Key Points
- The US economy still appears set to accelerate into the fourth quarter but near-term risks are significant. We believe pullbacks will be buying opportunities for those investors looking to add to equity exposure.
- The Federal Reserve surprised the market by continuing its asset purchases at the same rate, while downgrading their assessment of the economy's prospects. Meanwhile, attention remains on Washington as budget and debt ceiling rancor escalates.
- Japan seems to have conflicting policies with tax hikes being considered along with continued monetary easing, while Europe is showing signs of continued improvement. China may see a short-term rebound, but we are still concerned about possible longer-term consequences of investment-led spending.
Note: The next scheduled Schwab Market Perspective publication will be October 18, 2013.
Just when investors think they "know" what's going to happen, something occurs to humble traders. There was little disagreement heading into the most recent Federal Reserve meeting that it was going to pull back at least modestly on its asset purchases. After all, that's what the Chairman and other voting members seemed to be telegraphing since Bernanke's May 22 testimony before Congress. Not so fast.
The Committee surprisingly held the program in place and provided no further clarity as to the possibility of the timing of future moves. In addition, its forecasts over the past couple of years have not been particularly reliable as the Fed again downgraded its outlook for near-term growth. As a result, stocks initially pushed to new highs on the Dow and S&P 500, only to fall back in subsequent trading while Treasury yields fell. But where to from here?
Bullish, but Cautious
Volatility is likely to be elevated in the near-term. With uncertainty rising about what the Federal Reserve may do at coming meetings; some concern that the economy, from the Fed's point of view, is not even healthy enough to withstand a modest unwinding of extraordinary monetary measures; and rancor in Washington reaching a fever pitch with budget and debt ceiling deadlines; the market could be quite choppy in the near-term. We remain optimistic that stocks can continue to move higher once we get past these policy risks, but for those trying to time the market in the short-term, a better opportunity may be ahead.
Our still-bullish longer-term view is due to both the liquidity that continues to flood the market, and leading indicators pointing higher for the economy. The Index of Leading Economic Indicators rose a surprising 0.7% in the most recent month, up from the 0.5% reading the previous month.
LEI points to economic growth
Source: FactSet, U.S. Conference Board. As of Sept. 20, 2013.
Additionally, we've seen regional manufacturing surveys confirm the recent uptick in the national ISM reading. The Empire Manufacturing Index remains in territory depicting expansion, while the Philly Fed Index jumped to a robust 22.3, up from the previous reading of 9.3. And initial jobless claims, the leading indicator of the labor market, have moved sharply lower, while continuing claims moved to their lowest levels since 2008.
One of the Fed's concerns was likely the apparent "tightening" that had already occurred in the market as mortgage rates rose in anticipation of a slightly more hawkish central bank. This has caused some moderation in the housing market as the Mortgage Bankers Association reading on mortgage applications just recently came off the lowest levels seen since 2008. Additionally, housing starts only grew 0.9%, while building permits actually fell by 3.8%. We believe this is a temporary pause in the housing recovery, with the Fed intent on keeping the momentum moving in the right direction. Encouragingly, the National Association of Homebuilders' survey remained at 58, which indicates confidence among builders, and is up from a reading of 44 in early May.
We also believe that business capital spending will help to fuel the next leg higher in the market. Companies have been sitting record-high levels of cash, resulting in a low velocity of money and frustrating the Fed's attempts to stimulate through liquidity. Confidence surveys and new orders data may be signaling they're at a point where they will start to put some of that money to work in longer-term investments. The replacement cycle is extended and in order to compete globally, efficiency and productivity is important, which requires investment.
Velocity of money remains low- lots of cash to put to work
Source: FactSet, US Bureau of Economic Analysis, Federal Reserve. As of Sept. 20, 2013.
* M2 velocity = GDP divided by M2
Fed communication leaves something to be desired
Clearly the Fed remains concerned about the economy, although it would be tough to argue that we haven't made substantial progress since the first round of quantitative easing was implemented. In its efforts toward transparency, we are keenly aware the Fed may be no better judges of future actions than anyone else.
We are in the camp that the Fed should have already begun the process of monetary policy normalization. The crisis is well past and continuing to manipulate the market is not productive, and may even be counter-productive given still-elevated uncertainty. Near-term, the continuation of bond purchases is likely to be positive for risk assets, but we also believe longer-term risks are rising. The Fed may have to act more quickly and harshly now than if it had started earlier to unwind QE; while continuing to pump up risk assets through liquidity has its own set of risks. We aren't forecasting a crisis at this point, but the odds of the next crisis having the Fed's fingerprints on it is rising.
Congress again takes the spotlight
The highest risk to the market in the near term may be a government shutdown as a result of the inability to work out a budget agreement. We continue to believe cooler heads will prevail, but volatility and uncertainty is likely to be elevated as bickering over the budget and the debt ceiling escalates.
Japan: will the economic revival continue?
Political and monetary issues are also in focus in Japan, where we remain relatively optimistic. Japan's two lost decades often cloud investors' optimism about a recovery because inevitably the three "D" headwinds of demographics, debt and deflation become part of the conversation. The Bank of Japan's (BoJ) massive QE program is aiming to stamp out deflation, and while that alone is navigating in unchartered waters, addressing aging demographics and a large debt overhang are even more thorny issues.
