Key Points

  • Headwinds have reemerged and investor concern is heightened yet again. We still believe stocks can run further, but a pullback is more likely in the near-term.
  • The sequestration is now in affect but that doesn't necessarily mean it's here to stay and more budget fights loom, particularly in advance of the potential government shutdown on March 27. Meanwhile, some members of the Fed are in favor of scaling back its quantitative easing (QE) program, rattling markets a bit.
  • The European debt crisis was again brought to the forefront with the inconclusive Italian election, but we believe this will prove to be a buying opportunity. In China, officials are becoming more concerned with property inflation, which could derail their willingness to pursue growth-oriented policies.

How quickly things can change in the investing world. Several weeks ago it seemed to many like clear sailing, but recently headwinds have emerged and volatility has increased. A pullback in the market was not unexpected given the strong run since last November, and we view a modest selloff as a positive from a sentiment perspective. However, given recent history, this could prove to be an important inflection point for the market.

The past three years has seen the market rally to start the year, only to start to stall around the March-April time frame and sell off into early summer before again rallying to end the year. Are we starting to see a repeat?

Pattern Repeating?

Pattern Repeating?

Source: FactSet, Standard & Poor's. As of Feb. 25, 2013.

Investing flows reported by EPFR Global show that for the week ended February 13, flows into bond funds outpaced those into equities for the first time since early December. We don't believe this is the start of a new sustainable trend, but now appears to be a critical time for investors' faith in stocks. Can the economy continue to grow with the payroll tax hikes now hitting consumers' paychecks with full force, the sequestration going into affect, higher gasoline prices, Europe still struggling, continued US political dysfunction, and China easing back on stimulus? Add to those concerns the news that at least some Fed members discussed altering its bond buying programs and you can see the "wall of worry" building again.

This time is different…at least somewhat

Equity markets typically like to climb that wall and a healthy bit of skepticism can be good for stocks. Additionally, in comparison to the previous periods reference above, we have some solid tailwinds to help offset potential weakness. Chiefly, housing continues to be a positive contributor as building permits rose 1.8% and new home sales jumped 15.6%. Housing can help consumer sentiment as well as provide jobs in several different industries, such as construction and retail. Additionally, we are finally seeing merger and acquisition activity (M&A) accelerate. According to the Wall Street Journal, M&A activity to this point in the year is the highest since 2005, indicating increasing business confidence; which can also help other investment possibilities and the hiring picture. Finally, unlike the past several years, global central banks are nearly universally keeping monetary policy easy. So we believe any weakness will be relatively minor in scope and short-term in nature and remain positive on stocks.

However, equity investing is long-term in nature and trying to time the market is typically a losing game. Investors who need to raise equity exposure to match targets should use weakness to add to positions in a steady way; while those that may be overexposed to any asset class should look to achieve a more balanced portfolio. After the run over the past several months, it's quite possible some equity positions are extended, while risks to bonds are elevated due to continued near record-low rates, resulting in near record-high prices. For those that invest in bonds for capital appreciation purposes, the investing axiom "buy low, sell high" only works if you actually buy low and sell high, so be mindful of high prices.

Economy keeps chugging along

Despite the aforementioned headwinds, recent economic data continue to indicate modest economic growth—helping to maintain that potential sweet spot of keeping us out of recession, but not so strong as to push the Federal Reserve into tightening. Regional manufacturing surveys continued to paint a mixed picture, with the Philly Fed disappointing at -12.5, while the Empire Manufacturing Index surprisingly rose to 10.0. And the more important national Institute of Supply Management (ISM) Manufacturing Index posted a solid reading at 54.2, which was the best number since June 2011.

Additionally, the Index of Leading Economic Indicators (LEI) posted another monthly gain of 0.2%, and jobless claims continued to hover in the range of modest growth in the jobs market—again, not too hot or too cold with relation to the Fed.

Claims continue to indicate modest growth

Claims continue to indicate modest growth

Source: FactSet, U.S. Dept. of Labor. As of Feb. 25, 2013.

Fed minutes rattle, but policy stays in place

Given the still-elevated level of joblessness, it seems unlikely that the Fed will make any substantive change to current policy in the very near future. But that didn't keep the market from selling off following the release of the minutes noting discussion surrounding the current bond buying program. Discussion and debate about the Fed's exit strategies will likely be heightened all year as QE winds down, which could bring additional volatility to both the fixed income and equity markets.

Next up is an assessment of the economy's impact from the sequestration having kicked in. This remains a fluid situation and more budget battles are just around the corner, but how the economy absorbs this will be interesting to watch. We believe there is a possibility that a cut in growth of government spending, despite its very blunt nature, may help to instill some confidence that the deficit (and debt) is being addressed more forcefully.

Dysfunction also evident in Italian politics

The eurozone sovereign debt crisis is as much a confidence game as it is about fiscal health. Each country has a mix of indebted consumers, banks, or governments; and fiscal deficits. The risk is that losses on debts would culminate in government bailouts, bank deposit flights, and a dearth of liquidity that would freeze financial systems.

The negative spiral was thwarted when European Central Bank (ECB) President Mario Draghi vowed to "do whatever it takes" to preserve the euro, and introduced a conditional bond purchase program—the Outright Monetary Transactions (OMT)—shortly thereafter. The ECB's OMT gave investors confidence that there would be a credible lender of last resort in the event downside risks evolved—a "safety net."

