Key Points

  • Fiscal cliff part one was largely averted but there will still be a fiscal drag on the US economy. We believe there are enough positive factors to largely absorb the blow at this point and remain positive on stocks; but the debt ceiling/sequestration fight to come could mean volatility comes back.
  • Kicking the can may be the way things get done in Washington for the foreseeable future and the next two months will likely see more of the same. Meanwhile, the Federal Reserve continues to provide unprecedented amounts of stimulus.
  • Europe still faces numerous headwinds but slow progress is being made, while China's growth has reaccelerated and we're closely watching Japan's new government's attempts at stimulating activity.

Note: The next scheduled Schwab Market Perspective publication will be February 1, 2013.

Although not the way most reasonable people would have designed the deal, the fiscal cliff was averted…sort of. Markets cheered the deal that kept income tax rates constant for the majority of citizens and raised capital gains and dividend rates by less than many had been expecting; but much was left to be desired. The debt ceiling is scheduled to be breeched by the end of February, and the spending cut portion of the cliff was only postponed to the beginning of March, meaning more of the same in Washington. And then there's this rub: taxes for almost all Americans actually did increase. The payroll tax rate was bumped back up by two percentage points- from 4.2% to 6.2%. Those with modestly higher incomes will see higher income, payroll, dividend and capital gains taxes; and now limits to the deductions they can take after a certain threshold. It all adds up to a drag on the US economy that wasn't exactly humming along.

But we remain optimistic longer-term. Markets are not driven by politics alone. In fact, in our view there are several other important factors that are beneath the surface that trump politics—at least for now.

After a third consecutive mid-year soft patch in 2012, the economy has gained momentum yet again. Although there remains some uncertainty due to the continuing post-Hurricane Sandy data volatility, the economic expansion is intact for now; and the market powered higher despite all the hoopla surrounding the fiscal cliff, leaving investors on the sidelines losing ground. As always we urge investors to look at the longer term and maintain equity positions with at least a three-to-five year view.

The Counterbalance

While rancor in Washington is likely to remain a drag on confidence, the entrepreneurial and innovative spirit appears to be alive and well in much of the country. Manufacturing broadly, and domestic energy specifically, are likely in the midst of a renaissance. Regional manufacturing surveys are showing a notable improvement in conditions, while the Institute of Supply Management (ISM) manufacturing survey returned to territory depicting expansion following the Sandy-induced dip below the dividing line. We believe "onshoring" will be an even more prevalent story in 2013, with companies looking to bring previously outsourced workers and production back to the United States due to rising wage costs elsewhere and logistical advantages to local production and distribution. The government could help improve US competitiveness further by reducing the corporate tax rate and simplifying both the tax code and the regulatory structure.

Tax rates are a headwind for US business growth

Tax rates are a headwind for US business growth

Source: KPMG. As of Dec. 31, 2012.

However, we are encouraged by the improvement in consumer confidence and continued solid retail sales readings. Although MasterCard Advisors SpendingPulse initially reported a mere 0.7% gain in sales during the holiday period versus a year ago, ISI Research noted that the same survey last year actually undershot the actual rate of growth by 3 percentage points once the final tallies were in. And there are other signs of strength as well, with auto sales continuing to improve. The average age of autos currently on the road is 10.8 years according to JD Power, which is above historical averages, so strength seems likely to continue. Meanwhile, housing continues to improve markedly as inventory gets sopped up while prices have accelerated. With new home construction moribund for some time, pent-up demand has been building. With mortgage rates remaining historically low, it appears the improvement is just getting started. One of the leading indicators we look at to show us where housing may be headed is lumber prices, which tell a pretty good story at the moment.

Lumber prices bode well for continued housing improvement

Lumber prices bode well for continued housing improvement

Source: FactSet, CME Group. As of Jan. 4, 2013.

