The New, Old Normal
June 28, 2013
by Liz Ann Sonders, Brad Sorensen and Michelle Gibley
of Charles Schwab
- Friction has increased across markets, resulting in some hair-raising moves in various assets. We don't believe equities are in for a prolonged downturn or that bond yields will spike substantially higher, but these are the times when keeping long-term goals in mind is most important.
- Reduced asset purchases by the Federal Reserve seem nearly certain to occur later this year. While markets reacted poorly, this is something that needed to happen and should not be viewed as tightening—the Fed's balance sheet will continue to expand. Volatility has increased, but we believe a healthier environment will emerge.
- Emerging markets have taken it on the chin in this changing environment and risks remain elevated, with China's interest in structural reforms leading the way. Meanwhile, Japan remains attractive to us for patient investors and the eurozone appears to be turning a corner, although rising yields and renewed Greek concerns could cause problems.
Times of transition can be difficult, and despite the efforts of the Federal Reserve, this period is no different. For several years since the financial crisis of 2008, investors have only known one mode for monetary policy direction—easing; notably quantitative easing (QE). This resulted in record low interest rates for an extended period, gold moving to record highs, and equity investors, finally over the past seven months, embracing the "Don't fight the Fed mantra." But we knew this couldn't last forever, nor should we want it to. An economy that relies on a central bank purchasing $85 billion worth of fixed income assets, while pushing interest rates artificially lower, is not one that is sustainable for the long run.
Investors and markets are adjusting to a new paradigm; one where the Fed, while not tightening policy, is easing off the accelerator. In short, the investing mindset is adjusting to a long, slow, but inevitable return to a more normal monetary policy environment. The end of financial repression (negative real rates) and a return to more market-oriented conditions is a good thing, but the journey will bring bouts of volatility and likely more "taper tantrums." This reinforces our belief that investors need to have a long-term, diversified plan in mind and the discipline that goes along with it
What's behind the shift?
Bond yields are not rising because inflation has spiked; quite the contrary. The core Producer Price Index (PPI) was up only 1.7% year-over-year (y/y) in May, matched by the core Consumer Price Index's (CPI) y/y gain. Instead, the Federal Reserve made it clear that it's making the decision to cut back on asset purchases only if the economy continues to improve, which we believe is ultimately a good thing for stocks.
Although growth remains sub-par, the recovery continues with housing a particular bright spot. Housing starts rose 6.8% in May, while existing home sales rose 4.2%, reaching their highest level since 2009. Additionally, the median price for those sales was up 15.4% y/y, helping bolster net worth and consumer confidence.
Housing continues to be a support
Source: FactSet. Nat'l Assoc. of Realtors. As of June 24, 2013.
In fact, there is some concern that in at least some areas of the country, housing may have come too far, too fast. Reduced inventories have sparked bidding wars in some areas, while there are anecdotal stories of homes being purchased for above their appraised value—glimmers of the housing bubble. We don't subscribe to those concerns as lending standards remain relatively tight, supply is starting to increase, and the uptick in mortgage rates that we've seen should diffuse any froth we may be seeing. We continue to believe the housing story will be a support for the economy in the coming months, but acknowledge that the rate of change cannot continue to accelerate at the same pace as it has since the bottom.
Manufacturing is a mixed story, but we believe it's more of a soft patch than a sustainable decline. In fact, we believe the US economy is enjoying a secular manufacturing resurgence, the details of which can be read here.
After the disappointing May ISM Manufacturing Index reading below 50, we've received some encouraging data that supports the soft patch idea. The Empire Manufacturing Index rose to 7.84 from -1.43, while the Philly Fed Index jumped to 12.5 from a negative 5.2. In fact, the amount by which all of the regional manufacturing surveys exceeded expectations is as wide as it's been since April 2009. Additionally, more credence is being given to the Markit PMI reports around the world and their latest print on US manufacturing showed a relatively steady level of 52.2, still indicating expansion.
The labor market, a primary focus of the Fed's, is also improving. Perhaps the best sign of this is the announcement from Fed Chairman Bernanke that they are looking to scale back their asset purchases, which were largely started due to a continued disappointing job growth. Job growth is running at about a 190,000 average so far this year; while weekly jobless claims have largely been below 350,000, which indicates that monthly job growth should improve in the coming months.
Still extremely accommodative
Given the market's initial reaction to the most recent Fed meeting, outsiders may have thought the Committee had announced that they were eliminating their asset purchase program and raising interest rates. Instead, they said they may start to slowly reduce the amount of assets they're purchasing later this year, only if economic conditions continue to improve. It would likely lead to an end of quantitative easing by the middle of next year, again as long as economic growth continued to improve—not exactly hawkish in our opinion. In fact, the Fed has gone out of their way to note that if conditions reverse, the decision to "taper" is not on automatic pilot, and can be stopped or even reversed if warranted. Finally, the Fed reiterated that this was not a tightening of monetary policy and that the target rate should remain close to zero until at least 2015. The nearly $3.5 trillion balance sheet of the Fed illustrates just how stimulative they've been, and how much cash remains in the system that still needs to be put to more productive uses.
Fed's balance sheet has exploded
Source: FactSet, Federal Reserve. As of June 24, 2013.
For investors this means that the economy is either continuing its steady advance or that the Fed will again step in with more stimulus; an environment that we believe should ultimately be supportive of stocks and that the advance in yields will be relatively controlled.