The Italian elections threaten confidence in Europe and have injected uncertainty, as either another election or coalition government is likely to result in an unstable government that is unable to last a full five-year term. Uncertainty could prompt worries about a bailout for Italy and contagion that ensnares Spain; but we view new bailouts in the near term as unlikely. Positively, Italy runs a primary budget surplus (surplus before debt service) and high levels of bond market stress typically force policymakers to make unpopular decisions to reduce deficits—we believe Italy's politicians want to avoid a bailout.

The inconclusive election in Italy is the latest addition to the eurozone's well-known negative case. Economies in the region remain in recession, but there are positive developments and the future could improve. Labor market reforms have reduced costs and improved flexibility for companies, which can improve future profits. The brunt of fiscal austerity is likely in the rear view, as policymakers have realized the fallacy of aggressive austerity at the expense of growth. As a result, deficit reduction targets have been extended to more realistic timeframes. Meanwhile, improved confidence and the search for yield have created strong demand for government, bank and corporate debt, which helps give corporations much-needed access to credit at a time when bank lending is weak. Lastly, the global outlook has improved, and leading indicators of the eurozone economy are stabilizing.

We have a positive outlook for eurozone stocks and believe the uncertainty from Italy could create an opportunity for investors who are underweight the eurozone relative to their targets. Eurozone stocks have underperformed in recent years, and have depressed earnings and valuations. Along with the potential for sales growth to accelerate, earnings have additional upside as margins could expand.

We prefer the markets in core countries such as Germany and France; and individual eurozone stocks in cyclical sectors, such as consumer discretionary, technology, industrials, materials and energy sectors—sectors that tend to do well when global growth improves, as we expect.

Global easy monetary policy, Bank of Japan joins

Global growth took a hit in the second half of 2012, with China slowing to 7.4% GDP growth in the third quarter and five of the seven G7 nations reporting a contraction in the fourth quarter. Economic growth in late 2012 was pressured by a number of headwinds that have reversed in 2013 and leading economic indicators of future growth are turning up.

Global easing improves growth prospects

Global easing improves growth prospects

Source: FactSet, OECD. As of Feb. 25, 2013.

* Major non-member economies include Brazil, China, India, Indonesia, Russia, and S. Africa.

Factors that brought about this global turnaround:

  • The United States avoided going fully off the "fiscal cliff;"
  • China avoided a hard landing as its government directed a significant rebound in infrastructure spending;
  • The ECB put in place a safety net to ease the eurozone crisis;
  • Global easy monetary policy has remained, with several major central banks increasing accommodation and the Bank of Japan expected to undergo a "sea change" and accelerate easing after pursuing an overly conservative policy in the recent past.

While global growth is improving, it is still sluggish as many developed economies still have slack in the form of high unemployment and low factory utilization. But that is keeping inflation subdued and easy monetary policy by developed countries is likely to support growth for some time.

Inflation concerns in China and emerging markets

Monetary policy for emerging markets is less clear than for developed markets. India's central bank noted limited scope for easing due to the risk of inflation escalation, Brazil's consumer price index is rising and China is becoming concerned about inflation. Tight labor markets and/or infrastructure constraints account for the inflation divergence relative to developed markets.

As the world's second largest economy, China's outlook is critical. Yet China's command-control policies have a way of creating arresting developments. Case in point are the property and infrastructure markets, on which strict measures were implemented to slow both markets; but then later eased, which unleashed rapid recoveries. Chinese home prices are rising again, a development the government dislikes as it could fan social unrest. and new regulations are likely to constrain property market growth. This prospect hit stocks despite a small 3.3% weight of property developers in the Shanghai Composite and 12% of gross domestic product (GDP) according to the International Monetary Fund (IMF), as the property market influences a larger portion of the economy when housing-related industries are included.

China's market tends to follow property trends

China's market tends to follow property trends

Source: FactSet, Shanghai Stock Exchange. As of Feb. 25, 2013.

Additionally, the People's Bank of China (PBoC) removed the reference to supporting growth in the latest quarterly report. Inflation is not yet a problem, but could accelerate later this year. We believe monetary policy measures will be of the "fine-tuning" and targeted variety for now, not yet tightening. Short-term, Chinese-related investments could benefit as long as economic reacceleration continues. The infrastructure spending outlook may determine whether growth continues to improve. We will be monitoring the National People's Congress (NPC) that begins March 5, where a new "urbanization plan" and the funding mechanisms for sustaining infrastructure spending will be discussed.

However, China's economy is more reliant on debt than in the past to generate growth, a potentially unsustainable situation. We discuss how shadow banking fueled the 2012 recovery, in our article and 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 international research at www.schwab.com/oninternational.

So what?

Stock market volatility has increased as concerns, both domestically and globally, have risen. Given the somewhat skeptical attitude that still appears prevalent among retail investors, now could prove to be a crucial time for the near-term performance of the stock market. We believe money will continue to move into equities as the returns from cash and fixed income are historically low, but vigilance and adherence to asset targets are needed.

© Charles Schwab

www.schwab.com

Read more commentaries by Charles Schwab