Key Points

• At the end of a year that saw a remarkable series of crises, the stock market has held up remarkably well. With stocks roughly flat on the year, earnings increasing, inflation decreasing, and economic data improving, the environment for a renewed upward move may be in place to start the new year.
• The situation in Washington has become almost humorous, if it weren't for the impact that the disconnect has on business and consumer confidence. There seems to be little hope for any relief in the near term, but 2012 brings an election cycle that will likely have a major impact on the future of the US.
• A near-term implosion in Europe seems to have been avoided but real solutions remain absent and the risks for a greater economic pullback are growing, which would likely have global implications. Meanwhile, questions are increasing regarding China's ability to engineer a smooth financial transition.

Although frustrating for investors, it is remarkable to us how well stocks and bond have both held up over the past year in the face of literally unprecedented challenges. Stocks will end the year roughly flat, while the 10-year Treasury has seen its yield go from about 3.5% to start the year to roughly 2% as we end 2011. This occurred during a year that saw a nuclear meltdown in Japan, riots and uprisings throughout the oil-producing Arab world, a downgrade of the United States' credit rating, and the continuing threatened dissolution of the European Union due to an ongoing debt crisis. Somewhat incredible.

But, the past is the past and decisions can only be made for the future. We believe that this year has helped to set the stage for a possible sustainable upward move in stocks as we begin 2012. As mentioned above, prices were roughly flat on the year, while earnings continued to move higher, resulting in a lower price/earnings ratio and valuations that look attractive to us when keeping the longer-term horizon in mind. Further helping the valuation case is the easing of inflationary pressures, aided by the reduction in commodity costs.

Lower commodities help the case for stocks

Source: FactSet, Commodity Research Bureau. As of Dec. 23, 2011.

When inflation is low, based on historical tendencies, stocks can typically support a higher price/earnings ratio, while easing price pressures can also bolster consumers' pocketbooks, which has the potential to increase profitability among American companies.

And while Treasuries again outperformed stocks, we strongly believe that a reversion to the mean is coming in the near term. In fact, by definition, bond prices can only go so high as yields can only go to zero, which for short-term Treasuries is roughly where they stand. In fact, according to Ned Davis Research, following a decade where bonds outperformed stocks, as they did in the past decade, stocks outperformed bonds in all of the decades that followed. Of course, the past is no guarantee of the future, but it can give us a roadmap that may be helpful to follow. 

US economy also seemingly supportive

Another leg in the supportive stool for stocks has been the largely better-than-expected economic picture that is currently being painted. We've seen recession fears fade as consistently improving data has emerged, but stocks have largely ignored the positive developments in the US picture as international concerns have seemingly dominated attention. But we've seen the much-maligned employment situation steadily, if slowly, improve as jobless claims continue to move lower, recently posting the lowest reading since April 2008, while the lagging unemployment rate has declined, showing an 8.6% reading in the most recent release—still higher than we want to see, but moving in the right direction.

Manufacturing also continues to contribute to the economic expansion as the Philly Fed Survey moved to its highest level since April and the Empire Manufacturing Index surprisingly moved from 0.61 to 9.53. A development that we believe is largely overlooked is the increasing "onshoring" that we believe is occurring and will help to further improve the employment picture. Companies that had moved manufacturing jobs out of the US to try to take advantage of lower labor costs are increasingly bringing at least some of those operations back as they realize logistical problems, combined with a skills shortage in many of these locations that has resulted in far fewer benefits than first predicted.

And even housing may be getting in the act. It's still far too early to definitively say we've turned the corner, but there are some glimmers that we may be slowly emerging from the depths. The National Association of Homebuilders Sentiment Survey, while still well below the 50 mark that separates general optimism from pessimism, moved to its highest level since May 2010, when it was somewhat artificially boosted by the Homebuyer Tax Credit. Additionally, housing starts rose 9.3% in November, the biggest gain since April 2010, while the forward looking building permits number rose 5.7%, the best reading since March 2010. And while credit standards still remain extremely tight, we have seen bank lending trend higher, which also should help support economic activity.

Bank loans showing signs of life

Source: FactSet, Federal Reserve. As of Dec. 23, 2011.

US Government continues to amaze

Given the positive momentum that we believe the economy is trying to gather, it is incredible to us that the government continues to manage to surprise on the downside. The continued political posturing on both sides of the aisle has most recently resulted in what can be described as nothing less than a mess. The payroll tax cut, along with extended unemployment benefits and a Medicare fix for doctors was extended for the grand total of two months—with more negotiations to occur in the hopes of getting to a full year deal. It's something, but this continued political game-playing does nothing to improve the confidence of consumers and businesses. These short-term "fixes" seem to actually harm business confidence and increase costs as they scramble to react to last-minute changes to laws. As we've said before, businesses can make money in a variety of ways, but they have to know the rules of the game. Until they do, it's difficult to imagine many business owners wanting to risk capital by expanding operations or hiring new worker.

Additionally, we are keeping an eye on the escalating trade tension developing with China, with both sides recently slapping tariffs on certain goods. We are long believers in moving toward freer trade and are concerned what the impact of a trade war with China may have on both economies.

And finally, for now, the populist rhetoric coming out of the Administration, pitting one group of Americans versus another, seems completely detrimental to the stated goal of President Obama of creating jobs and expanding the economy. Targeting those that create jobs and invest capital in businesses as the "problem" with America seems to us to be largely counterproductive and we hope to see a change in the new year, but aren’t holding our breath as the election season heats up.

