- Summer lethargy was jolted toward the end of earnings season as stocks are experiencing our expected pullback. We believe this increase in volatility may be the start of a near-term trend where uncertainty will be elevated for several reasons.
- Congress comes back to Washington soon facing a battle on the debt ceiling; the implementation of the Affordable Care Act and the second round of Sequester spending cuts. Meanwhile, the Fed will also be in the spotlight with their September meeting being eyed for QE-taper possibilities; while talk of who the next Fed Chair will be is likely to intensify.
- Emerging markets appear to be entering a new economic and market era and we remain cautious, while Japan's recovery is in a definitive pause mode. On the other hand, Europe's attractiveness grows as they exit recession.
Note: Due to the upcoming holiday, the next scheduled Schwab Market Perspective publication will be September 13, 2013.
Since the end of June, when the market started to recover from taper-induced selling, investors were able to enjoy a relatively calm ride to new record highs on the major indices. Equity market volatility remained historically low, while fixed income yields traded in a relatively tight range. But complacency and excessive optimism are rarely a good combination and markets were jolted recently as some major companies missed earnings estimates, economic data was on the softer side, and taper concerns reemerged. Importantly, the 10-year Treasury yield rose sharply out of its recent range, touching a new high not seen since July of 2011. Due to elevated optimistic sentiment, a contrarian indicator, we have been in the pullback camp since mid-August. The recent weakness has not yet been sufficient to reverse that sentiment; but pessimism is on the rise and the selling could subside before the pullback becomes more sinister.
But we are likely not out of the woods yet; even in the context of a bull market that's not dead. In the near term, we're likely to see gyrations in the stock market due to political bickering in Washington, debate over tapering, speculation about the next Fed chief, European events, a new round of Sequester cuts, the upcoming debt ceiling deadline, and the always-present possibility of a "surprise."
Economic traction still hard to come by
After a summer stall for the economy—in keeping with the past three years' trends—the hope is for an acceleration into year-end. We believe we will see some lift in growth, driven by improving exports, rising capex and the still-recovering housing market; but growth is likely to remain relatively weak. However, given that it's accompanied by low inflation, it's not a bad environment for the equity market.
Recent economic data has been mixed at best. Retail sales growth was decent at 0.4% ex-autos and gas, but some disappointing retail earnings reports tempered hopes of a strengthening consumer. And while the consumer has held up relatively well in the face of higher taxes and reduced government spending, helped at least somewhat by the strength in stocks and housing, a new round of Sequester cuts is scheduled for October 1st in the amount of $189 billion.
Initial manufacturing data for August was also somewhat mushy as the Empire Manufacturing Index surprisingly fell to 8.24 from 9.46, while the Philly Fed Index also declined more than expected to 9.3 from 19.8. Both readings still indicate expansion in manufacturing, but when combined with a 0% increase in industrial production and a slight decline in capacity utilization, growth doesn't appear to be accelerating at this stage. That said, the most recent ISM Manufacturing and Non-Manufacturing readings were both stellar.
The gains in housing have been moderating as mortgage rates have risen recently and lending standards remain relatively tight. Some moderation was likely given the unsustainability of the trajectory, but we don't expect housing to retrench. The Fed has no interest in another housing decline and would very likely step in to the mortgage market to an even greater degree if it became concerned. And housing "insiders" are increasingly positive as the National Association of Homebuilders' (NAHB) Index rose again to 59 from 56, the best reading in almost eight years.
And finally the all-important labor market continues to show signs of improvement as the leading indicator of initial jobless claims continued its trend lower, recently hitting the lowest level since 2007.
Claims indicate improving labor market
Source: FactSet, U.S. Dept. of Labor. As of Aug. 20, 2013.
Concern over the quality of the improvement in the job market is rising as those working in part-time jobs that would like full-time work continues to be elevated; while many companies are reducing workers' hours and/or are making major adjustments to their health care offerings in advance of the rollout of the Affordable Care Act (ACA).
Washington returns to the forefront
The ACA is but one of a variety of high-level debates that are coming up in Washington. Members of Congress may try to tie the ACA to the negotiations over the increase to the debt ceiling. It appears we'll still be waiting for a deal as we head into the week before the October 1st deadline, which will mean more uncertainty for investors and likely more volatility for the market. On top of that, the tax reform debate is ongoing, while the budget debate for next year will heat up.
The September 17-18 Federal Open Market Committee (FOMC) meeting will be closely followed and is probably one of the most anticipated in recent memory. Will the Fed start to trim its buying of securities and begin the long process of normalizing monetary policy? We believe a very modest decrease is still likely although recent soft data raises questions about whether they'll wait or announce some form of "taper-light." However, it's important to keep in mind that the Fed's balance sheet will continue to expand, just at a slower rate. And, given the plunging budget deficit and falling Treasury issuance, the net result from a supply/demand balance, on the economy, is likely to be minimal.
Fed balance sheet expansion will continue
Source: FactSet, Federal Reserve. As of Aug. 20, 2013.
Emerging markets entering a new era
The emerging market (EM) story of improved growth and inflation fundamentals, lower government debt levels relative to developed markets, and foreign exchange reserves, has gotten plenty of attention in recent years. Investors became somewhat complacent about EM risks—some even arguing that EM stocks deserved a valuation premium over developed markets, reversing the historical discount.
