Finally!! Now What?
- Stocks continue to move higher, with the Dow hitting a record. Fund flows have picked up but many investors remain on the sidelines waiting for an elusive pullback. The economic news has been generally positive and above expectations, but headwinds haven't disappeared and a pullback is always possible.
- There's little question that continued easy monetary policy by the Fed has helped fuel stocks and should remain a support; but there are traditional fundamentals at work as well. At the same time, investors and politicians alike seem to be suffering from a bit of "crisis fatigue."
- Europe's economy remains mired in recession, but stocks tend to lead the economy and we remain positive on European equities as long as confidence in the ECB remains high. Conversely, we are concerned about the buildup in debt in China and suggest caution for investors who have aggressively invested there.
Day after day the Dow has been hitting new record highs and is now back to a level that preceded the Great Recession and financial crisis. The S&P 500 is not far behind. The financial and mainstream media is all over the story and it's helped raise enthusiasm about stocks by investors after a long drought of optimism. The media's message is often a call to "get in," or "get out," depending on the pundit's proclivities… as if getting in and getting out are investing strategies. They're not—they're a call to gamble on a moment in market time; whereas investing should be a process over time.
Discipline should never take a back seat to market timing. It's been our call to investors that are underweight equities to add to positions; while investors that have enjoyed the bull run so far be mindful of taking some profits to keep allocations in line. This is the art of rebalancing, and it never goes out of style.
A pullback at any time should be expected, but we remain optimistic about stocks. The attention garnered by the stock market lately could bring investors who have been sitting on the sidelines back into the market, fueling a further move higher. But there remains ample sidelined money waiting for the elusive pullback; and that often means a pullback is less likely. Sentiment measures are actually a bit mixed—with some showing extreme optimism (a contrarily negative indicator); while others showing more subdued optimism. Let us reiterate that picking tops and bottoms is generally a losing strategy.
Fuel for the fire continues
We heed the Wall Street axiom "Don't fight the Fed" (coined by Liz Ann's first boss and mentor, the late Marty Zweig). It's easy to conclude that the gains in the stock market can be at least partially attributed to the continued extreme easing of the Federal Reserve. The whiff of a possible reduction in easing saw stocks sell off recently, while Fed Chairman Ben Bernanke and Vice Chairman Janet Yellen dispelling those rumors helped to push the market higher.
Fed continues to push the accelerator
Source: FactSet, Federal Reserve. As of Mar. 12, 2013.
With the Fed practically begging investors to move out the risk spectrum, it can be detrimental to investors trying to fight that trend. Additionally, economic data continues to indicate decent economic growth, a sweet spot of sort that we have mentioned before—not so hot as to drive inflation higher and force the Fed to tighten, but not cold enough to stoke fears of recession—a good environment historically for stocks.
Housing continues to improve, with housing starts moving higher and inventories at near-record lows relative to the working population. With the improvement, we do expect inventory to start rising at some point as sideline sitters spring into action, but we continue to believe the improvement is sustainable. Housing is set to contribute to both job and economic growth this year: several economists we follow have housing-related job growth this year of 700,000-800,000 and a one percentage point contribution to gross domestic product (GDP). The labor market continues to heal, with the four-week moving average of initial jobless claims dipping to the lowest level since 2008 and ADP reporting private payrolls increased by 198,000, while January's number was revised higher to a gain of 215,000. Finally, the broader report from the Bureau of Labor Statistics showed stronger-than-expected gains as 236,000 jobs were added, with the unemployment rate dropping to 7.7%, the lowest since December 2008.
And after a better-than-expected 54.2 reading by the Institute of Supply Management (ISM) Manufacturing Index to start the month, we got a very solid ISM Non-Manufacturing Index (a bigger driver of the economy) reading at 56.0—the highest level since February of 2012. Importantly, within the report, the new orders index rose 3.8 points and employment held relatively steady at 57.2.
Service sector continues to hum along
Source: FactSet, Institute for Supply Management, US Dept. of Labor. As of Mar. 12, 2013.
Fed support continues, but at what cost?
These improvements are not enough for the Fed to ease off the accelerator as they continue to purchase $85 billion in Treasuries and mortgage-backed securities on a monthly basis; adding to an already bloated balance sheet (see above chart). And while they seem to have no plans to end purchases in the foreseeable future, some members have started to question the costs of continuing this program. We are also concerned about the unwinding process that will ultimately occur and the resulting impact those actions will have on financial institutions, markets of all kind, and the overall economy. With unprecedented action by the Fed, there's no history to lean on regarding how to "normalize" monetary policy from these levels; no roadmap. As such, we believe risks will rise as the Fed moves closer to tapping the brakes, and that this will be a growing issue for market participants to pay attention to as the economic expansion moves forward.
While the market seems to have a lot of confidence in the Fed, the same can't be said about the Federal government. We are still digesting the economic impact of both the fiscal cliff resolution and the sequester going into affect. One somewhat hidden drag mentioned by the Fed in the recent Beige Book release is the Affordable Care Act, with concerns rising about its effect on job creation—which we share. But the perceived ineptitude of Washington is a well-known story, which means it's likely well reflected in stocks. However, there is the possibility of an upside surprise regarding a budget agreement, especially with expectations so low. And there seems to be an increasing sense of crisis fatigue among politicians who may be growing tired of pushing everything to the brink. Even a modest compromise plan could encourage investors that all is not broken in DC, pushing even more money sitting on the sidelines into the market.
