- Stocks continue to exhibit no clear direction, although record highs for the larger-cap averages were again reached. A retreat in fixed income yields gives us pause as a potential warning sign, although distortions exist. The next decisive move in stocks could go either way, but we believe the ultimate trend is higher.
- The economic expansion appears to be gathering momentum, which should feed on itself, although housing continues to be a concern. Fed tapering is ongoing as signs are emerging that inflation is picking up.
- First quarter growth in Europe disappointed but there are some optimistic signs looking ahead, and equities look attractively valued. The Chinese property market weakness is concerning, but we believe extreme worries are overblown.
NOTE: Due to the upcoming holiday, the next scheduled Schwab Market Perspective is June 13, 2014.
The economy appears to be improving; yet the stock market has been meandering, some segments have had more serious corrections, and bond yields have moved lower once again. Markets and fundamentals can become disconnected over short time horizons, but ultimately tend to move together over the longer term. We see the U.S. economy picking up steam off the weak first quarter, which should help to boost corporate profitability and ultimately stock prices. The likelihood of a near-term correction is elevated as we are in the heart of a traditionally dangerous time in the calendar for stocks (both the typically-weak May through October and the midterm election periods). But there is little to indicate to us that an economic downturn is on the horizon, which leaves us in the optimistic camp believing that the bull market is not winding down.
In additional to aforementioned seasonal/election pattern risks, there are others as well. The retreat in the 10-year Treasury yield is high on that list, with the yield recently dipping below 2.5% again. With the economy improving and some signs of inflation picking up we would traditionally expect yields to move higher—and we still believe that will ultimately occur. At this point, we don't believe the bond market is signaling a serious economic problem. There are several reasons beyond just recent weak growth for lower yields, including: demographics, waning Treasury issuance thanks to the dramatic improvement in the budget deficit, central bank policies around the world, deflationary impulses from Europe, China, and Japan, and geopolitical risks. There is clearly a global search for yield as we've seen high yield bonds also rise in price; while demand for sovereign debt, even in some of the countries that were recently on the precipice of default, has resulted in record low yields around the globe. We urge investors to be especially mindful of the risk associated with the search for yield. Low yields can be frustrating, but capital losses due to taking on more risk than appropriate can cause real damage to financial plans.
The economic snowball
We don't believe low yields are sending a dire economic warning given that leading indicators are showing a healthy rebound from the weak first quarter. And we believe this improvement can build on itself and become reinforcing as we head into the second half of the year. For example, corporate confidence—even among smaller companies—is improving, while other leading indicators of capital spending have moved higher.
Source: FactSet, Natl. Federation of Independent Business. As of May 19, 2014.
In a clear sign of improving confidence and the return of "animal spirits," merger and acquisition activity is booming. Heightened deal activity tends to feed on itself as it unleashes corporate competitiveness and attendant activity.
We believe this will also lead to more spending on structure, equipment and efficiency-enhancing technology. This could result in increased capital spending and a boost in hiring, as seen in reduced jobless claims and falling unemployment. As slack gets removed from the labor market, wages may start to rise, which provide more disposable income, increasing demand, and causing companies to add to capacity, and so on. This is the self-reinforcing cycle that we've been looking for since the recession ended, and it appears we may be on the precipice.
Although retail sales ex-autos and gas fell slightly in April, March was revised higher and we are seeing signs of a healthier and more confident consumer. With unemployment lower, housing prices higher, and wages growing at least moderately, consumer confidence should continue to improve. And in a sign that the most extreme phase of the deleveraging cycle households have been in since 2008 may be over, debt growth has been rising for three consecutive quarters. With debt levels down meaningfully, and savings rates up, this is likely a healthy sign for the economy more broadly.
Source: FactSet, Federal Reserve. As of May 19, 2014.
However, one potential fly in the ointment is the slowdown in home sales and the associated weakness in confidence by builders. The National Association of Homebuilders (NAHB) Index surprisingly fell to 45, indicating more homebuilders thought the housing market was weakening. And although housing starts jumped a robust 13.2% in April, much of that was attributable to the more volatile multifamily category. The heart of the home selling season is right now, and we would like to see some improvement, especially with lower bond yields leading mortgage rates down. Higher rates and home prices had meaningfully crimped affordability, which could be in the process of easing. A possible aid comes from Washington via the recent announcement by the Obama Administration that they are pushing for looser mortgage lending standards (Wall Street Journal, May 14, 2014). While we certainly don't want to return to the "no standard" days of the housing bubble, some loosening of overly tight standards seems to be appropriate.
Fed maintains its course
Commentary by Fed Chairwoman Janet Yellen, as well as other Fed members, indicate that while the Fed is somewhat concerned about the weakness in the housing market and continued elevated unemployment, the tapering of the bond purchases will continue. Purchases of Treasuries and mortgage-backed securities (MBS) are down from $85 billion to $45 billion per month, and likely headed toward zero before the end of the year. With that action largely baked in, attention has turned to when the Fed will begin hiking short-term rates. Fed members are attempting to convince markets that it will be well into 2015 before that occurs, but developments in the economy could force their hand. While we don't see inflation as a concern at this point, the cycle described above can push prices higher relatively quickly and unleash an inflation "scare." In fact, we are seeing at least nascent signs of increasing inflation as the April Consumer Price Index (CPI) showed a rise of 2.0% year-over-year on the headline level, and 1.8% at the core level; not concerning, but up from previous readings. And the April Producer Price Index (PPI) showed an even sharper increase over the past two months. We've also seen a rash of anecdotal stories of skilled labor shortages, which should help to support wage increases, signs of which are appearing. And, minimum wage hikes historically have caused inflation to rise a bit as companies try to pass on higher labor costs to their end consumers. That said, the bond market doesn't indicate inflation is a concern, but sentiment can change quickly.
