Market Resilience

Key Points

  • The sustained upward trend in stocks has been resilient, overcoming events that may have sent investors running in the past. US growth is highlighted by a continued improving housing market, but concerns remain.
  • The Fed continues to navigate tricky waters and maintained its extremely accommodative stance at its recent meeting, but talks of an exit strategy are heating up. The rhetoric in Washington has cooled and fiscal policy risk has eased.
  • A crisis was avoided with the Cyprus banking predicament, but the handling of the "solution," via a hefty levy on depositors, may prolong the Eurozone recession; although investment opportunities remain. China continues to disappoint but glimmers of hope are emerging in Japan amid a very strong stock market.

The environment surrounding the US stock market seems to have changed over the course of the rally since November of last year that has seen the Dow hit new highs and the S&P 500 bump up against them. The recovery since the lows reached in 2009 was often marked by nice runs, interrupted by relatively sharp pullbacks, as skittish investors sold on largely macroeconomic concerns—i.e. the European debt crisis or US fiscal concerns. It now appears that investors are increasingly running toward stocks (and even the US dollar) during times of increased concern, limiting pullbacks. Investors who have missed out on the recent rally, or the massive gains seen since the lows, appear to be looking for opportunities to buy—a marked difference from the first few years of the recovery. This is a change that could fuel further gains in stocks as the year progresses.

A changing market environment?

A changing market environment?

Source: FactSet, Standard & Poor's. As of Mar. 21, 2013.

Nothing goes up in a straight line, pullbacks are inevitable, and the chances of the next three quarters matching the first quarter in terms of stock market performance seem relatively low. But as we've seen, waiting for the "perfect" time to get into stocks can be detrimental to portfolio performance.

Investing is a relative game—money has to be put somewhere, whether that be under the mattress (a strategy we don't find particularly attractive) or in global markets. And while we continue to strongly recommend a diversified portfolio appropriate for your time horizon and risk tolerance, on a relative basis, the US market appears to us to be one of the better places in which to invest. Discussed more below are the problems facing many other parts of the developed and developing world that raise risks in the near term for investors in those markets. And of course, the fixed income markets still generally offer extremely low, but now rising, yields that may be increasingly frustrating for investors.

US growth continues

Meanwhile, the US economy continues to be in somewhat of a relative sweet spot, highlighted by a continually improving housing market. The job market continues to improve, with initial jobless claims recently hitting another five-year low based on a four-week moving average; and job growth picking up steam in the latest report. Manufacturing is holding up, with the Philly Fed Index recently bumping up to a positive reading of 2.0 from the previous reading of -12.5, joining the Empire Manufacturing Index in positive territory (9.2) and boding well for the next national release of the ISM Manufacturing Index, although the Chicago PMI disappointed slightly, putting a bit of a damper on things. Additionally, the Index of Leading Economic Indicators posted a rise of 0.5% in February, while the January reading was revised from a gain of 0.2% to 0.5%.

But in the present environment, the most important support we see developing is the continued improvement in the housing market. Housing contributes in numerous ways to the US economy; impacting jobs, wealth, confidence, mobility, financial stability, and overall economic growth. And we continue to see better conditions build on themselves as confidence among potential buyers and sellers returns after a long hiatus. New home starts rose 0.8% in the most recent report, while the more forward-looking building permits rose 4.6% month-over-month. Existing home sales, which continue to represent the lion's share of the housing market, rose 0.8% month-over-month and 10.2% year-over-year. Inventories also increased, indicating an increase in confidence among sellers and a much-needed development as the National Association of Realtors continues to point to a lack of inventory as a hindering factor. Finally, affordability continues to near all-time highs based on historical levels, which should help to fuel even further improvement.

Housing affordability should help recovery continue

Housing affordability should help recovery continue

Source: FactSet, Nat'l Assoc. of Realtors. As of Mar. 21, 2013.

Fed maintains, while Washington pressures ease

As the US economic expansion continues, there is increasing discussion surrounding a potential exit strategy for the Federal Reserve's extraordinary measures since the financial crisis. But at their most recent meeting, they made no changes to policy and few changes to the accompanying statement. The Fed continues to point to the elevated unemployment rate and still-contained inflation that allows them to maintain their $85 billion/month purchases of mortgage-backed and Treasury securities. They also seem to be waiting further, as we are, to see what the impact of the tax hikes and the spending sequestration will be on overall economic growth. While the economy has barely missed a beat so far, we believe the impact would just now be coming into view so we are watching closely.

And while the Federal government is not a model of efficiency, it seems to have managed to work its way out of crisis mode—at least for the time being. The threat of a government shutdown due to lack of a budget agreement has been avoided with little drama, and it appears that the upcoming debt ceiling debate may lack the political fireworks seen in the last couple of instances.

We haven't gotten the "grand bargain" that was significantly talked about over the past several months, but progress has been made on deficit reduction, and it may be that when we look back, incremental steps added together look very similar to the major deal hoped for. Tax rates for individuals have been solidified, with the Bush tax rates locked in for the majority of the country; spending growth has been cut, without the dire consequences to this point that were predicted; and negotiations on the next budget are beginning with both parties at least talking about further spending reductions—although major disagreements remain. We continue to believe that an agreement to simplify the tax code, reduce the corporate income tax rate, credibly address unsustainable spending, and realistically address the growing entitlement problems with Social Security and Medicare would be a huge boost to growth—but we'll take what we can get. We remain concerned about the impact of the Affordable Care Act and ongoing Dodd-Frank Act uncertainty on both the budget and business growth; and are watching developments in that area as more provisions come into affect over the coming months.

Eurozone's recovery likely delayed

The eurozone debt crisis has been a fixture in markets for more than three years, with periodic missteps by policymakers. The events in Cyprus are another reminder the crisis continues and that a true union remains elusive.

