Soft Patch - Part Four?

Key Points

  • Stocks continue to trade at all-time highs, but concerns are rising over a possible pullback and downturn in economic growth. A consolidation of gains is likely, but trying to trade around a pullback can be quite difficult.
  • A potential tapering of Fed asset purchases continues to be discussed, but the Central Bank also appears nervous over the potential for a spring downturn. Cooler heads appear to be gaining traction in Washington and at least some marginal progress is being made.
  • Economic improvement is gaining traction in Japan, raising hopes of sustainable change, while Europe continues to suffer, although expectations are already depressed. China has growing issues to deal with and concerns are rising, making us cautious in the near term.

"History does not repeat itself, but it does rhyme"—Mark Twain.

Stock resilience continues to be impressive as the uptrend has gained momentum despite growing global tensions (North Korea), some softer US economic data, and numerous calls for a long-awaited correction. But we are entering a period during which the past three years have seen a pullback in stocks and a weakening of economic data. Looking back we can see these were soft patches, with both stocks and data recovering later in the year. Are we in for a repeat performance in 2013?


S&P 500 Composite Index, price return

Source: FactSet, Standard & Poor's. As of Apr. 9, 2013.

It's possible, but if so, it's likely to be less severe than the past few years. First, trying to time such a potential event is not recommended. With hindsight being 20/20, investors would had to have known to sell in April of the past three years (not quite the traditional "sell in May" mantra) after a nice start, while also knowing to buy back in July, August, and June, respectively to take advantage of the gains seen during the rest of each year—much earlier than the traditional fall time frame often cited as the best time to return to the market. This illustrates the folly of trying to time the market, although we do suggest investors who are nervous look into some simple hedging strategies that may help to limit losses in the event of a near-term pullback.

A different environment-but some concerning signals

Economic data as of late has been modestly disappointing, raising the prospect of at least a minor soft patch, although that doesn't have to mean a pullback in stocks. There is the possibility that the data will be just soft enough to convince the market the Fed's easing stance will stay in place. In fact, Chairman Bernanke has referred to the desire to see how the economy navigates this time period that has been problematic the past few years. This could continue to buoy equities.

While data has been mildly weaker, most releases still indicate economic expansion. The Institute for Supply Management (ISM) Manufacturing Index dipped to 51.3 from 54.2 (with a reading above 50 indicating expansion), while internally the new orders number dropped sharply to 51.4, but employment gained 1.6 points. The service side told a similar softening story as the ISM Non-Manufacturing Index fell to 54.4 from 56.0, while both the new orders and employment components dropped as well.

Additionally, the improvement in the job market may have lost some momentum, although it's too early to call a trend. The ADP report showed a somewhat disappointing 158,000 jobs were added in March, although the February number was revised to a gain of 237,000 from the initial reading of 198,000. The non-farm payroll report by the Department of Labor told a similar, if not more disappointing story, as only 88,000 jobs were added in March, although both February and January were revised nicely higher. And although the employment rate fell to 7.6% from 7.7% it was due to a drop in the labor participation rate to the lowest level since 1979. The recent big drop in initial unemployment claims, which is a leading indicator, does suggest though that the recent uptick had much to do with seasonal factors; not underlying weakness.

However, there are quite a few positives that weren't around the previous three years. First, on the equity side, our friends at ISI Research report that equity fund inflows for the year through March 29th totaled $73 billion, the best reading since 2006, indicating increasing confidence in stocks. Additionally, while somewhat counterintuitive, as we enter the heart of earnings season, our friends at Strategas Research Partners report that the negative-to-positive preannouncement ratio for the S&P 500 stands at 4.65, the highest level since 2001. The market has held up well through these negative preannouncements, and the average gain for the month following the end of the quarter when the ratio is above 2.1 has been 2.0%; while when the ratio has been below that, the average performance has been a loss of 0.1%. Lowered expectations often help to facilitate upside surprises and earnings season could be the market driver over the next several weeks.

Additionally, we have a couple of major positives that we believe help to limit the magnitude of a potential soft patch. First, housing is now contributing to economic growth and helps construction, certain retailers, and confidence. Second, auto sales continue to be strong, with recently upping their 2013 light vehicle forecast to 15.5 million, which would represent the best year since 2007.

Autos indicate increasing confidence

Total motor vehicle sales - US

Source: FactSet, U.S. Bureau of Economic Analysis. As of Apr. 9, 2013.

Government may be helping…for a change

Previous years have been marked by ugly political battles that have unnerved investors. From debt ceiling debates to pending sequester and tax increase battles and a downgrading of the US credit rating, there was plenty to send investors toward the exit. However, we have seen some progress in deficit reduction, with tax rates being solidified, spending growth being pared back, and an agreement on the budget for the rest of the fiscal year. Surely, more fights are coming, but the rancor has eased and perhaps politics can move to the background again. One side note—we are somewhat concerned that there is talk coming out of Washington regarding forcing banks to provide home loans to buyers with lower credit ratings. Haven't we been down this road before?

And finally, the Federal Reserve remains quite committed to maintaining its current asset purchase program for at least the foreseeable future, which makes it even more accommodative than it was during any of the last three soft patches. And while discussion is growing over what the Fed's "exit strategy" may look like, it appears that investors will have some time before seeing that plan put into action.

Global data disappoints

Beyond the United States, negative economic surprises have outpaced positives globally, with weakness extending to both developed and emerging economies.

Economic data globally has disappointed

Economic data globally has disappointed

Source: FactSet, Bloomberg. As of Arp. 9, 2013.

