Key Points

  • Stock indices hit record highs recently and retail investors appear to be reengaging. While August is typically quiet, the potential for surprises always exists and there are upcoming events that could test investors' commitment to equities.
  • Congress has joined many on Wall Street on vacation and won't return until after Labor Day, when they will be under a tight deadline for a debt deal. The most recent Fed meeting was uneventful, but taper questions remain and speculation over the next Chairman continues.
  • Europe's economy is quietly showing signs of improvement, while the toughest challenges to Abe's reform plan to date lie ahead. Meanwhile, sentiment toward China has declined among investors but it's still a bit too soon to call it an attractive opportunity.

Records continued to fall as both the S&P 500 and Dow hit new highs. Contributing to the gains is the apparent and long-awaited return of the retail investor, many of whom seem to have remained largely on the equity sidelines following the financial crisis. But after a soft patch to start the summer, the renewed rally seems to have enticed sidelined investors to ease back into equities as Trim-Tabs reported that inflows into equity funds during July were the highest ever recorded, at the expense of bonds that saw outflows at a rate of the fifth-highest on record. One month doesn't make a trend, but it is encouraging that we may be seeing the fuel for the next move upward being put in place.

Although we wouldn't be surprised to see some profit-taking after the solid summer run we've had, it is encouraging that investor sentiment, by most measures, hasn't gotten too carried away. Some readings are modestly elevated, but on balance they appear to be showing investors that are still hesitant to fully embrace the market. We believe this to be positive, with the possibility of those skeptics finally returning to the stock market. As always, we continue to recommend a diversified portfolio consistent with your risk tolerance and time horizon. We also remind investors that fixed income positions cannot be substituted for with equities, which have a much longer time horizon.

Economy on the Rebound?

Helping to fuel the recent rally, in our opinion, is data that shows US growth perhaps reaccelerating after a soft spot in the earlier part of summer. Recent releases can best be described as "not too hot and not too cold," neither hot enough to force the Fed's hand nor cold enough to engender recession fears. This is especially true with the payroll report, which showed 162,000 jobs were added in July, a bit below estimates but still moving in the right direction and helping the unemployment rate fall to 7.4%, which is the lowest since December 2008. While positive, the internals of the release likely didn't thrill the Fed as hours worked fell and the number of part-time workers that would like full-time work rose. However, it's important to remember that the unemployment report is lagging in nature and should be taken in context with the more forward-looking data we receive. For example-the leading indicator of initial jobless claims continued its downward trend, recently posting its best reading in almost six years.

We believe we saw a soft patch early in the summer as we saw manufacturing data weaken and a sluggish 2Q GDP reading of 1.7% growth and may now be showing up in the lagging employment report. Encouragingly, we're starting to see a reacceleration. The Chicago PMI reading rose to 52.3 from 51.6. The larger Institute for Supply Management (ISM) Manufacturing Index rose to its best level since June 2011 by posting a reading of 55.4, up from 50.9. Internals for the report were even better as new orders jumped to 58.3, employment moved back into territory depicting expansion at 54.4, up from 48.7, and production boomed at 65—the best reading of that component since May of 2004. The manufacturing data was matched on the services side by the ISM non-Manufacturing Index by a reading of 56.0, well above consensus and up from the 52.2 seen in the month prior.

Indications of an upturn

Source: FactSet, Institute for Supply Management. As of Aug. 6, 2013.

Two of the major drivers of the economy continue to do well, although the recent rise in interest rates has caused some consternation as to the potential for further improvements. Auto sales continue to be quite strong, with July sales reports being quite positive, and one US automaker cutting the time of its traditional summer slowdown in order to meet solid demand. On the other driver, we've seen the spike in rates have at least a temporary impact on the housing market as mortgage applications have fallen.

Interest rate gains are having an impact

Source: FactSet, Mortgage Bankers Association. As of Aug. 6, 2013.

However, prices continue to rise, inventories are still tight in most of the country and rates, although somewhat higher, still remain historically low. A modest slowdown in the housing recovery is a good thing in our view as there were some indications that bubble-like conditions were returning in some areas of the country—a situation we certainly don't want to return to. And we remain confident that the Federal Reserve has no interest in slowing the housing market too much, and would likely respond quickly should the deceleration become too severe.

Fed questions growing, while Congress "rests"

The housing situation is but one of the myriad of factors the Fed is looking at when trying to determine when to begin to wind down their asset purchase program, with which they are currently buying $85 billion/month in government securities. Many on the Street had been focusing on the September Fed meeting as the one when the "tapering" would most likely begin, although the lackluster July jobs report injected more uncertainty into that prediction. We believe its still likely the Fed will at least get the ball rolling with a very modest pullback in its asset purchases, but we still have quite a bit of time for emerging data to sway their decision in one direction or the other. The Chairman and other Fed members have been preparing investors for this eventuality since May and it appears to us that there is at least a certain amount of comfort in the market with the idea of a modestly less accommodate Fed. And after Labor Day, we should hear more chatter about who the next Fed Chairman will be, which could inject some additional volatility into the market.

Additional uncertainty will almost certainly come from down the street when Congress comes back to work following their current five-week hiatus. Job one will likely be coming to an agreement to raise the debt ceiling, which needs to occur by October 1. Time will be tight, and rhetoric surrounding the issue has heated up over the past couple of months—making it appear highly unlikely that anything will be resolved until the last minute. Additionally, the corporate tax structure and the funding of the Affordable Care Act have already caused squabbles in Washington which are likely to escalate. We don't know how the current disagreements will be resolved but we remain fairly convinced of two things: 1. agreements avoiding the worst possible scenarios will be made in time, and 2. the uncertainty surrounding the discussions will cause consternation in the markets that result in buying opportunities.

