Seeing the Forest

Key Points

  • Equity markets continue to be resilient and investor confidence is elevated in various sentiment indices, suggesting a near-term pullback is possible. But there are longer-term trends developing that give us hope that the US economy's expansion and market's rally are sustainable.
  • Federal spending cuts via the "sequestration" appear sure to happen, but there will continue to be debates about the nature and size of the cuts. Similarly, questions are increasing as to the potential unwinding of current Fed policy with regard to timing and rapidity.
  • Labor market changes in Europe are relatively small at this point, but the trend is encouraging. Likewise, the rhetoric coming out of Japan has resulted in a strong equity rally, but its durability is still in question.

Resilience may be the best word to describe equity markets over the past several weeks. Despite a robust start to the year—and some disappointing data recently such as a negative fourth quarter gross domestic product (GDP) number, lackluster January retail sales and a renewed flare-up in Europe—equities continue to grind higher. It appears to us this resilience is helping to pull previously-nervous investors out of cash and some fixed income products and back into stocks. Should this nascent trend take hold, we believe it could add fuel the next move higher in the stock market as sidelined cash remains relatively high after five straight years of equity mutual fund outflows.

Elevated optimistic sentiment, a contrarian indicator, gives us some pause in the near-term and the risk of a pullback is elevated. But any correction is likely to be contained and could serve as a decent buying opportunity. But if your portfolios have become out of whack in any asset class, you should not try to time the market in the short term in an attempt to find the best entry/exit points. A better strategy would be dollar-cost averaging over time. Investing should never be about moments in time; but should be a process over time.

Bullish-short…and long-term

Recent economic data continues to indicate to us an environment that is supportive of equities. The stock market seems to appreciate incoming reports that have been neither too hot, which may push the Fed to reduce their accommodation and stoke inflation concerns, nor too cold, which could raise the fear of a renewed recession—modest growth seems to be the watchword.

The four-week average of initial jobless claims remains within shouting distance of 350,000, which indicates a modestly improving job market; regional manufacturing surveys have been disappointing but the national Institute for Supply Management (ISM) Manufacturing Index remains in territory depicting expansion. Further, the ISM Non-Manufacturing Index, which tracks sentiment in the far larger service sector, dipped only slightly to 55.2 from 55.7, indicating continued expansion. A weighted combination of the two suggests a real GDP growth rate of around 3%, but it's been over-shooting actual GDP recently. We're also watching the continued housing recovery as we're beginning to see mortgage rates creep up slightly. If the improvement can continue, or even accelerate as fence-sitters are pushed into action, further fuel to the economic fire could be added.

Service sector continues to expand

Service sector continues to expand

Source: FactSet, Institute for Supply Management. As of Feb. 8, 2013.

We remain optimistic about the United States. The innovative and entrepreneurial spirit has not been crushed and there are several key bright spots on the horizon for the US economy. The US manufacturing renaissance we've been talking and writing about for some time is gaining traction among a wider audience. The most recent example was a cover-story in Barron's entitled "Made in America" ("The Next Boom"), which further illustrated our belief that "onshoring" is developing into a long-term trend that can help to propel growth into the future. We continue to see major companies bring their manufacturing operations back to the United States, as the skill and productivity of US workers, combined with logistical advantages, seems to be outpacing the now-rising costs of labor and doing business in many emerging economies.

Also contributing to the onshoring trend, and having, in our opinion, an even more profound potential impact on US growth over the next couple of decades, is the complete shift in the energy picture over the past several years. The United States is now flush with domestic energy to the point that some analysts are predicting energy independence for both North America and the United States in the next decade. According to our friends at ISI Research, we are now importing 41% less oil than at the peak, with imports at a 25-year low; while domestic production has increased 32% in the past year. Reliable and sustainable energy sources are vital to a growing economy, boding well for the future, but perhaps more importantly, this again illustrates what creative minds in America can achieve when market forces are left to work.

The changing, and encouraging, energy equation

The changing, and encouraging, energy equation

Source: FactSet, Institute for Supply Management. As of Feb. 8, 2013.

In a low-growth world, are global investors doomed?

Deleveraging by governments and households nearly globally has suppressed potential growth, possibility creating a fear that this subdued growth is bad for global equity investors. Put another way, do investors need higher growth to achieve good returns?

Paradoxically, higher economic growth doesn't always equate to the best investment returns—academic research suggests no clear correlation. While stronger economic growth creates higher sales growth potential; high earnings per share and dividend growth don't necessarily follow. Profits can suffer if wages in rapidly-growing economies rise faster than productivity increases. Low corporate governance can reduce returns when profits are expropriated rather than passed along to shareholders. Additional capital can be needed to sustain high growth, which can reduce shareholder returns. And of course, a high pace of growth can incite inflation which, in turn, can force the Fed to tighten monetary policy, a negative for stocks.

The role of expectations and valuations are also very important. High growth expectations can be accompanied by high valuations, resulting in future underperformance—the good news is priced in. Another important factor is the sustainability of future growth.

Europe moving in the right direction, but risks remain

Our international equity outlook incorporates the different global growth strategies, with the eurozone beginning structural reforms, Japan weakening the yen, and China using debt.

