprised on the upside by moving higher by 0.3% thanks to the surge in building permits, another sign housing is recovering.
Also indicative of sluggish growth is the recent plunge in oil prices, which help to bolster consumers' pockets, and the aforementioned healing of the housing market. The National Association of Homebuilders (NAHB) survey moved to its highest level since 2007, although remaining at a still-depressed reading of 29. And building permits, which is part of the LEI and mentioned above, rose 7.9% in the most recent reading. And although a lagging number, the April Case-Shiller Home Price Index rose a seasonally adjusted 0.7%, the largest monthly increase since August 2009. Even a modest improvement in housing would be a marked contrast to the past couple of years and could help to contribute to ongoing economic growth.
Fed extends Twist; market yawns
During its most recent meeting, the Federal Reserve acknowledged the economic softness and chose to extend "Operation Twist", which was scheduled to expire at the end of June, through the end of the year. Their goal is to continue to push down long-term interest rates, in an attempt to help the housing market, while also trying to entice businesses to borrow and invest. Positively, bank loans have moved higher, indicating some measure of increased demand combined with a slight easing in credit standards, but cash is still largely sitting on companies' balance sheets, as they remain cautious over extending themselves in the current environment.
Bank loans increasing is encouraging
Source: FactSet, Federal Reserve. As of June 25, 2012.
In addition to the Fed having added a "monetary cliff" to the "fiscal cliff," we remain doubtful that the Fed has many bullets left that can make a large impact on the economy. There appears to be plenty of liquidity in the economy, but the Fed can't force companies to spend or banks to lend that money. It reiterated that it stands ready to engage in more accommodative actions if needed but we think the bar remains quite high for a new round of quantitative easing, as even Chairman Bernanke has noted that their ability to substantially impact the market is likely limited.
Europe playing catch up
What could impact the market would be a resolution to the European debt crisis, as we saw with the sharp rally on news out of the recently completed summit in Europe. The European summit had some positive aspects, including using the bailout mechanisms to recap banks directly, reverse the seniority of the European Stability Mechanism, and purchase sovereign debt using bailout funds without countries entering full bailout programs. However, the market has an increasingly short time horizon, while a true monetary union likely needs a fiscal union. The problem is that instead of union, divisions remain:
- France not only reduced the retirement age to 60 while Germans must wait until age 67; it is also making its labor market less competitive by raising the costs to fire workers and reducing manufacturing location flexibility.
- Germany's Merkel commented that joint debt such as euro bonds would not be a possibility in her lifetime.
As such, piecemeal solutions short on details continue to come up short and lack the large scale needed to put uncertainty to rest. We equate it to putting a finger in the dike when the dam remains structurally unstable—partial solutions result in short-term reprieve, but markets remain vulnerable to new outbreaks in other areas, and relief is not long-lasting.
We've been concerned about the health of the European banking system and the impact on economic growth. Delays in improving the health of the banks have resulted in increased costs of funding and reduced ability to lend. As the Bank for International Settlements (the bank for central banks) said in its 2012 annual report, sustainable economic growth cannot be begin until banking system woes are addressed by forcing banks to recognize losses, take write-offs and raise capital. Lending is likely to suffer in the meantime, reducing economic growth potential in Europe.
Policymakers have finally acknowledged a key problem—the negative feedback loop between eurozone sovereigns and banks. While the European summit made some progress toward a banking union some components remain missing, such as a European-wide deposit insurance program and a way to resolve insolvent banks (a bank resolution mechanism). However, even a full banking union isn't a panacea for the banks as it is likely to be accompanied by increased costs and regulations; and could result in a reduction in the number of banks in the European banking system. While there would likely be winners and losers, the adjustment period could be challenging, as we experienced in the United States in the post-Lehman period.
We don't believe Europe will achieve either full union or break-up in the near-term, resulting in "muddle through" as the most likely scenario at this point. The outcome of the European summit was greeted positively, but markets increasingly have a short-time horizon, and the question is how long the reprieve lasts. We believe the rollercoaster loop of sentiment is likely to remain in place, and we continue to recommend an underweighting of European stocks. From a long term perspective, a break up of the euro remains a possibility, which could improve the longer-term outlook, but would likely be accompanied by extreme volatility at the time of occurrence.
Does Japan's high debt load make it an accident in waiting?
There are often comparisons of Japan's debt problems to those in peripheral Europe. However, we believe the differences outweigh the similarities. A main difference is that Japan remains a creditor, not debtor nation, due to its high level of domestic savings. While Japan's trade balance has slipped to a deficit from surplus over the past year, we believe this is likely a temporary, not structural phenomena, due to increased reliance on importing energy after the nuclear plant shutdowns.
However, we believe Japan does need to improve its fiscal revenues and reduce its debt load, and the aging of its population is reducing the time to complete this adjustment. A plan to double the sales tax from 5% to 10% is only a first step to improve fiscal revenues. While it remains to be seen if the Bank of Japan will move more aggressively to target inflation, the market is giving some credence, with implied inflation now in positive territory.
Markets may believe Japan's deflation could end
Source: FactSet, Bloomberg. As of June 26, 2012.
* Implied inflation rate equals 7-yr Japanese bond yield minus 7-yr inflation-linked securities yield.
Global growth under pressure
Troubles in peripheral Europe, where economic growth has taken a hit from fiscal austerity and uncertainties about government bailouts, have spread to the economic stronghold of Germany. While many of Germany's engineering-oriented companies enjoy competitive strengths on the global stage, the European Union (EU) comprises 58% of Germany's exports and Germany bares a large financial burden in funding rescue programs.
Elsewhere, China's exports to the EU have also taken a hit. However, the focus on the importance of exports to the Chinese economy may be overstated. Gross exports are roughly 27% of China's GDP and the EU is 18% of exports, resulting in the EU having a 4.9% impact on China's economy. Additionally, as the manufacturing purchasing manager indexes (PMIs) illustrate, China's slowdown is less severe than that occurring in Europe. Separately, there are some indications the slowdown in China is moderating.
Europe's slowdown outpaces China's
Source: FactSet, Bloomberg. As of June 26, 2012.
We believe economic growth in China could remain under pressure in coming months; but in contrast to Europe, China still has levers for growth, and we believe a hard landing will be averted. Slower growth is likely to be the new normal for the Chinese economy in our view.
Lending is the lifeblood of economic growth and central banks globally are moving to incent lending. China's interest rate cut in June helps improve financial conditions, but demand for loans is declining as businesses see sales and orders fall, and there is typically a lag between monetary policy actions and economic growth. Elsewhere, lending in the United Kingdom never recovered from the post-Lehman global economic slowdown. The Bank of England (BoE), in conjunction with the UK government, is pursing non-standard measures to stimulate lending. On the surface the two UK programs seem encouraging. However, we are doubtful they will significantly alter growth in the United Kingdom, under pressure from austerity and close ties to the eurozone, with the EU comprising nearly 50% of exports.
Interestingly, China's interest rate cut came along with increased flexibility for banks to set rates. While this is a positive market-based reform, it could reduce the profitability of banks, which have large weights in Chinese indexes.
We believe global growth will likely remain subdued amid negative headwinds in many countries. Read more international research at www.schwab.com/oninternational.
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.
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