Will a flare up in the eurozone debt crisis disrupt the calm?

In recent years, every summer seemed to have a flare up in the eurozone debt crisis. However, a sense of calm has prevailed since European Central Bank (ECB) President Mario Draghi said the ECB would do "whatever it takes" to preserve the euro just over a year ago. As a result, eurozone financial conditions have improved, with yields on peripheral government bonds falling.

Eurozone peripheral debt markets calming

Source: FactSet, iBoxx. As of Aug. 6, 2013.

Despite the calm, not all is rosy. European banks continue to be undercapitalized and deleverage, resulting in weak lending that is a headwind to growth—private sector lending fell by a record 1.6% in June from a year ago. Positively, more companies are tapping capital markets for funding, but this is not an option for small- and medium -sized businesses.

Some have questioned whether the calm is waiting for the German election on September 22 to break. We don't believe chaos is about to set in, but German elections could bring changes that increase volatility, particularly another Greek restructuring. Elsewhere, political stability in many peripheral countries remains, but politics are unlikely to shift dramatically. Early elections could be called, notably in Italy, but voters in most countries have been reluctant to leave the safety of the center. As BCA Research notes, voters fear the uncertainty of extreme parties more than bad economic realities.

We're taking some solace from the economic and sentiment data and believe that improving economic conditions can partially "cure" many ailments. Some of the positives:

  • Leading economic indicators for most eurozone countries have been improving since October 2012.
  • The eurozone manufacturing PMI moved above the 50 level that denotes expansion for the first time since July 2011 and the eurozone composite PMI that includes services increased above 50 for the first time since January 2012.
  • The German Ifo survey showed optimism by businesses rising for the third straight month, French business sentiment at the highest level in 15 months, and eurozone consumer confidence at a 22-month high.
  • Spanish unemployment has fallen for five months.
  • Spanish exports are at an all time high.
  • Irish home prices rose for the first time in more than five years.

From an economic perspective, the eurozone may be bottoming and could emerge from recession later this year. We believe volatility in eurozone stocks is likely to be a buying opportunity, as a fair amount of bad news has likely already been priced in, and earnings and valuations are depressed.

Japan: will they or won't they raise the sales tax?

Japan's economy has rebounded in 2013 on the heels of fiscal and monetary stimulus, the first two of Prime Minister Abe's "three arrows" to revive the economy. Now comes the hard part—structural reforms to improve the growth outlook—which we believe are needed to sustain the economic recovery.

The most imminent policy decision will likely be the consumption tax, which hinges on second quarter GDP growth, issued in two estimates, the second expected on September 9. The current plan is to raise the tax in two increments, from 5% to 8% in April 2014 and then to 10% in 2015. The tax would likely boost growth before implementation and reduce growth immediately after. However, looking at yearly figures, the impact is more muted, with the Bloomberg consensus expecting 1.4% GDP growth in calendar 2014 and 1.3% in 2015.

Consumption tax could put Japan's economy on pause

Source: Bloomberg. As of Aug. 6, 2013.

The government wants to make sure the economy is healthy enough to withstand the tax increase and may consider ways to reduce the hit of raising the tax by either implementing a short-term offsetting fiscal stimulus or slow the increase to 1% at a time. Markets likely want Abe to tackle reforms to prove he is serious about fiscal consolidation. We believe Japanese stocks could move sideways near term, but the intermediate term outlook is positive for patient and disciplined investors. A weak yen relative a strong US dollar could reduce returns, and investors may want to consider hedging currency exposure.

Is China stimulating?

China's leadership transition this year ushered in restraint and the recognition that some excesses were building in the world's second-largest economy. Policymakers tried cracking down on the shadow banking sector, government extravagance, and property speculation, enduring short-term economic pain for longer-term gain.

However, with concerns about whether the government could stop growth from falling further, it appears 7.0% is the "bottom line" 2013 growth that the government will defend. Positively, Beijing realizes that they need to avert a hard landing and are seeking ways to moderate the slowdown in the economy.

However, most of the measures announced so far sound like those of the old model for growth (investment in infrastructure and property), something we view as unsustainable. These measures can provide a floor, but until there is more excess removed from the economy, we don't believe growth will be healthy.

Sentiment is now fairly pessimistic, a positive from a contrarian point of view. However, it might be too early to say conditions are favorable for a new bull market in China-related investments. The rally since the end of June in Chinese stocks has been led by conservative sectors, typically not the type of leadership that indicates a new bull phase and foreign investors are more bullish than domestic investors. Additionally, we remain concerned that bank profits will be reduced by reforms, and financials are the largest weight in broad market indexes.

We believe there is a structural change happening in China, not a cyclical one, in other words, not a "soft patch." This means a longer-term adjustment and more pain is likely. Thus far there has been no "rebalancing" away from debt-led investment growth.

We believe China-related investments, including emerging market stocks and commodities, 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.

So what?

Record highs in US equities have resulted thus far in only modestly elevated investor sentiment and it appears retail investors are returning to the market, which could fuel further gains. However, volatility is likely to increase with political and Fed issues on the horizon. Europe remains attractive, along with Japan, but we are watching the potential consumption tax increase closely, while China's valuations are improved but concerns remain.

© Charles Schwab

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