- Stocks had a rough start to the year, and economic data has been mixed-to-weak; albeit highly weather-related and likely temporary. The pullback in stocks may have further to run but frothy investor sentiment conditions are correcting, likely setting the stage for another sustained uptrend.
- A debt deal avoids another government showdown in the near term but concerns over the impact of the Affordable Care Act continue to swirl. The Fed, however, remains comfortable enough with economic progress to continue paring back asset purchases ("tapering").
- European equities remain relatively attractive although work remains to be done in terms of the eurozone economy. Japan's economic progress seems to have stalled and we are concerned about their commitment to growth. Meanwhile, we don't believe emerging market (EM) troubles will spread, while China looks relatively attractive in that space.
Consider yourself fortunate if you haven't had to deal with severe winter weather conditions, either directly or indirectly, over the past couple of months. Given the weak start to the year, investors are wondering whether it's an omen for the rest of the year; or whether the weakness is temporary, and a buying opportunity.
Stocks have been weaker and more volatile for a variety of reasons. Profit-taking and asset allocation adjustments are natural after a stellar year in 2013. Fed tapering has also unleashed round two (round one was last summer) of concerns in many emerging market (EM) countries. Low yields in the United States and developed markets led investors to hunt for higher yields among higher-risk emerging markets. Now that the Fed has begun to taper, some of that risk is being unwound. Although earnings season has been decent, it hasn't provided the necessary offset to the aforementioned drags. Finally, there have been some weaker economic releases, including job growth and retail sales, that may be indicating a slowdown in the US expansion.
The market's weakness has caused many sentiment indicators to move down from extreme optimism levels, which may help set the stage for a potential renewed move higher. But more work likely needs to be done, with the Ned Davis Crowd Sentiment Poll only moving into the low end of neutral territory. This is also a midterm election year, and looking at history, the S&P 500 posted an average decline of over 18% in every midterm election year since 1962 according to Strategas Research Partners The good news is that in every one of those instances, the S&P 500 was higher one year after the trough of the correction, by an average of 32%.
Cold weather = soft data?
An extremely soft December employment report was followed by another lackluster gain of 113,000 jobs in January, although the unemployment rate did dip to 6.6%—the lowest level since October 2008. The details of January's job report were much more positive than the headline, with 650,000 jobs created as per the "household survey" (from which the unemployment rate is calculated); and the rate declined despite an uptick in the labor force participation rate.
Also on the weaker side, the Institute for Supply Management (ISM) Manufacturing Index fell from 56.5 in December to 51.3 in January, with the internal readings on new orders and employment showing similar weakening. Fortunately the weakness was not matched by the ISM Non-Manufacturing Index, which maintained its recent strength (and represents a much larger share of the US economy). Finally, we've seen some weakening in retail auto sales, and some softness in the housing market; all undoubtedly affected by the extreme weather.
Source: FactSet, Institute for Supply Management, US Dept. of Labor. As of Feb. 10, 2014.
As you can see from the chart above, the recent ISM Manufacturing reading was a departure from recent trend, as were the December and January jobs reports. Also, other data has been more inline with the recent trends we've seen; including regional manufacturing surveys and the aforementioned ISM services index. Within the latter, the employment index was notably strong; further reinforcing the view that weather has wreaked havoc with the published jobs numbers. Also encouraging was Markit's Purchasing Managers Index (PMI) for manufacturing, which is gaining more credibility relative to the ISM and posted a solid 53.7 reading in January. And one of the most important leading indicators, jobless claims, continues to trend along in the range that indicates a decent labor market.
Claims indicate improving labor market
Source: FactSet, U.S. Dept. of Labor. As of Feb. 10, 2014.
Although it appears weather has had an impact on economic data, the weakness should not be completely dismissed. Higher energy bills cost consumers real money, postponed hiring means a delay in getting some people back to work, and some purchases not made due to cold will likely never be made up. But in terms of growth trends in the economy, we don't believe this will inflict lasting damage.
One benefit that should not be overlooked from the weak equity start to the year has been the downtrend in yields that we've seen, as the 10-year Treasury yield has moved from about 3% at the end of last year back down to under 2.7% recently. This helps to support both equity valuations and the housing market. As rates began to move higher last year, we've saw the improvement in the housing market slow; but with rates lower again, it could reignite the housing market, supporting both the economy and consumer confidence.
Another showdown avoided
Congress decided the debt ceiling wasn't worth the drama again and extended the ceiling for one year. However, the controversy over the Affordable Care Act (ACA) continues to simmer, with both sides using incoming numbers to help bolster their case. We share the concerns over the ACA's impact on the economy. There are increasing stories of companies cutting workers hours in order to not have to provide health insurance, while the healthy/sick signup ratio appears to be unworkable at this point. Adding fuel to the fire was the recent report by the Congressional Budget Office (CBO) predicting that the ACA will result in over 2 million people leaving the workforce over the next seven years; not a positive for productivity specifically, or the economy overall.
Europe's recovery still intact
Similar to the United States, a reduced fiscal drag and less uncertainty about an economic cliff are benefitting the eurozone. Unlike 2013, the eurozone could actually add to global growth rather than subtract from it; with the Bloomberg consensus forecast expecting a swing from -0.4% in 2013 to growth of 1.0% in 2014. While not terribly exciting growth, the turnaround in the eurozone should not be ignored, as the 18-countries of the eurozone equate to the second-largest economy globally.