The European Central Bank's (ECB's) conditional bond purchase program provided a safety net and restored confidence, thawing credit markets for governments, corporations and banks; and potentially staved off downside risks to economic growth. The eurozone is broadly in recession, but the economic outlook could shift direction in 2013 from contraction back to mild expansion.

Economies in the eurozone aren't as market-oriented as the United States; but they are slowly changing, which could bode well for the longer term. Labor reforms have reduced unit labor costs (ULCs) in Spain, Portugal, and Ireland, improving competitiveness. These declining ULCs have either been driven by significant wage decreases, or by productivity growth, in part due to job cuts. Opening up "closed" professions to new entrants can reduce prices due to new competition. Reforms that allow companies to have more flexible labor forces to respond to changes in demand can improve profitability. The improved competitiveness is illustrated by Spain's recent success in attracting automotive manufacturing expansions by Ford, Renault, Nissan, and Volkswagen, despite a weak overall market in Europe.

Eurozone: those with lower costs more competitive

Eurozone: those with lower costs more competitive

*Indexed to 100=Dec. 31, 2003.

Source: FactSet, OECD. As of Feb. 12, 2013.

Structural reforms to improve growth prospects have the potential to reap sustainable benefits. We have a near-term positive view on eurozone equities due to the reform progress, credit markets thawing, reduced global uncertainty, possible reacceleration in growth; as well as still depressed earnings and valuations. In addition to the potential for sales growth to accelerate, earnings have additional upside as margins have room to expand.

Meanwhile, there are still political risks in the eurozone:

  • Italy's election on February 24-25 could result in new leaders reversing austerity and reform progress. We believe the most likely outcome is a fragmented vote that will need a coalition, resulting in stalemate and little change to policy. There is an outside risk the elections result in an inconclusive decision that could result in another vote in several months.
  • Cyprus' bailout could raise concerns if it results in another debt "haircut," but we believe market reaction will likely be modest due to the ECB's safety net and Cyprus' small size.
  • Spanish government corruption allegations could reduce support for reforms, and the ongoing housing bubble burst could result in additional bank capital needs. As a result, Spain could still need a bailout in the future, but the ECB's conditional bond purchase program has likely reduced this possibility.

The euro has risen due to improved fundamentals, reduced uncertainty, and a decline in the ECB's balance sheet, as banks have returned money and the conditional bond purchase program has yet to be tapped. A rising euro could hurt eurozone export prospects, particularly for countries with low-value exports more exposed to competition. However, as long as the rise is modest, it's not necessarily a barrier for higher eurozone equity prices – eurozone stocks and the euro have tended to move together in recent years.

Japan using currency to capture growth

Japan's new Prime Minister Abe is pursuing a multi-faceted growth strategy including fiscal stimulus, investment and an aggressive monetary policy. A major component of "Abenomics" is to end deflation by making the Bank of Japan (BOJ) responsible for achieving a 2% inflation target by aggressively easing monetary policy via asset purchases, which could pressure the yen.

Expectation of BOJ shift from prior conservatism

Expectation of BOJ shift from prior conservatism

* Rebased to Jan. 5, 2007 = 100

Source: FactSet, Federal Reserve, European Central Bank, Bank of Japan. As of Feb. 12, 2013.

The market has started pricing in expectations of more aggressive monetary easing yet to come after new governors are put in place in the spring. The rapid decline in the yen likely reflects the shift in expectations from the past history of an ineffective and tepid BOJ; however a breather might be in order. Oil priced in yen terms has risen 36% in the past six months, which could hurt Japanese consumers and give Abe's opposition the leeway to create a difficult BOJ appointee process.

However, if the BOJ convinces markets it will do "whatever it takes" to weaken the yen, it may become self-fulfilling and benefit Japanese stocks, giving us the mantra "don't fight the BOJ." Relative US dollar strength would reduce returns and investors may want to consider hedging currency exposure.

Increases in sales from market share gains due to a weaker yen could lift earnings, particularly for Japanese companies with high operating leverage. However, the long-term sustainability of relying on a weak currency growth strategy is uncertain, and fundamental corporate change is likely still needed to become less insular and target new growth products and markets.

China's recovery fueled by debt

China's economy is rebounding, led by infrastructure spending, as well as an improvement in exports. However, this been accompanied by a surge in speculative debt from the shadow banking sector, as we detail in our article. China's economy is more reliant on debt than in the past to generate growth, a potentially unsustainable situation.

Chinese-related investments could continue to benefit from the economic turnaround in the near term. However, longer-term investors may want to consider re-orienting international exposure away from China and toward developed markets.

Read more international research at

So what?

Stock market resiliency continues to impress, although the possibility of a near-term correction exists and we would view such an event as a buying opportunity. The day-to-day noise can distract investors but there are bright spots on the horizon for the US economy that we believe bode well for future growth and longer-term investors.

There are also some development in both Europe and Japan with nascent labor reforms in the former, and a new effort to stimulate spending in the latter, that could develop into longer-term positives. But it's a bit too early to say as history tends to argue against both movements. And China is looking better in the near term, but longer term concerns are growing and a day of reckoning may be coming.

© Charles Schwab

© Charles Schwab

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