Calming Downand Changing Focus
July 12, 2013
by Liz Ann Sonders, Brad Sorensen and Michelle Gibley
of Charles Schwab
- Following a spike in volatility, markets have calmed and attention is on second quarter earnings season. While we believe earnings will largely beat muted expectations, revenue growth will likely gather more attention than usual.
- The Federal Reserve has attempted to clarify its position of reducing asset purchases only if economic growth warrants. We believe they need to stick to their guns and expect quantitative easing to start to wind down later this year.
- Europe appears to be making progress and should be reflected in equity markets. Japan is also attractive in the intermediate term but China's problems seem likely to continue and should be largely avoided.
Markets appear to be calming down from the Fed-induced volatility that saw a roughly 6% pullback in stocks, a $200 further drop in gold (which has fallen about $500 since the start of the year), and a spike in the ten-year Treasury yield of roughly 100 basis points—all in the span of a few weeks. While we don't believe the volatility is over, it should be less pronounced as we head through second quarter earnings season and the rest of summer. It may be more difficult to get a solid read on the market over the next month given light summer trading volume.
We remain optimistic about equities over the rest of the year; although we expect more volatility associated with the Fed's eventual tapering. We also believe that bond yields may drift higher but seem unlikely to see another major spike in the near term.
The next near-term catalyst for the market may be second quarter earnings season as investors look to see what company leaders are seeing in the economy. Projections going into the heart of the reporting season are for relatively flat earnings growth, so the bar is set fairly low But revenue growth has gained more of the spotlight given that earnings can be somewhat manipulated and boosted by cost cuts, shifting expenses, one-off charges, etc. In gauging how the economy is growing, revenues (and forward guidance from management) are less susceptible to "noise."
Modest growth continues
Earnings will augment economic data to help decipher whether the economy is gaining steam, and finally approaching "escape velocity," allowing the Fed to begin normalizing monetary policy. Growth has been steady, but given the rise in rates over the past month, activity will be closely watched in order to discern the impact. We saw encouraging personal income numbers, which have been lackluster, with a 0.5% rise in May; which helped to fuel a 0.3% rise in personal spending—indicating American consumers continues to hold their own. Although they have had to deal with higher payroll taxes, consumers have been aided by a stable-to-lower commodity prices, an improving labor market, higher stock and housing prices, and growing confidence.
We are watching the housing market carefully over the next couple of months, as we expect the pace of improvement to dissipate a bit, while remaining positive. According to the Mortgage Bankers Association, mortgage rates recently had their biggest one-week rise in over two years and reached their highest level since August of 2011. This rise, combined with the strengthening of prices, has resulted in affordability measures coming of their all-time highs, and at least a short-term pullback in mortgage applications.
Affordability falling, but still supports further improvement
Source: FactSet, Nat'l Assoc. of Realtors. As of July 8, 2013.
Positively, the Institute for Supply Management (ISM) reported that their Manufacturing Index returned to territory depicting expansion at 50.9, up from the disappointing 49 reading seen previously, while new orders rose from 48.8 to 51.9. Somewhat disappointing was the employment component dropping below 50 (48.7) for the first time since September 2009, indicating the soft patch in manufacturing continues. Additionally, the service side of the economy was a bit disappointing as well with the ISM Non-Manufacturing Index falling to 52.2, the lowest level since February 2010. Helping offset that disappointment was the employment component, which in contrast to manufacturing, jumped from 50.1 to 54.7.
Focus remains on employment as the Federal Reserve continues to target labor improvement. Payrolls grew by a better-than-expected 195,000, while the unemployment rate remained at a still-elevated 7.6%. Temporary employment, which tends to lead permanent employment gains, rose to the highest level in 13 years; although there is concern about the growth in temporary jobs related to the Affordable Care Act.
Labor market continues steady, if not impressive, improvement
Source: FactSet, US Labor Dept. As of July 8, 2013.
Fed officials attempt to clarify positions
There's a reason we are now referring to the FOMC as the Federal Open Mouth Committee. But after seeing the extreme volatility in the market, Fed members have made a concerted effort to reassure investors and clarify their position that the Fed would only scale back its asset purchases if the trajectory of the economy justifies it.
To some, the Fed bungled the message, but we believe the intent is right, and supportive of further gains in stocks. Stimulus into infinity is neither healthy nor desirable, and likely not feasible; and we have been calling for a slow return to more normal conditions for some time now. A Fed that maintains it will stimulate if conditions lag, but will back off if the economy improves, seems to us to be the right combination for equities—almost like a put option on economic growth. For now, it seems they have retreated a bit and will let the economy progress before the next round of pronouncements, allowing investors to focus on other things for the time being.
Congress remains relatively quiet on the economic front. Investors should enjoy the respite, as we expect rhetoric to heat up as the summer winds down. The debt ceiling is looming, fights over the implementation of the Affordable Care Act will likely escalate with the employer mandate recently delayed, and the debate over both corporate and personal taxes will resume. In a recent study of 10k filings by companies performed by Strategas, they found that mentions of government as a risk factor have more than doubled since 2005.