Europe's Lehman moment diminishes, but crisis not "solved"

As frustrating as the problems are in the US, Europe continues to win the prize for being dysfunctional. Recently, the risk of a near-term collapse in the European banking system has likely diminished, but the debt crisis has not been resolved. The European Central Bank (ECB) provided additional support for banks via three-year loans by conducting its first of two long-term repurchase operations (LTROs) on Dec. 21. However, the LTRO is being viewed through a mixed lens.

Negatives include the amount of money and number of banks borrowing from the ECB, 490 billion euros ($645 billion) and 523 banks, respectively. Such high demand and reliance on the ECB indicates dysfunction in the system. The positive aspects of the LTRO include borrowing that exceeded the amount of debt maturing in the first quarter of 2012, removing some uncertainty and allowing for building cash buffers or new lending. Additionally, to the extent peripheral sovereign debt is parked at the ECB in the form of collateral, it may ease selling pressure. However, despite the recent equity rally, bank stress remains high, although year-end factors may be obfuscating things.

Bank stress remains elevated

Source: FactSet. As of Dec. 27, 2011. Europe Bank Stress = three month EURIBOR (Euro Interbank Offered Rate) minus three-month EONIA (Euro Overnight Index Average) swap rate.

The crisis has highlighted the major flaw of the euro—monetary union without fiscal union. The ECB is treating the symptom, not the cause of the crisis, but has likely bought time to allow for the possibility of fiscal union. Meanwhile, banks and sovereigns are interlinked, and the banks cannot truly be stabilized until the sovereigns are. Contrary to the hope that banks would use the LTRO to enter a "carry trade" by borrowing at 1% from the ECB to buy sovereign debt yielding over 5%, we believe the funds will be primarily used to pay down debt.

On fiscal coordination, we have little faith that an agreement can be achieved by the March target. Still high yields on Italian government debt, although retreating from their crisis peaks, indicate the bond market may not be convinced either.

Italy remains at the forefront both because of the size of its debt, at 1.9 trillion euros ($2.2 trillion), and the lack of growth. Through the third quarter, Italy has grown a mere 0.27% per year on average over the past decade. Even worse, growth has been driven by the government sector, as an aging population has cut spending and a lack of export competitiveness has reduced trade. Now, the government sector is set to contract as austerity measures are implemented.

Government outgrew Italy overall, but set to decline

Source: FactSet, Italian National Statistics Institute. As of Dec. 27, 2011. Indexed to 100 = 1/1/2000.

A disconcerting result of the LTRO was that Italian banks participated after obtaining Italian government guarantees to issue debt that they then brought to the ECB to acquire additional loans. Layering on new debt to fix a debt problem does not instill confidence. Yet this characterizes the problem with Europe’s "solutions" thus far; they require countries that are already heavily indebted to provide money that they do not have to bail each other out. Additionally, as more countries are ensnared into troubled situations, there are fewer remaining countries to provide aid.

The crisis has festered for so long that further write-downs of government debt may be needed. With several countries having debt exceeding government revenues and low or no growth, the situation may be insurmountable because expenses are growing faster than revenues. Investors in turn require higher interest rates to compensate for the higher risk, and bond prices fall due to the vicious cycle of austerity, weak growth and credit rating downgrades. In order to stabilize the situation, debt write-downs would need to be accompanied by a concurrent bank recapitalization through an infusion of cash from the ECB via money printing.

We believe a mild recession in Europe may be priced into markets at this point, as it is frequently discussed. However, extending the time to stabilize the situation may only elongate and deepen a recession in Europe, and markets may not be appreciating the risk of a longer recession in Europe and the negative implications for global growth.

China concerns ramping up

China's growth is slowing and the concern is whether policymakers can avert a hard landing. The question is whether policymakers have the foresight and tools to tightly manage growth, or whether the slowdown is out of their hands. So far, the slowdown is driven by a moderation in exports, particularly to Europe, and a reduction in construction spending.

Exports, the area of China's economy that policymakers have little ability to influence, are 26% of China’s GDP, with Europe comprising 18% of exports. As an example of the potential impact, in the case of a severe recession in Europe and assuming exports fall 20%, this could subtract 0.9% from China's growth.

However, a bigger portion of China's economy is construction-related, where the government can influence growth. Remember that the Chinese government initiated its housing market slowdown. We don't expect a change in stance anytime soon, as the target of price declines has just barely started. However, authorities can reverse policies and re-stimulate demand, particularly for the affordable housing sector. On the infrastructure side, rail budgets have been cut, but there remains room to spend on power and environmental protection programs.

Small, targeted easing moves in November and the bank reserve requirement ratio (RRR) cut at the end of November ushered in hopes that China had shifted to easing. Subsequently, in contrast to easing, the central bank has been removing liquidity from the system. It appears that the slowdown in exports may have reduced expectations of appreciation in the currency, the yuan, and combined with growth concerns, foreign capital flowing in during the fall timeframe slowed. As such, the RRR cut may have been a technical measure intended to offset the impact of the decline in foreign inflows on bank balance sheets.

Devoid of positive news on easing, investors have had little to cling to except attractive valuations and the Shanghai Composite has continued to fall. There could be more downside in Chinese equities until monetary stimulus begins in earnest, which may occur around the Chinese New Year, on January 23. We discuss why monetary stimulus could result in outperformance, in China Fear is a Potential Opportunity.

Please visit www.schwab.com/oninternational for more international perspective.

Important Disclosures

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.

The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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