Jobs are being produced at a decent pace, with the ADP employment report showing a surprising 215,000 private jobs were added in December, while the broader Labor Department nonfarm payroll report showed 155,000 jobs were added and the unemployment rate remained at an upwardly revised 7.8%.

We still have a ways to go and there are risks as a full hit from the spending sequestration (assuming no changes) is estimated by the Pentagon to cost 800,000 jobs to the Department of Defense alone. But with consumer demand appearing to remain solid, the lack of hiring since the recession, and massive cash sitting on corporate balance sheets, it is also quite possible that companies will almost be forced to start adding to payrolls at a more rapid pace in 2013. It's also likely that the residential construction industry will be a much bigger job creator this year given how it has historically tracked the NAHB's Housing Market Index, which recently had a record percentage increase.

Bernanke and crew remain determined

Better news on the jobs front would be just what the Federal Reserve ordered. At their last meeting, the Fed set an unemployment rate threshold of 6.5% and an inflation threshold of 2.5%. Although the subsequent release of the Fed's minutes suggested some Federal Open Market Committee (FOMC) members believe quantitative easing will end this year; it's always been assumed (by us at least) that QE would end well before rate hikes are begun. It's the decision on rate hikes that is tied to the aforementioned thresholds. However, the Fed has been clear in noting they will use incoming data to assess their timing of both ending QE and raising rates; and a path that gets them there sooner than expected—assuming it's because economic growth is humming—would be great news for the economy and markets.

Eurozone muddles through

The potential for the Fed's colleagues at the European Central Bank (ECB) to purchase sovereign bonds has given a "safety net" to the eurozone that has likely reduced worst-case scenarios of sovereign defaults and a eurozone breakup. Political disagreements continue, but this "floor" allows investors to focus on some modestly positive developments in Europe.

Albeit slow, eurozone governments are moving toward integration, first with fiscal budgets and, in 2014, common bank supervision. Financial conditions have improved, with US money markets returning to the eurozone, deposit flights out of the periphery arrested, peripheral sovereign government bond yields falling, and capital markets reopened for eurozone banks. Structural reforms have started in many countries, resulting in falling unit labor costs, improving the competitiveness of these countries. The OECD reports that the previously-large current account deficit in the periphery has all but disappeared, and adjusting for cyclical factors, the International Monetary Fund (IMF) estimates that all peripheral countries except Ireland will have primary budget surpluses (fiscal budgets before interest expense) in 2013.

However, eurozone economies are likely to remain sluggish at best due to austerity and an undercapitalized banking sector. Lending will likely suffer – already credit to the non-financial sector contracted in each of the last six months and eight of the last ten. Eurozone economic growth continues to contract when extrapolating PMI data; although it appears the pace of contraction has slowed.

Volatility could yet return in the eurozone. Falling unit labor costs improve competitiveness but also reflect lower incomes and higher unemployment—eurozone unemployment hit a new record high of 11.8% in November. The longer growth is suppressed, the more likely citizens get impatient and reject austerity. The next test will come when Italy's late-February elections are held; during which the challenger coalition may promise tax cuts to garner votes.

The mixed outlook results in our neutral stance for European stocks as a whole; although there are likely opportunities in individual companies that have competitive advantages and export sales prospects.

China accelerating, for now

China's economy is rebounding, led by infrastructure spending by the government. While we believe China's infrastructure still has scope to improve, it has funding headwinds. Local governments' budget surpluses have been reduced, banks are reluctant to lend and the ability of the shadow banking sector to continue to provide funds may be unsustainable.

We are concerned about a potential credit bubble brewing in the shadow banking sector in China. Investors have been lured by double-digit returns offered by trusts and wealth management products (WMPs) marketed through banks. The trusts and WMPs lend the money invested to corporate, property developer and infrastructure construction borrowers who are higher risk and unable to obtain formal loans at banks. Negatively, due to lack of transparency and due diligence, investors and the agents marketing these products have little understanding of the mechanics of these products.