However, the MSCI World Index is up 7.1% year-to-date—are global investors complacent? We believe one month does not make a trend and importantly, global central banks remain accommodative, with Japan just now embarking on "monetary policy in an entirely new dimension, " to quote the new Bank of Japan governor, Haruhiko Kuroda.

Bank of Japan's balance sheet will "hockystick"

Bank of Japan's balance sheet will hockeystick

* Rebased to Jan. 5, 2007 = 100

Source: FactSet, Federal Reserve, European Central Bank, Bank of Japan. As of Apr. 9, 2013.

Japan a bright spot?

Investors' negative mindset for Japan has pervaded for so long that even noting Japan as a relative bright spot seems quite odd. The impetus is a dramatic shift in monetary policy to do "whatever it takes" to achieve a 2% inflation target in two years. In fact, the Bank of Japan's "kitchen sink" of measures announced this month surpassed high expectations.

Capital markets started pricing in the effect of the BoJ's change in policy back in late November, with the yen falling 21%, the Nikkei 225 Index up 41%, and yields on 10-year Japanese government bonds (JGBs) down 14 basis points to 0.58% since that time. Similar to the Fed's quantitative easing (QE), one manner in which monetary policy can impact the real economy is through the wealth effect. Rising wealth improves consumer confidence, which can boost consumer spending, drive higher corporate sales and profits, and result in job and income gains, in a positive self-feeding cycle.

We believe we could be transitioning from the first phase for Japanese stocks, driven by the yen; and entering the second phase, driven by benefits for the real economy and corporate profits. Consumers are roughly 60% of Japan's economy, an often-overlooked statistic. Already, consumer confidence improved to the highest level since early 2008, retail sales positively surprised in February and inflation expectations have started to rise. In the BoJ's quarterly survey, 9.5% of consumers expected incomes to rise in a year's time, the highest percentage since March 1997! 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.

On the business side, the message is mixed. Japan's manufacturing PMI rose to 50.4 in March, the third-straight gain, above 50 for the first time since May 2012, while the services PMI increased to 54.0, the quickest rate of expansion in over five years. However, the first quarter Tankan survey showed pessimists continue to outnumber optimists and capital expenditure expectations were downgraded, as excess capacity still exists; but this could change if demand rises. Longer term, with improved demand and sentiment, high corporate cash hoards could be redeployed into research and development and improve the competiveness of Japanese products, and/or increase dividends and stock buybacks.

In sum, Japan's economy is unlikely to improve in a straight line, and consolidations of the moves in the yen and Japanese stocks are possible. However, we believe there could be a multi-year improvement in Japan's economy and stocks, and global and local Japanese allocations to Japanese equities are still low. Risks include inflation without rising incomes, parliamentary elections in July, or the possibility that Japan-China relations or the situation in North Korea deteriorate.

Europe continues to muddle through

The difference between central bank action in Japan and Europe is striking, with the European Central Bank (ECB) appearing hamstrung in terms of new bold measures to reinvigorate the economy. In combination with continued stumbles by European government officials (such as the Cyprus experience), the result is a mood of low confidence, depressing economic activity.

In fact, negative economic surprises were numerous in recent weeks:

  • German business sentiment as measured by Ifo unexpectedly fell
  • Germany's manufacturing PMI fell back into contraction and the German composite PMI that includes services showed near-stagnation
  • France's manufacturing PMI remained at a steep rate of contraction and the French composite PMI showed output falling at the fastest rate in four years
  • Consumer spending in France and retail sales in Italy both disappointed

Additionally, Italy has yet to form a new government. Italy's political outlook is likely to remain uncertain, and even a new government may not last a year before another set of elections occur.

While eurozone stocks could continue to struggle near term, we believe valuations and earnings are sufficiently depressed and a fair amount of negative news has likely already been priced in.

China uncertainty

Investors are questioning where China's growth is headed. While exports slowed in March after posting unusually strong growth in January and February, the March rebound in imports, up 14.1% from a year ago, was viewed positively after a 15.2% drop in February; although the volatility of the data left investors pondering the trend. The government's admission that exports may have been overstated by some firms to evade capital controls and bring foreign capital into the country added to the uncertainty.

China's investment-led growth model likely needs reform to continue to drive growth, in particular the funding mechanism. Fitch Ratings cut China's long-term local currency debt rating to A+ from AA-, citing concerns about the risks surrounding shadow banking and local government debt, as well as the outsized growth of credit relative to the size of China's economy. China's economy is more reliant on debt than in the past to generate growth, and we believe growth is likely to continue to trend lower, which could disappoint investors until it stabilizes. 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 Shadow Banking and Emerging Markets, as well as our article "Avoid China—Subprime-Like Bubble Brewing".

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So what?

Are we in for a repeat of "soft-patch" history? We tend to think not but certainly don't dismiss the possibility as investor perception can turn into market reality. For now, however, investors appear to be increasingly grabbing hold of the TINA (there is no alternative) idea first coined by Jason Trennert of Strategas Research Group; moving more assets into US equities as the alternatives aren't particularly attractive. However, nothing moves up in a straight line and pullbacks are inevitable. We continue to urge investors to have a globally diversified portfolio and maintain a long-term time horizon when thinking of equities. Finally, for those investors who are concerned about a substantial pullback, we urge you to investigate some relatively straight-forward hedging strategies rather than liquidating your positions completely.

© Charles Schwab

© Charles Schwab

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