The size of Cyprus itself is not as important as the potential precedent set. While insured depositors were spared, there appears to be a shift in philosophy toward using "bail-ins" in conjunction with "bailouts," by shifting risks onto private investors rather than automatically using taxpayer money to resolve failing banks. While the Dutch finance minister's comments about Cyprus being a template for the future were later restated, his full interview along with commentary by other officials and resolution of other banks (such as SNS Reaal) recently indicate that the view for more private sector involvement may be gaining momentum.

The implications of a potential philosophical change to push risks to private investors include:

  • The eurozone banking system could consolidate further as weaker banks lose support from both depositors and investors
  • Bank funding costs could increase as investors may perceive a bigger probability of loss
  • Banks could pullback on lending and/or increase lending rates
  • The recession in the eurozone could last longer than previously hoped

Eurozone contagion risk appears contained

Eurozone contagion risk appears contained

Source: FactSet, iBoxx. As of Mar. 27, 2003.

However, broader market reaction to events in Cyprus was fairly benign. Unlike a year ago, when the mishandling of the Cyprus situation would have likely resulted in a bigger market rout, systemic risk has been significantly quelled by the European Central Bank's (ECB's) conditional bond purchase program. Still unknown are the after-effects of capital controls in Cyprus; trapping euros from moving freely in the monetary union, as well as how to address missing aspects of a banking union, such as a common resolution framework for winding down failed banks and eurozone-wide deposit insurance.

Meanwhile, Italy is still attempting to form its government, but another near-term election is in nobody's best interest, and therefore we believe it will be avoided. However, the fractious election results indicate that the resulting government is likely be in gridlock and unable to last the full five-year term. We believe reform momentum will be stalled but that prior reforms will remain mostly intact.

As for eurozone companies, we believe the outlook has improved relative to 2012, as uncertainty regarding the future of the euro and the global economic recovery has improved, in particular in the United States and China. And Japan is about to embark on a stepped up stimulus campaign. In some sense, the eurozone debt crisis is just "more of the same" and not new news.

Eurozone stocks could continue to struggle in the near term as investors incorporate the new macro outlook and reduce earnings expectations. In the intermediate term, we believe valuations and earnings are depressed and a fair amount of negative news has likely already been priced into eurozone stocks. Read more in our article.

China's recovery weak so far

Investors are questioning where China's economy is headed as industrial production for the combined January-February period posted the smallest gain for the first two months since 2009; retail sales growth for the period was the weakest since 2004; and new infrastructure projects, which led the recovery in 2012, have stalled. Meanwhile, growth questions have been accompanied by inflation concerns. Chinese home prices are rising, resulting in new regulations that are likely to constrain property market growth. Additionally, the People's Bank of China (PBoC) noted that inflation could accelerate later this year and moved to a "neutral" stance.

Reforms likely hold the key to growth. We believe infrastructure funding mechanisms need reform to sustain spending. Additionally, new Premier Li has said that state-owned enterprises (SOEs), which account for 55% of the Hang Seng H-shares Index, need to compete on a level ground, requiring "real sacrifice," indicating the preferential treatment for SOEs may subside.

China's economy is more reliant on debt than in the past to generate growth, and growth is likely to downshift. We believe longer-term investors may want to consider re-orienting international exposure away from China and emerging markets and toward developed international markets. Read more about China in our January article and "Avoid China: Subprime-Like Bubble Brewing".

A new era in Japan

Hopes are high for a potential generational shift in Japan. A key building block of new Prime Minister Shinzo Abe's economic policy is to urge the Bank of Japan (BoJ) to undergo a "sea change" from an overly conservative policy to aggressively easier one.

Hopes are high in Japan

Hopes are high in Japan

Source: FactSet, Nikkei Stock Exchange, MSCI, Reuters. As of Mar. 27, 2003.

* Indexed to 100 as of Mar. 27, 2003. A larger (smaller) number above 1 denotes greater outperformance (underperformance) of the Nikkei relative to the EAFE Index.

Ahead of his first meeting on April 3-4 new BOJ Governor Kuroda expanded the toolkit of potential assets to purchase, but traders are watching to see if Kuroda will pull forward the timeframe for open-ended quantitative easing from next January. However, markets have already moved quite dramatically in advance, and there is the potential for "sell the news" reactions in the near term if expectations aren't met.

We believe Kuroda's determination to do "whatever it takes" to achieve a 2% inflation target indicates aggressive policy is likely. If markets have confidence that aggressive policy will be maintained, it may become self-fulfilling and weaken the yen. and benefit Japanese stocks over the intermediate term, 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.

It is uncertain is whether Japanese attitudes will break free from a decade of deflation. Inflation generated from rising prices without an increase in demand—where a weak yen pushes up import prices and reduces disposable income—would be "bad" inflation. On the other hand, "demand-pull" inflation, caused by rising wages, could propel a transformation in Japan's economy after 15 years of declining wages. The economy is unlikely to improve in a straight line, but we are encouraged by a rebound in Japanese household confidence as well as increases in compensation in the spring Shunto wage negotiations. Longer-term, Japanese corporations could reinvest improved profits into R&D and/or redeploy excess cash.

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So what?

After a stellar first quarter performance from US stock markets, which showed impressive resilience to continued headwinds, a pullback is certainly possible but we don't suggest investors who need to add to allocations wait. In a relative world, the US stock market continues to look like an attractive place to invest, although there may also be opportunities in Japan and Europe as well. The upcoming earnings season could tell the story for the market over the next couple of months, but we continue to advocate a long-term point of view and maintaining a diversified portfolio.

© Charles Schwab

© Charles Schwab

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