We began expressing caution on EM stocks earlier this year due to the prospect of slowing growth. However, since the apparent bottom for US interest rates, EM risks have risen. The increase in Treasury yields in response to Fed tapering prospects has boosted the attractiveness of the US dollar, to the detriment of EM currencies. Countries dependent on foreign investment for growth due to current account deficits, such as Brazil, India, Indonesia, South Africa and Turkey, could be disproportionally hit. Capital outflows and falling currencies can result in a negative feedback loop—creating inflationary pressures and prompting monetary tightening, further pressuring growth.
Economic indicators for emerging markets as a group have been deteriorating since early 2013. Additionally, the EM composite PMI fell to 49.4 in July, the first sub-50 reading since April 2009, and new business in the PMI contracted for the first time in four years. China appeared to buck the EM trend in July, with economic data improving from June as the government unveiled a mini-stimulus to defend 7% growth.
The combination of economic stabilization in China, pessimistic sentiment, and a sell-off in emerging market equities, could combine to fuel a near-term rally in Chinese and emerging market stocks. However, we're skeptical the rally can last due to structural headwinds in China as described in our Avoid China article. China's economic improvement and stimulus can be characterized as the old model for growth (investment in infrastructure and property); something we view as unsustainable. China's economic stabilization in 2013 may be followed by a renewed slowdown in 2014.
End of the bull for emerging market stocks?
Source: FactSet, MSCI. As of Aug. 20, 2013.
We believe we may be in a new era for emerging market stocks, characterized by slowing growth, higher inflation, and limited scope for policy easing, as discussed in Emerging Markets: Proceed with Caution. We maintain our preference for developed international stock markets.
Japan in "wait-and-see" mode
After a breathtaking rebound in early 2013, Japan's economic recovery has lost momentum. The Japanese government's leading economic indicator fell by the most since January 2009 in June, and a slew of other measures ranging from industrial production to consumer confidence have also declined. Additionally, a decision on the consumption tax is pending, but is not scheduled until October, adding to the uncertain environment.
For investors, Japanese stocks appear to be taking their cue from the direction in the yen in an inverse relationship, rising when the yen falls and losing ground when the yen strengthens. Surprisingly, given the large QE program unveiled just this April, the Bank of Japan's (BoJ') balance sheet has not grown over the past two months, resulting in the yen being range bound. The BoJ may have gotten so far ahead of its 7.5 trillion yen monthly pace that it decided to rest according to ISI Research, and it seems likely the BoJ will resume purchases shortly.
Japanese stocks are likely to be directionless over the near term, with the consumption tax decision lingering and no change expected to monetary policy on the horizon. Some believe the tax decision is a lose/lose proposition, resulting in an economic hit if it does take effect, and the lack of improvement on the fiscal front if it does not. It is possible a gradual 1% annual rise in the tax over a longer period, rather than a 3% jump to 8% in April 2014 and additional 2% rise in October 2015, may be a happy medium for investors.
Disruption of Europe's calm is likely an opportunity
After numerous predictions of the potential demise of the eurozone, it may have surprised some investors to see the eurozone emerging from recession in the second quarter, ending a six-quarter contraction.
We believe the economic recovery in the eurozone is sustainable, despite some temporary factors that helped boost growth in the second quarter. The reduced threat of financial contagion due to the European Central Bank's (ECB) conditional bond purchase program—the Outright Monetary Transactions (OMT)—has resulted in a reversal of business and consumer sentiment from the depressed levels of a year ago. Additionally, the biggest fiscal drags are likely in the rear view due to past progress and because of an eased stance on austerity. However, growth is likely to be held back by continued bank deleveraging, which is pressuring lending, a fuel for growth.
Many believe the calm in the eurozone is about to end, with unpopular issues pushed out until after the German general election on September 22. The passing of this event could end a period of calm, but we don't believe panic will set in, due in large part to the ECB's OMT program and a strong commitment by most policymakers to the euro. Upcoming risks include:
- A Greek debt restructuring is likely, but investors are fully aware of Greece's problems by this point, and we don't believe Greece will leave the euro.
- Portugal's emergence from its bailout program in mid-2014 is not guaranteed and Portugal may need a credit line or a new bailout package. We believe Portugal's problems will remain a country-specific risk.
- Italian early elections are a rising risk due to a fragile coalition government and the conviction of Silvio Berlusconi, the leader of the PDL party. While elections would likely upset European markets, politics are unlikely to shift dramatically. Voters in most countries have been reluctant to leave the safety of the center, as they fear the uncertainty of extremist parties more than bad economic realities according to BCA Research.
Eurozone stocks appear to offer opportunity
Source: FactSet, Standard & Poor's, MSCI. As of Aug. 20, 2013.
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, and earnings and valuations are depressed. Read more international at www.schwab.com/oninternational.
Caution is warranted near-term. For investors that have a solid strategy of dollar-cost averaging into the market, we don't recommend deviating from that path. However, for investors who are more tactical, better entry points are likely yet to come. Longer-term, we remain bullish on US equities and prefer developed international markets over emerging markets.
© Charles Schwab