Will Europe bring down global growth?
After emerging from recession in 2013, the eurozone began 2014 in a disappointing fashion, with first quarter gross domestic product (GDP) growth of 0.2% (quarter-over-quarter) missing the 0.4% consensus forecast. In fact, growth in Italy and Portugal fell back into negative territory and France stagnated; and when combined with consumer prices still falling in many countries, some have questioned whether the region will fall back into recession.
We concede that with growth at such a slow pace, there is the risk economic momentum moves the opposite direction of the United States and slips into a negative virtuous cycle; with deflation the primary potential culprit that sets off the negative reaction. Deflation, or a broad-based decline in prices, is a risk because once expectations of lower prices in the future set in, consumers and businesses tend to postpone spending, resulting in lower sales and job losses, and a negatively reinforcing cycle.
Paradoxically, the strength of the euro has also contributed to the eurozone's problems. Typically, currency strength is viewed as a positive because it increases consumers' purchasing power by suppressing prices. However, with demand and inflation at such low levels, it has become a risk to the continuation of the eurozone's economic recovery, causing "serious concern" for the European Central Bank (ECB). To combat this risk, and given the likely downgrade to the ECB's economic forecasts, the ECB has signaled its expectation that it will act at its June meeting. We believe this action is likely to be more symbolic in nature rather than revolutionary; and there is the risk the market is disappointed. We discuss how the ECB's current stimulus program differs from the Fed's, and our belief that the need for a large scale asset purchase program, or QE, dissipates by the time it could be deployed in our article.
In fact, there are reasons to be optimistic the eurozone's recovery improves rather than deteriorates. After previously subtracting from growth, the contraction in lending could be stabilizing and remove a headwind. Domestic demand is also improving and could start adding to the recovery. Broad eurozone unemployment peaked at 12.0% in September 2013 but has been trending down—even employment in Spain increased 1.2% year-over-year in April. In Germany, a tight labor market is likely to result in increasing wages. Retail sales in the eurozone have been a glimmer of hope as well, rising at a 2.7% quarter-over-quarter annual rate in the first quarter.
Source: FactSet, Eurostat. As of May 20, 2014.
We believe that easier access to credit, and economic recovery, will eventually feed through to better earnings; although the near-term could be uncertain. Meanwhile, we believe eurozone stocks are attractively priced and solid dividend yields will pay investors to wait. On a cyclically-adjusted price earnings (CAPE) basis, which adjusts for changes in the business cycle, eurozone stocks trade at a 40% discount to US equities; close to the largest difference in at least 30 years according to BCA Research.
Will China's property bubble burst and create a hard landing?
China's economy continues to slow; with the slowing property market the latest addition to the risks that include a shadow banking crisis, excessive local government debt, and industrial overcapacity.
Of these, the slowdown in the property market is the biggest risk in our view. In particular, it could also ensnare local governments, which are tied to the property market due to their reliance on land sales for revenues. The origin of the Chinese property market slowdown started with a big increase in supply late last year, combined with cash flow constraints for property developers this year due to reduced credit availability. Developers began to slash prices to unload inventory to meet cash flow needs and reduce risk. This in turn has resulted in Chinese buyers delaying purchases and has slowed new construction.
The good news is that price cuts are starting to attract interest, with Chinese households' intention to purchase homes increasing notably. Additionally, China's banks have been ordered to loosen lending standards for first-time buyers, and some cities have begun to ease purchase restrictions. While the inventory of homes available for sale has increased, household formation is a strong demand force that can soak up inventory in a short time frame; and current levels of inventory are not at record high levels. Notably, developer confidence remains elevated despite the slowdown, and the property developer stock index has been trending sideways. A crash in the property market does not appear imminent in our view.
Source: Bloomberg. As of May 20, 2014.
China's growth slowdown isn't over however, and more growth scares are likely in the coming months. A key factor in the slowdown is restrictive monetary policy, as access to credit has been reduced and real interest rates have increased. Liquidity in the banking system is could become tight, and more debt defaults may occur as the June quarter ends. In fact, the longer policymakers keep the screws on credit, the higher the risk of a policy mistake and a hard landing.
We believe Chinese policymakers have plenty of ammunition to fight a plunge in economic activity, and monetary and fiscal policy appears to be loosening at the margin. While the United States "over-spends," China "over-saves"—domestic savings are about 50% of GDP, translating into new savings of $4.5 trillion every year. Additionally, China has a closed capital account that restricts money moving in and out of the country. Also, the government controls the majority of bank assets, and has $4.0 trillion in foreign exchange reserves to fight a liquidity crisis. Lastly, the recent decline in the Chinese currency, the yuan, is likely to boost earnings later this year, creating the potential for upward earnings revisions and an eventual rise in the stock market.
Meanwhile, Chinese stocks are pricing in a lot of bad news. As long as a hard landing is averted, we believe the risk/reward is favorable for owning Chinese stocks, within a market weight to emerging market stocks overall. Read more in Why New Reforms Make Chinese Stocks Attractive.
Although the stock market remains sluggish, with the potential for a correction elevated, the U.S. economy appears to be improving. There is probably no great rush to get into the stock market at this point, but maintaining a steady investing discipline in the face of what we think is a continuing secular bull market is key. Investors frustrated with the low yield environment should be careful about adding too much risk to a portfolio in search of higher yields.
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