Unfortunately, the eurozone's recovery is not yet self-sustaining. Lingering after-effects of the recession are evident; with lending still contracting and prices of goods and services moderating to levels that have brought about concerns of deflation, or a broad-based decline in prices.
While there are downside risks, we believe the eurozone's recovery will continue, as leading economic indicators, PMIs, and confidence continue to improve. The eurozone's PMI hit the highest level since July 2011 in January, while Germany's hit the highest since May 2011. The improvement in the German survey was led by demand from both domestic and foreign markets, with Asian countries and the United States mentioned as sources of growth.
Indications eurozone recovery likely to continue
Source: FactSet, German Federal Statistics Office, IFO National Institute of Research, Eurostat. As of Feb. 11, 2014.
Improved confidence and new orders could help create self-sustaining growth in the eurozone. The German recovery may be translating into "meaningful job creation" according to Markit, and eurozone unemployment has been steady for months. Job growth could help stimulate consumer spending, which would likely create a healthier and more sustainable recovery than one reliant on manufacturing and exports.
In terms of risks, we believe France and Italy need significant reforms to avoid lost decades and that the European Central Bank (ECB) needs to provide more stimuli to thwart deflation. Additionally, bank resolution rules have yet to be finalized and European parliamentary elections in May could reignite anti-euro sentiment. Despite these risks and the potential for volatility, we remain positive on European stocks, due to the prospects for economic, lending and profit margin improvement.
Japanese stocks awaiting clarity
Japan's economic outlook is uncertain, as inflation is rising due to the weak yen lifting import prices for food and energy and a sales tax hike that begins in April. Consumers are having a hard time keeping up, as basic wages fell 0.2% in December; and taking into account inflation, real wages fell by 1.1%. As a result, this Spring's wage negotiations will be closely scrutinized.
Adding uncertainty, investors are confused about Bank of Japan (BoJ) monetary policy. Investors believe the BoJ needs to increase stimulus, as the BoJ's own forecast has inflation still below the 2% target for the fiscal year ending April 2016. Meanwhile, the amount of monthly BoJ asset purchases has been unpredictable, and commentary by BoJ Governor Kuroda that inflation would level off at 1.25% until the summer, prompted some investors to believe the BoJ would not increase its asset purchase program in the near term.
Lastly, emerging market turmoil resulted in the yen strengthening to the detriment of Japanese stocks, which have tended to take their cue from the yen in an inverse relationship over the past year. Until these issues have better clarity, we believe the wait-and-see stance toward Japanese stocks is likely to continue.
Will emerging markets hurt developed markets?
After a strong rebound in 2010, emerging market (EM)growth has been slowly waning. In fact, growth in 2012 and 2013 for the overall emerging world disappointed many investors who thought a return to pre-crisis growth rates was inevitable.
We've been flagging EM structural issues for over a year, but "tapering" by the US Federal Reserve and capital outflow from emerging markets is exacerbating the problems. US Treasury yields are expected to rise due to Fed tapering and US economic growth accelerating, boosting the attractiveness of the US dollar relative to other currencies. Countries dependent on foreign investment due to current account deficits and/or high amounts of short-term debt denominated in US dollars could be vulnerable to the self-feeding loop of currency declines, inflation threats, monetary tightening and slowing growth.
Forecasted rebound in EM growth could be postponed
Source: FactSet, IMF WEO Oct. 2103 Outlook. As of Feb. 11, 2014.
As a result, the recent EM financial market turmoil is likely to slow economic growth and postpone the reacceleration in EM growth that was forecasted by the International Monetary Fund (IMF) last fall. Already, the HSBC composite PMI for 17 emerging economies fell to the weakest in four months in January, to 51.4 from 51.6 in December. Notably, manufacturing and exports outperformed services in January; and countries with closer ties to developed markets posted stronger growth. While EM growth is likely to slow further in coming months, the data thus far support a slow moderation, not a collapse. Additionally, we do not believe we are on the verge of a repeat of the Asian financial crisis in 1997, as EMs are in a stronger position due in part to flexible exchange rates, which allow for gradual, rather than abrupt adjustments; larger local currency debt markets; lower external net debt; and higher foreign exchange reserves.
The implication is that unless the EM slowdown becomes more pervasive or long-lasting, global growth could take only a modest hit. While EMs have been a major driver of growth in recent years, the good news is that developed country growth is improving, notably in the United States and Europe. Additionally, developed market companies have been adjusting to operating in a slower EM growth environment for several years.
EM stocks could continue to struggle, but we believe they still deserve a weight equal to your long-term strategic asset allocation to EM. Within the EM equity allocation, we believe Chinese stocks could outperform as its recently-announced reforms begin to take hold. Chinese stocks could continue to be weighed down by concerns about slowing growth and Chinese debts souring; but China could be a ray of light in the EM turmoil, as it is ahead of the EM universe in taking steps to restructure its economy. Read more in Emerging Markets: Stay or Go?, Why New Reforms Make Chinese Stocks Attractive and at www.schwab.com/oninternational.
The recent slowdown in economic data appears to be largely weather related and we believe decent growth will reassert itself. Stocks have bounced after a weak start to the year, but the threat of a further pullback remains, although our longer-term optimism has not been dented. Likewise, we believe Europe offers some attractive investment opportunities but we're in a wait-and-see mode with Japan. Finally, we don't see EM turmoil becoming overly contagious, but we are watching that situation closely.
© Charles Schwab