- Stocks have seen some selling pressure, while other assets have also reversed course. We believe this is the start of the next phase of investing, with an increase in volatility and more grinding action likely.
- The Federal Reserve continues to prepare the market for its "tapering" of Treasury and/or mortgage-backed securities associated with quantitative easing (QE). This process is likely to be met with continued elevated levels of volatility.
- Emerging markets have had a rough ride, with heightened volatility, and we think it's likely to persist. Japan's market and currency action has been stomach-churning recently but we remain optimistic and urge patience, while Europe's economy may be turning the corner.
Since Chairman Bernanke's testimony in front of Congress in late May, where "taper" entered the lexicon, we've seen a shift in market behavior.
Recent action may be a foreshadowing of action to come as we slowly transition to a more normal economic environment. Gold has retreated over $300, stocks have seen a roughly 3-5% pullback, and we've seen the yield on the 10-year Treasury move to its highest level in over a year. Equities are likely to remain more volatile in the near-term. But it is encouraging to note that many of the technical and sentiment conditions that were troubling at the recent market highs have corrected. The AAII bull/bear ratio has moved close to zero—which is a neutral reading; while the Ned Davis Research Daily Trading Sentiment Composite moved from excessive optimism to extreme pessimism. Both are contrarian indicators. Many of the indicators we watch reversed quite quickly, suggesting that further downside may be limited; albeit with heightened volatility.
We don't believe we're in store for a large spike higher in yields. Yield-hungry investors may be attracted to the higher yields, but the Federal Reserve doesn't have much stomach for much higher yields. We continue to suggest caution with regard to certain segments of fixed income; with a focus on higher-quality credit and away from longer-term Treasuries.
Economy not hitting on all cylinders
The Fed will continue to telegraph its tapering plans consistent with incoming economic data. Although the data has been mixed, there are encouraging signs, and we believe improving growth is likely for the second half. The Chicago purchasing managers index (PMI) rose to 58.7 from 49.0; and the Institute for Supply Management (ISM) Non-Manufacturing Survey rose to 53.7 from 53.1, indicating improving conditions in the much larger service side of the economy. But there was softness in manufacturing as the ISM Manufacturing Survey dropped to 49.0, its lowest reading since June 2009. Additionally, within that report, we saw the employment component dip to 50.1 from 52.0.
Services diverging from manufacturing?
Source: FactSet, Institute for Supply Management. As of June 11, 2013.
On the jobs front, ADP reported a relatively soft 135,000 jobs added in the private sector. But the government's labor report surprised on the upside by reporting a gain of 175,000 jobs. The unemployment rate did uptick to 7.6% from 7.5%—largely due to an increase in the participation rate, which is generally viewed as a positive development. Job growth is improving but likely not yet where the Fed would like to see it at this point in the recovery.
Finally, housing, one of the pillars of support for the economy, may be facing some minor headwinds as the recent rise in yields has also pushed mortgage rates higher by about 80 basis points. We don't view this as overly concerning, and may in fact result in fence-sitters being spurred into action. In addition, the "real" mortgage rate remains negative thanks to double-digit increases in home prices; a very strong support for housing.
Mortgage rates creeping higher
Source: FactSet, Freddie Mac. As of June 11, 2013.
Does the Fed move sooner rather than later?
We agree with the consensus that September is likely the earliest meeting at which the Fed might announce a tapering of purchases associated with QE. Inflation continues to be quite low and is not yet forcing their hand; however some Fed members have expressed concerns about asset bubbles. Recent action has appeared to remove some of the air from those potential bubbles (such as REITs), giving them some more leeway.
It's important to remember that tapering is initially likely to be quite modest. The Fed has been clear about its ability to reverse direction if the impact of tapering is detrimental to the economy, and specifically the job market. As long as taping is initiated because of an improving economy—and not rising inflation—it's' likely to have a limited negative impact on the stock market, beyond some near-term volatility.
Congress quiet…for now
With other things dominating attention on Capitol Hill, Congress has been less of a market needle-mover recently. We still have a debt ceiling debate to deal with this fall, while corporate and individual tax reform remains on the table. Additionally, the sequester remains in place, with impacts potentially growing as the year winds down. Finally, we are getting closer to the implementation of the Affordable Care Act, which may be at least a near-term drag on economic activity.
Great rotation – out of emerging markets
The discussion over US Fed tapering alerted investors that a reduction of QE could potentially occur in their near-term investment horizon. As a result, risk-based trades that benefitted from what was perceived to be a relatively free lunch from zero interest rate policies (ZIRP), have experienced pressure. Emerging markets (EM), on which we've had an underperform rating, have experienced a particularly big hit.
Emerging markets melting down
Source: FactSet, MSCI. As of June 11, 2013. Indexed to 100 as of June 11, 2010.
* A larger/smaller number above 1 denotes greater outperformance/underperformance of the MSCI EM Index relative to the MSCI EAFE Index.