Emerging markets - risks have risen
While volatility increased in the United States, Fed tapering concerns hit emerging markets (EM) investments hard. A reach for yield by investors and improved EM fundamentals relative to their troubled past likely resulted in investors becoming somewhat complacent about the risks in EM.
However, EM investments still have unique risks. While we have been expressing caution on EM stocks for several months due to the prospect of slowing growth, the unwind of risk-based trades and resulting emerging market currency weakness could create inflationary pressures and reduce the ability for some EM central banks to ease. Additionally, US dollar strength on Fed tapering could "steal" investment flows from emerging market economies and further pressure growth; an issue for countries dependent on foreign investment due to current account deficits, including Brazil, India, Indonesia, South Africa and Turkey.
Prior episodes of US dollar strength and capital flight out of EM contributed to financial crises, but we believe a widespread crisis this time is less of a threat. Relative to the past, EMs have less debt denominated in US dollars and higher foreign exchange reserves, reducing the threat of a financial crisis.
However, we may be in a new era for EM, characterized by slowing growth and stock market underperformance due to the combined pressures of:
- wage growth in excess of economic and revenue growth (resulting in inflation and profit pressure)
- the need for private sector deleveraging in some countries (such as in Brazil, South Korea and China)
- limited scope for policy easing.
We maintain our preference for developed international stock markets over emerging market stocks.
China's liquidity crunch illustrates risks
Concerns about a liquidity crunch in China likely contributed to market volatility in June. The end of a quarter typically results in banks needing liquidity to meet capital ratio requirements; but this quarter had two additional factors, as China's government sought to reduce speculation in both lending and capital flows related to exports.
China's rapid credit growth a risk
Source: Bloomberg. * Year-to-date data as of May 31, 2013
China's policymakers are in a bit of a bind, as they need to crack down on speculative lending. Total credit issued in China grew by $1.5 trillion just in 2013 through May, with 54% coming from outside the formal banking system. Policymakers want to send a message that there are consequences of speculation, but in the process, they risk making a policy mistake. Confidence is a key factor to the functioning of financial markets, and confidence can be fleeting.
Cracking down on lending is an act of tightening, and could slow activity across the economy. This could result in reverberations, as borrowers may struggle to roll over short-term debts, small banks could run into funding issues, companies may have difficulty financing daily operations, defaults on loans could rise, companies in industries with overcapacity issues (steel in particular) could go bankrupt, jobs could be lost and social unrest could take hold.
However, we believe China's government won't let the situation spiral out of control, and will inject money when and where necessary. China is sacrificing near-term growth for attempted structural reforms and a transition of the economy from debt-fueled, construction-led growth, which could be a positive development longer term. However, we believe this transition, even if successful, could be difficult and risks are rising. We believe China-related investments will encounter difficulty until investors have confidence about where and how China's economy stabilizes. Read more Avoid China – Subprime-Like Bubble Brewing, as well as related topics at www.schwab.com/oninternational.
Japan: pause, but not panic
Domestic and global factors contributed to volatility in Japanese markets over the past month. Domestic factors included unclear structural reforms in Premier Abe's much-anticipated speech and unchanged monetary policy. The global unwind of risk-based trades prompted by the Fed's taper talk resulted in yen strength as yen shorts covered their positions. However, we believe yen strength is a temporary adjustment and the yen will resume its downtrend. QE in Japan is just beginning while the Fed's QE appears to be waning, which should result in a weakening of the yen, all else equal.
Additionally, the potential for revival in Japan is still in the early stages, the economy and corporate profits have begun to improve, and leading indicators imply the potential for the economy to accelerate from the already strong 4.1% real GDP growth in the first quarter. Consumer spending is leading the recovery, with confidence and spending rebounding and wages starting to rise, as discussed in Japan: Land of the Rising Consumer.
Japan's recovery led by consumers
Source: FactSet, Japanese Cabinet Office. As of June 25, 2013.
Japanese stocks could remain volatile until there is more clarity about reforms, economic growth and monetary policy; but to us the intermediate term outlook is positive for patient and disciplined investors. Longer term, structural reforms need to be implemented for a sustained recovery, and the government needs to provide fiscal consolidation plans to maintain the confidence of the bond market.
Eurozone may be bottoming
Despite the recession narrative, we believe the eurozone may be in the process of bottoming. Policymakers are easing fiscal austerity and the fiscal drag in 2013 will likely be less severe than in 2012. Even Germany, the epicenter of austerity, may be considering fiscal stimulus ahead of September elections. Additionally, easing inflation pressures allowed the European Central Bank (ECB) to cut the benchmark interest rate in May and consider other non-standard measures. The lagged effect of monetary policy adds to the potential for the economy to emerge out of recession.
That said, there are still risks in the eurozone. Austerity is weighing on Greece, with the shutdown of the public broadcaster ushering in riots and the reported walk out of part of the coalition government, which could threaten new elections. Already, peripheral sovereign government yields have risen as risk trades unwind globally, and new elections in Greece could bring renewed bond market volatility. However, a fair amount of bad news has likely already been priced into eurozone stocks, where earnings and valuations are depressed and could volatility likely offers opportunity for investors.
We believe the recent volatility will be relatively short lived and provides an opportunity for investors who need to adjust their portfolios to do so—with long-term goals in mind. The risks associated with fixed income have been illustrated over the past couple of weeks and rising yields have caused equity volatility and a pullback. But we remain optimistic about US equities as well as developed international markets; particularly relative to emerging markets.
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