- Global growth concerns have put some pressure on stocks and weighed on commodities, while providing another tailwind for fixed income. However, a pullback is welcomed and we don't believe the magnitude will be overly onerous.
- The US economy still can't achieve "escape velocity", disappointing some investors but keeping the Fed firmly in the easing camp. Attention on Capital Hill has turned away from the economy for the time being, but a new round of debate is likely right around the corner.
- Both Europe's and China's growth have disappointed, and we are watching policy responses closely. Meanwhile, Japan's aggressive monetary easing has been positive to this point and hope is growing that it could be the start of sustainable improvement.
Hopes had been rising that the US economy was finally reaching the point of being in a self-sustaining expansion; one that would create a growing number of jobs, and would see gross domestic product (GDP) growth finally accelerate out of its muddle through mode.
But recent data has indicated we are stalling yet again in growth; which combined with weak growth in China and Europe, has increased the volatility in stocks, and pushed down commodities and Treasury yields. But we don't believe a severe downturn is in the cards. Sentiment has never suggested an enthusiastic embrace of the impressive bull market over the past four years. Cyclical sectors that usually lead in such a move, such as energy, materials and industrials, have lagged; while defensive industries—often with "bond-like" characteristics, such as utilities, consumer staples and health care—have led.
Sector leaders don't tell an optimistic story
Source: FactSet, Standard & Poor's. As of Apr. 22, 2013.
This apparent lack of enthusiasm plays into our belief that any pullback we see will be relatively benign. And most down days over the past few weeks have been followed by gains, which indicates cash still wanting to get off the sidelines. Additionally, earnings season has been lackluster, with bottom line earnings ahead of expectations, but revenues and forward guidance below expectations. Additional selling is certainly possible, but we wouldn't suggest waiting for a pullback of the magnitude of the previous three years to add to equity positions as needed. Money has to go somewhere and as our friend Jason Trennert from Strategas Research has said, "There is No Alternative" (TINA). The US equity market has risks, but when compared to most other investment options, i.e. China, commodities (lately), cash, Treasuries, etc., it looks pretty good.
Economic data still mushy
There is little doubt that recent economic readings have reinforced the muddle along scenario, and that escape velocity still eludes us. Some regional manufacturing surveys reinforced the national survey and still point to growth; but perhaps at a reduced rate as the Empire Manufacturing Index fell to 3.05 from 9.24 and the Philly Fed Index surprisingly dropped to 1.3 from 2.0 (with a reading above zero in both surveys indicating expansion). And while industrial production rose by a solid 0.4%, the rise was due to a 5.3% gain in utilities, which was attributed to the abnormally cold weather. Even housing, which has been a bright spot and which we continue to believe will be a linchpin of growth in 2013, saw mixed results. The National Association of Home Builders (NAHB) Survey fell to 42 from 44, building permits dropped 3.9%, and while housing starts posted an impressive 7.0% rise, it was entirely due to multi-family construction as single family starts actually fell 4.8%. Finally, the Index of Leading Economic Indicators fell 0.1%, the first decline since August of last year.
A soft patch?
Source: FactSet, U.S. Conference Board. As of Apr. 22, 2013.
While disappointing, there are enough positive offsets in our view that any "soft patch" will be relatively limited. Despite the somewhat disappointing data in the housing market as of late, nothing goes up in a straight line and it's quite possible that the cold weather mentioned above also contributed to a pause in activity that will reverse itself. We continue to believe housing will be a positive contributor. Additionally, as mentioned above, weak global growth has weighed on commodity prices, including crude oil, corn and wheat. This should help to bring down the prices of various items, putting some extra money back into consumers' pockets.
With the mushiness of the data lately, combined with a still elevated unemployment rate and low inflation, the Federal Reserve continues to pump $85 billion a month into the economy, with no end in sight. And while we worry about the Fed's ability to stick the landing on its eventual exit, it hasn't paid to fight the Fed during this rally, and we think that will continue to be the case for the foreseeable future.
US policy uncertainty has waned, which should be a positive for the market in the near term. We anticipate economic and debt debates will heat up as the year progresses, but for now the rancor has diminished, which could set up for less drama during the upcoming budget battle. But we remain concerned over the impact of the 2014 implementation of the Affordable Care Act and are watching to see if some concessions may be made that would ease the burden on American business.
Across the pond, the year began with hopes that the eurozone could emerge from recession, as economic leading indicators had improved for several months. However, the Italian political stalemate and the Cyprus banking crisis weakened sentiment. Deterioration in economic data has added to the pessimism:
- Germany's manufacturing purchasing managers index (PMI) fell into contraction in March and declined further in April; and the German composite PMI that includes services indicated a decline in output in April, ending a four-month period of expansion. Disappointingly, the PMI survey indicated weakness could continue, as new orders fell at a faster rate. German business confidence, as measured by the Ifo business climate index, fell for the second month in April, although severe winter weather was cited as contributing to the weakness.