Eurozone's path "broadly unchanged"
Across the pond, despite hopes of a rebound in the eurozone, recent economic reports have injected some doubts due to mixed results. Eurozone GDP fell 0.6% in the fourth quarter and German factory orders declined 1.9% in December, while German exports rose 1.4% in January. Purchasing manager indexes also illustrate the mixed picture, with the eurozone composite PMI falling to 47.9 from 48.6 in January, with manufacturing staying at an eleven month high, but services declining.
However, according to the OECD, the January composite leading indicator points to a pick up in eurozone growth, with "no further declines in growth" for both Italy and France. As a result, despite the mixed data, we agree with the assessment of the European Central Bank (ECB) that the projected path for the eurozone recovery is "broadly unchanged." A key factor is the ECB's conditional bond purchase program, which improved confidence and provided a "safety net"— thawing credit markets and staving off downside economic risks. The rise in Germany's IFO Business Confidence Index is an illustration that German companies believe the outlook has improved.
Global confidence improves on central bank actions
Source; FactSet, Japanese Cabinet Office, IFO National Institute of Research. As of Mar. 12, 2013.
The eurozone is broadly in recession, but the economic outlook could shift direction in late 2013 from contraction to expansion. Labor market reforms reduced costs and improved flexibility for companies, which can improve future profits. The brunt of fiscal austerity is likely in the rear view—fiscal cuts for most eurozone countries will likely be smaller in 2013 than in 2012. Meanwhile, improved confidence and the search for yield have created strong demand for government, bank and corporate debt, giving corporations much-needed access to credit at a time when bank lending is weak. Lastly, the global outlook has improved.
Of course, divergences lie beneath the surface. The fragmented results of the Italian election will likely mean the political situation and economic outlook in Italy will remain uncertain. The "good news" for Italy is that the government has a primary budget surplus (surplus before debt service); the private sector has a high level of wealth and moderate debt, and over 60% of government debt is domestically owned; typically a stronger investor base than when reliant on foreigners.
We have a positive outlook for eurozone stocks and believe the uncertainty from Italy could create opportunities for investors who are underweight the eurozone. Eurozone stocks have underperformed in recent years, and appear to us to have depressed earnings and valuations. In addition to the potential for sales growth to accelerate, earnings have additional upside as margins could expand. Read more in our article.
Japan anticipating a better future
The potential for central bank action in Japan has also boosted confidence, with new Prime Minister Shinzo Abe prompting the Bank of Japan (BOJ) to undergo a "sea change" from an overly conservative policy toward aggressive easing with a goal to weaken the yen, raising growth, and targeting 2% inflation. Markets moved in advance of actual concrete action, with the yen falling and the Nikkei 225 Index rising to levels not seen in over four years.
However, markets rarely move in a straight line, with the most recent hiccup coming as the opposition party in Japan complicated the transition process for the three open governor positions at the BOJ. We believe the most likely outcome is that Haruhiko Kuroda will be the head of the BOJ beyond the interim period that expires April 8. He is likely to reiterate his pledge to do "whatever it takes" to achieve a 2% inflation target, and pursue aggressive policies to keep a ceiling on the yen. If markets have confidence that aggressive policies to weaken the yen will be maintained, it may become self-fulfilling and continue to benefit Japanese stocks, giving us the mantra "don't fight the BOJ." Increases in sales from market share gains due to a weaker yen could lift earnings, particularly for Japanese companies with high operating leverage. Relative US dollar strength would reduce returns and investors may want to consider hedging currency exposure.
What is uncertain is whether Japanese attitudes will be able to break free from a decade of deflation. Inflation generated from rising prices without accompanying demand increases—where a weak yen pushes up import prices and cuts into disposable income, and results in a further pullback in spending—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. We are encouraged by the spring Shunto wage negotiations, which have already resulted in nine companies heeding Abe's call for wage increases. Even before the negotiations, Japanese household confidence rose sharply (see above chart).
China's growth questions
After a recovery in late 2012, investors are beginning to question where growth in China's economy is headed. Despite a strong rebound in exports in 2013, industrial production for the combined January-February period gained only 9.9% year-over-year, the slowest for the first two months since 2009, and retail sales growth of 12.3% for the period was the weakest since 2004. New infrastructure projects, which led the recovery in 2012 under government direction, have stalled.
China's recovery pausing?
Source: FactSet, Nat'l Bureau of Statistics of China. As of Mar. 12, 2013.
Meanwhile, growth questions have also been accompanied by inflation concerns. Chinese home prices are rising again, resulting in new regulations that are likely to constrain property market growth and catalyzing a sell-off in the Shanghai Composite. Additionally, the People's Bank of China (PBoC) noted that inflation could accelerate later this year and moved to a "neutral" stance.
We believe the near-term growth outlook will depend on the government's ability to reform the funding mechanism to sustain infrastructure spending. Short-term, Chinese related investments could benefit as long as the economic reacceleration continues. However, China's economy is more reliant on debt than in the past to generate growth, a potentially unsustainable situation. 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 China in our January article and "Avoid China—Subprime-Like Bubble Brewing".
Read more international research at www.schwab.com/oninternational.
Surprise! We don't know what's going to happen in stocks over the next few weeks. But we are seeing an environment that we believe can foster further gains in the US as economic data remains generally positive, the Fed maintains its accommodative stance, and small progress is being made in the fiscal realm. Investors concerned about a pullback may want to hedge their portfolios, but maintain adequate exposure to equities. Additionally, investors who have shunned Europe may want to take another look, while caution is warranted in China. The long-term view should always be kept in mind, but that doesn't mean portfolios should be ignored in the short term.
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