While we have been expressing caution on EM stocks for several months due to slowing growth prospects, the new wrinkle since May 22 is notable weakness in EM currencies and bonds. The risk is that further emerging market currency weakness could create inflationary pressures and reduce the ability for some EM central banks to ease. Additionally, if the US dollar resumes its strength, this could reduce foreign investment flows into emerging market economies and further pressure growth. This is troubling for countries that are dependent on foreign investment due to current account deficits, such as in India, Brazil and Indonesia.
We are maintaining our preference for developed international stock markets over emerging markets due to the continued risks to EM growth. Our negative call on China remains a cornerstone of our view on EM, due to the outsized influence it has on the EM universe. We've been expressing our concern about the sustainability of China's debt-fueled, construction-led growth, and economic data continues to disappoint. Interestingly, China's Premier Li believes growth remains "relatively high and reasonable," according to a June 8th statement; but investors view the growth rate differently, as consensus estimates continue to fall. We believe China-related investments will encounter difficulty until investors have confidence about where and how China's economy stabilizes. Read more Avoid China—Subprime-Like Bubble Brewing, as well as related topics at www.schwab.com/oninternational.
Speed bump in Japan, but story still intact
In recent weeks, volatility has spiked in Japan's stock and bond markets, as well as for the currency. This comes on the heels of a 76% gain in stocks, 21% fall in the yen, and 29-basis-point drop in Japanese government bond (JGB) 10-year yields from late November to mid-May for the Nikkei and yen; and to April 4 for the low in JGB yields. The volatility in the yen, combined with the Fed taper talk, resulted in some unwinding of the yen "carry trade," where investors borrow money at low rates in Japan and invest in higher-yielding assets elsewhere. Investors have been forced to sell riskier assets to cover short positions in the yen. Adding to the negativity, early June brought disappointment in the lack of reform details in Prime Minister Abe's anticipated speech; and little change to Bank of Japan (BoJ) monetary policy.
Despite the extreme volatility, we don't believe it's time to panic. The potential for revival in Japan is still in the early stages, with the BoJ's targeted doubling of the monetary base just beginning. In our opinion, it's too early to expect changes to monetary policy, and tackling reforms makes more sense after the July 11 parliamentary elections. However, structural reforms are needed for a sustained recovery and will be more difficult than fiscal and monetary stimulus, while remaining a risk for a longer-term move higher for Japanese stocks. Additionally, the Japanese government needs to provide fiscal consolidation plans to maintain the confidence of the bond market.
The economy and corporate profits have begun to improve, with Japan posting the highest gross domestic product (GDP) in the G7 in the first quarter, at 4.1% annualized. Consumer confidence is at a five-year high, wages are starting to rise and consumer spending has rebounded, as discussed in Japan: Land of the Rising Consumer. However, despite the rebound in earnings, business sentiment remains subdued; but continued demand and structural reforms could improve the picture.
We believe Japanese stocks could benefit over a multi-year period, but markets could remain volatile until there is more certainty about economic reforms, and because Japan's economic data could moderate after a nice rebound.
Eurozone may be bottoming
While the narrative has been of a continued eurozone recession, we believe the eurozone may be in the process of bottoming. The region is receiving relief as policymakers are easing on fiscal austerity, and the fiscal drag in 2013 will likely be less severe than in 2012. Manufacturing PMIs in all nations covered by Markit rose in May for the first time since July 2009; and leading economic indicators in the major economies in the eurozone have been improving or stabilizing in recent months.
Eurozone may be bottoming
Source: FactSet, OECD. As of June 11, 2013.
Additionally, the slowdown in global growth has eased inflation pressures, allowing the European Central Bank (ECB) to cut the benchmark interest rate in May and consider other non-standard measures. As monetary policy works with a lag, changes by the ECB could add to our view that the eurozone could emerge out of recession later in 2013 and maintain recovery in 2014.
That said, there are still risks in the eurozone. In May, Spain's central bank urged banks to further write down questionable loans by September, with corporate loans joining real estate loans as a concern, with risks most pressing for smaller banks. Yields for government debt globally have recently rebounded, in tandem with the unwind of yield-chasing trades globally on the Fed taper talk, which could pressure countries with more risky outlooks, and a potential bailout for Spain could come back into the discussion. However, a fair amount of bad news has likely already been priced into eurozone stocks, where earnings and valuations for eurozone stocks are depressed and could offer opportunity for investors.
We could be in the beginning stages of an adjustment toward a more "normal" monetary policy environment, with attendant volatility. This once again illustrates the importance of diversification and focusing on long-term goals when investing. We continue to believe the US equity markets are an attractive place for assets and recommend buying on pullbacks to the extent that you need to add to equity exposure. Additionally, continue to exercise caution around fixed income allocations and focus more on the developed markets vs. EM.
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