Shadow banking surging in China

Shadow banking surging in China

Source: FactSet, China Trustee Association. As of Jan. 8, 2013.

The size of the shadow banking sector is unknown, but it could be large. The China Trustee Association measured the trust segment at 6.3 trillion yuan ($1.0 trillion) as of September 30, 2012, up 54% year-over-year, while Fitch Ratings says 2012 may end with over $2 trillion in WMPs. Government oversight of the shadow banking sector appears to be inadequate and the sector is showing signs of distress, and investor lawsuits have started. Banks, the largest sector in China's stock market, could have contingent liabilities, which could reduce their ability to lend and promote economic growth.

Chinese stocks have benefitted from the economic turnaround, which could continue for several more months. However, growth could face headwinds in mid-2013 as inflation could return, easy growth comparisons come into view, and the boost from infrastructure restarts in the second and third quarters of 2012 wanes. We believe China's economy needs to transition away from investment and toward consumption, which is likely to be accompanied by slower growth. Rallies in China-related investments may be short-lived, as we detail.

Don't fight the Bank of Japan?

The Japanese economy and corporations have many headwinds. However, Japanese stocks could rise in the face of these issues. A majority of past underperformance of Japanese stocks has been tied to yen strength. According to BCA Research, since 2002 the Nikkei 225 Index in dollar terms generated returns fairly close to the S&P 500 Index, and there is a high negative correlation between the yen and the Nikkei's relative performance.

Japanese stock performance inverse to yen

Japanese stock performance inverse to yen

Source: FactSet, Nikkei Stock Exchange, MSCI, Reuters. As of Jan. 8, 2013.

* Indexed to 100 as of January 8, 2003. A larger (smaller) number above 1 denotes greater outperformance (underperformance) of the Nikkei relative to the EAFE Index.

Japan's new Prime Minister Shinzo Abe has resolved to weaken the yen by influencing more control over the Bank of Japan (BoJ). As a result, when comparing the Federal Reserve and the BoJ, the Fed's announced quantitative easing (QE) is more likely to be reduced than increased; while the BoJ is more likely to increase QE. These potential diverging paths could keep pressure on the yen.

As we've seen in the United States, stocks rose even though the Fed's QE hasn't been very successful in creating growth or jobs - equities tend to respond favorably to central bank liquidity. If the BoJ is successful in convincing markets it will do "whatever it takes" to weaken the yen, it may become self-fulfilling. In the near term, moves in both the yen and Japanese stocks may be extended and due for a correction, but if the BoJ stays aggressive, Japanese stocks could rise further, giving us the mantra—"don't fight the BoJ."

Emerging markets showing strength

Growth in emerging markets could recover in 2013, led by Asia and a lesser extent, Latin America; while Emerging Europe is still hampered by ties to the eurozone. We like Mexico's longer-term story, benefitting from the changing cost equation in China, although the Mexican stock market appears expensively valued.

The improvement in emerging markets has both potential rewards and risks. For now, global central banks remain in easing mode, but stronger economic growth comes with the higher risk for inflation. In particular, there is the risk of higher input prices globally for raw materials, as well as food inflation. Thus far, there are few signs of concern, but we'll be monitoring this in 2013.

Read more international research at www.schwab.com/oninternational.

So what?

There seems to always be another crisis around the corner but over the past several years we've seen that it can be detrimental for investors to overreact. Although there are concerns all over the world, there are also bright spots. America averted the full force of the fiscal cliff and economic growth continues; Europe seems to have found at least a near-term floor and is making some progress; China's growth appears to have bottomed; and Japan has at least a glimmer of hope of escaping the grip of deflation. While there will be inevitable dips and potentially stomach-churning selloffs, we believe evidence is building that things are improving and investors who have been on the sidelines should use any weakness in first part of 2013 to add to equities as their risk profile and asset allocation model suggests.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

© Charles Schwab

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