Europe's potential for both monetary support and economic stabilization
Diverging from the United States, monetary policy in Europe looks likely to stay easy or even become more accommodative. In early July, the European Central Bank (ECB) took the unprecedented step of giving "forward guidance;" committing to an easy stance for "as long as necessary," with rates to be at present levels or lower for "an extended period of time." Additionally, the Bank of England (BoE), with new Governor Mark Carney at the helm, issued a statement after the last meeting for the first time. The BoE indicated that the path of rising rates expected by the market "was not warranted," signaling a potential move to explicit forward guidance at the August meeting.
Eurozone growth could be bottoming
Source: FactSet, OECD. As of July 8, 2013.
Meanwhile, economic growth in Europe is no longer deteriorating at a rapid clip, and may actually be bottoming. Eurozone policymakers are easing fiscal austerity measures and the fiscal drag in 2013 will likely be less severe than in 2012. There are signs of cyclical recovery in the large peripheral economies of Spain and Italy, and even Germany, the epicenter of austerity, may be considering fiscal stimulus ahead of September elections. In the United Kingdom, the economic outlook has improved, but remains weak.
However, recent developments in Portugal and Greece were a reminder that the eurozone debt crisis hasn't gone away, only subsided. Positively though, Portugal and Greece's problems didn't result in contagion to other peripheral countries, with the ECB's conditional bond purchase program apparently limiting downside risks. This is a positive sign that markets may become more discerning when viewing specific countries and focusing more on fundamentals.
We believe volatility in eurozone stocks is likely to be a buying opportunity, as a fair amount of bad news has likely already been priced in. However, despite an improved outlook, UK stocks don't appear as depressed or appear to offer as much value as eurozone stocks, in our opinion. Please note that investment returns in eurozone stocks for US investors could be reduced to the extent that the US dollar continues its uptrend relative to the euro.
Japan's revival still in an early stage
In Japan, QE is still in its very early stages; with stepped up asset purchases just unveiled in April 2013. QE in Japan is just beginning, while the Fed's QE is potentially waning, which should result in a weakening of the yen, all else equal. We believe the yen is in a down trend over the intermediate term.
Prime Minister Shinzo Abe came to power in December on the back of his plan to revive Japan, dubbed "Abenomics." Abe's LDP party is likely to get another boost in the July 21 parliamentary elections, with the potential for a single party majority in both houses for the first time in 20 years.
Japan's economy has been consistently surprising to the upside in recent months; so much so that we may be in for a period of negative surprises and a moderation in economic activity. Despite a rebound in consumer spending, wages need to rise to offset import-related inflation due to the weak yen. Additionally, once the July elections are in the rear view, markets are hoping to hear a more detailed plan for structural reforms, which are needed to sustain the economy recovery. We believe Japanese stocks could move sideways near term as economic and reform changes are weighed, but the intermediate term outlook is positive for patient and disciplined investors. A weak yen relative to a strong US dollar would reduce returns for US-based investors, and hedging currency exposure should be considered.
China's double whammy: slowing growth and little policy aid
China's economy has been slowing in 2013 after a brief rebound in late 2012. A leadership transition ushered in restraint and the recognition that that some excesses were building; and that China can no longer rely on the same economic model for growth. Illustrating the problem, Fitch Ratings estimates that despite the debt-to-GDP ratio rising by 73 percentage points from 125% to 198% in the four years ending 2012, each dollar of debt only created about $0.30 of economic growth on average during the period, down from $0.71 before the global economic downturn.
China's credit growth unlikely to continue
Source: Bloomberg. * Year-to-date data as of May 31, 2013.
As such, China's policymakers are attempting to crack down on speculative lending, which likely contributed to the liquidity crunch in the interbank markets in June. However, cracking down on lending is an act of tightening, and could further slow economic activity across the economy in the second half of 2013. The amount by which credit issuance will moderate is highly uncertain—estimates by economists polled by Bloomberg range from 20 to 3 trillion yuan less credit issued in the second half, from a base of 15.8 trillion yuan issued in 2012.
In July, China's government said it will cut off credit in industries plagued by overcapacity, which could force consolidation. We believe there is excess capacity in many industries in China, with producer prices symptomatic of the excess. The International Monetary Fund (IMF) estimated capacity utilization at 60% in 2011 and yet more capacity was added in 2012 despite the economic slowdown. Additionally, we believe there is a reduced economic payoff from debt issuance due to a combination of funding uneconomic projects and funding the rollover of maturing debts. To the extent maturing debt cannot be repaid due to the weakening financial health of corporations, capacity likely needs to be shuttered.
China's government has the financial wherewithal to thwart an economic hard landing. However, transitioning the economy from debt-fueled, construction-led growth, to consumption is likely to be difficult and there is a risk of a policy mistake. Confidence is a key factor that can be fleeting and not entirely under government control.
We believe China-related investments, including emerging market stocks and commodities, 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.
Markets are calming and investors seem to be focusing on fundamentals again—a nice change from recent history. The bar is relatively low for earnings season but focus will be on the commentary surrounding releases. We believe more sideways movement in both US equities and Treasury yields could prevail over the next couple of months, with summer months muting action; but remain optimistic about stocks longer-term. Likewise, Japan could tread water until new elections are held, but we believe the eurozone provides opportunities that should be looked into at the expense of investments in China.
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