- French manufacturing output fell 0.3% in the three months ending February from the prior three months, and Italian industrial production declined 0.8% in February.
Despite the gloom in the eurozone, there are some positives. European policymakers have recognized the fallacy of overly aggressive austerity, where growth weakens and tax receipts fall, reducing the ability to meet fiscal targets. As such, countries have been given additional time to reach their fiscal targets, and the fiscal drag in 2013 is likely to be less than in 2012.
New monetary easing may also be in the cards, as eurozone annual inflation was below the European Central Bank's (ECB) target of 2% in February and March, and is expected to moderate further in April. Market expectations are increasing for either a rate cut and/or other non-standard measures at the ECB's May meeting, although some members of the ECB may prefer to wait for confirmation of an economic deterioration. We doubt a rate cut will stimulate economic activity, but support targeted measures to ease lending for small businesses.
While eurozone stocks could struggle near term as economic and earnings expectations are reset, we believe valuations and earnings are depressed and a fair amount of negative news has likely already been priced in.
Red flags in China?
China has been the region that surprised investors most, as the reacceleration that began in the fourth quarter of 2012 was expected to continue in 2013, particularly with new political leadership in place. However, instead of reaccelerating to 8.0%, GDP slowed to 7.7% in the first quarter. Economic weakness was broad-based with momentum ending the quarter on the downside.
- Industrial production of 8.9% year-over-year (y/y) in March was below the 10.1% forecast and 9.9% gain in the first two months of the year.
- Fixed-asset investment, which includes construction of infrastructure, property and factories, increased 20.9% versus the 21.2% gain in the first two months.
- Only retail sales improved in March versus the first two months, to 12.6% from 12.3%, but the rate is still subdued relative to 14.3% in 2012 and 17.1% in 2011.
- Electricity consumption, a statistic favored by economists as it is viewed as less manipulated, was a slow 1.9% y/y in March, the second-lowest y/y rate in 46 months.
Debt surging but growth sagging in China
Source: FactSet, Bloomberg, People's Bank of China, National Bureau of Statistics. As of Apr. 23, 2013.
The weakness was particularly disappointing in light of rapid expansion of credit. For the first quarter of 2013 total new credit issued grew 58% from a year ago to 6,148 trillion yuan (nearly $1 trillion), with 58% of new credit coming from sources outside the formal banking system, also called the shadow banking system. The expansion in 2013 credit comes on top of $2.5 trillion issued in 2012, which was up 23%.
We've noted our concern about the sustainability of China's debt-fueled growth, and believe growth could gradually decline in coming years, particularly as the contribution from infrastructure spending is uncertain. While some of our concerns are being priced in to Chinese-related investments and construction-related commodities and countries-- and a bounce in these investments is possible-- risks remain. We believe China-related investments will encounter difficulty until investors have confidence about where and how China's economy stabilizes. Longer-term investors should look to reduce their exposure to China and other emerging markets in the international portion of their portfolios and instead invest more in developed markets.
New life in Japan?
Investors' negative view on Japan has been pervasive for so long that describing Japan as a relative bright spot might be surprising. The impetus is a dramatic shift in monetary policy to do "whatever it takes" to achieve a 2% inflation target in two years, with the Bank of Japan announcing a "kitchen sink" of potential measures.
The policy shift has dramatically weakened the yen and bolstered stocks. Similar to the Fed's QE, one manner in which monetary policy can influence the real economy is through the wealth effect. Rising wealth improves consumer confidence, which can boost consumer spending, drive higher corporate sales and profits, and result in job and income gains, in a positive self-feeding cycle.
Japan's economy responding positively
Source: FactSet, OECD. As of Apr. 23, 2013.
We believe we could be transitioning from the first phase for Japanese stocks, driven by the yen, and entering the second phase, driven by benefits for the real economy and corporate profits. Consumers are roughly 60% of Japan's economy, an often-overlooked statistic and consumer confidence has improved to a five-year high. Businesses are also supportive of the new policies, and longer term, with improved demand and sentiment, high corporate cash hoards could be redeployed into research and development and improve the competiveness of Japanese products, and/or increase dividends and stock buybacks.
In sum, Japan's economy is unlikely to improve in a straight line, and a consolidation of the moves in the yen and Japanese stocks is possible. However, we believe there could be a multi-year improvement in Japan's economy and stocks; and global and local Japanese allocations to Japanese equities are still low. Risks include inflation without rising incomes, parliamentary elections in July, or the possibility that Japan-China relations deteriorate.
Read more international research at www.schwab.com/oninternational.
Global economic growth has weakened, while the US economy hasn't reached "escape velocity." US stocks have held up relatively well. With few other attractive alternatives, domestic equities appear to be the best house in a rough neighborhood. With the Fed committed to easing, housing improving, and valuations reasonable, the trend should continue. Risks remain and diversification and some hedging strategies are recommended.
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