In order to put Japan's debt-to-GDP ratio of roughly 250% and high fiscal deficit of over 9% on a more sustainable path, Prime Minister Abe will likely begin raising the consumption tax in 2014. Spending will likely be pulled forward before the implementation, but then drop off. The risk is that raising taxes on consumers, which constitute roughly 60% of Japan's economy, so early in the recovery could prematurely cut off growth. That said, there are discussions of offsetting the tax hikes with fiscal stimulus as well as the possibility of a cut to corporate taxes.
Already consumers face higher prices for basic needs such as food and energy due to the decline in the yen as a result of the BoJ's policies, while wages have failed to keep up pace. Despite Abe's calls for businesses to raise wages, a Reuters survey in September indicated the majority of companies preferred to boost bonuses, which could be reversed if needed, rather than increase wages, which have a more lasting impact on changing consumer behavior.
The International Monetary Fund (IMF) believes the initial hit to economic growth from a consumption tax hike could be offset over time by improved confidence in the fiscal outlook, but markets are likely to take a "wait and see" stance. The good news is that while investor conviction is likely to be low, accommodation from the BoJ could increase even further if economic downside risks appear. We believe this could create a floor for Japanese stocks, giving us the adage "don't fight the BoJ."
Europe: progress, albeit slow
Investors can easily rattle off Europe's problems, and a number of upcoming issues – some new, some old – could renew investor discomfort. Upcoming issues include: a funding shortfall in the Greek bailout program, Portugal and Ireland may need temporary credit lines or potentially a second bailout for Portugal, Italy has political uncertainty, Slovenia may need a bailout, and banking union issues could creep up again. Political uncertainty in Italy, which could linger for a year or so, is likely the most impactful of these issues for investors, due to Italy's large debt load and internal political disagreements about reducing spending. While early elections in Italy are a possibility, we don't believe the policies of the new government would shift dramatically.
Despite the eurozone's problems, the worst may be in the rear view due to three stabilizing factors: improving economic conditions, continued easy monetary policy by the European Central Bank (ECB), and a smaller fiscal drag.
Indications Europe's recovery could continue
Source: FactSet, OECD. As of Sept. 24, 2013.
The eurozone emerged from recession in the second quarter and leading economic indicators point to continued recovery. Relative to a year ago, the reduced threat of financial contagion due to the ECB's conditional bond purchase program has resulted in a reversal of business and consumer sentiment. Additionally, fiscal drags are shrinking due to past progress and because of an eased stance on austerity. That said, growth is likely to be modest as continued bank deleveraging pressures lending, a fuel for growth.
The good news is that European stocks have likely already priced in a lot of bad news and we believe any volatility as concerns rise again is likely to be a buying opportunity. Read more in our Europe article.
Shanghai free trade zone—a glimpse of China's future?
China's government is heralding a new free trade zone (FTZ) in Shanghai; expected to be more open to foreign investment in a variety of industries and potentially serve as a testing ground for financial reforms aimed at opening up to market forces in areas such as interest rates, foreign exchange convertibility and capital movement.
China's economy is in need of reform to transition it away from debt-led spending on infrastructure, property and factories. Financial reforms are a key to this transition because:
- State-owned banks have had their profits protected and tend to lend to state-owned enterprises (SOEs), to the disadvantage of the private sector and small- and medium-sized enterprises. They have resorted to the shadow banking system for funding; and the lack of a reliable national credit-scoring database contributes to this problem.
- An implicit government guarantee to "bailout" banks has resulted in lax lending standards, entrenching the practice of funding projects that may have questionable economic viability.
- Financial repression, where rates paid to savers are suppressed that in effect "subsidize" lending to government entities, results in excesses in spending on infrastructure and factories.
Hopes are high that the FTZ could be reminiscent of the transformations experienced after China's Special Economic Zones (SEZ) were set up in the 1980s, and China committed to join the World Trade Organization (WTO) in 2001. We believe success in the FTZ could be a positive indictor of future national reforms to put China's economy on a more sustainable path longer term, but progress is likely to be slow. Some investors doubt the will of the government to follow through on reforms, in part because economic and social stability take priority. Just this year China's policymakers backpedalled on restrictions to reform the shadow banking system after a liquidity crunch in June threatened economic contraction. After narrowly escaping a policy mistake, the government added new stimulus and shadow banking grew to 55% of total lending in August after falling to below 20% of total lending in June and July.
Rapid ramp in debt is a headwind for China
Source: Bloomberg. Year-to-date data as of Aug. 31, 2013.
China's recent stimulus is more of the old economic model of debt issuance and construction of infrastructure and property that deepens economic imbalances and increases future risks. However, Chinese-related investments, including emerging market stocks, could rally in the near-term due to the economic rebound, coming off depressed stock prices. We recently shifted up to a neutral view on emerging markets due to the balance of these factors.
Read more international at www.schwab.com/oninternational.
So what?
Surprises come at any moment in the investing world, reinforcing the need to have both a long-term view and a balanced/diversified portfolio. We believe signs are pointing to better US and European growth, a near-term rebound in China, and some possible positive momentum building in Japan. But near-term fiscal policy risks abound. Investors that need to add to equity positions should use pullbacks to do so.
© Charles Schwab
