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Schwab Market PerspectiveLiz Ann SondersSenior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc., Brad Sorensen CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research, and Michelle Gibley CFA, Senior Market Analyst, Schwab Center for Financial Research October 14, 2011 Key points
The focus of investors so far in 2011 has been on global macroeconomic developments. Just last quarter we saw a solid earnings season largely overshadowed by the debt ceiling debate in the United States and the continuing debt crisis in Europe. To some extent, it's appropriate that focus remains on these larger issues as they could impact vast swaths of the global economy, including corporate earnings. However, earnings season can also provide a glimpse for investors as to how lack of confidence among businesses and consumers is manifesting itself in terms of actual activity. Earnings estimates for the third quarter have been revised down over the past couple of months as the global slowdown has led to top-down changes. According to ISI Research, the current consensus for S&P 500 companies is now 14.1% earnings growth year-over-year, down from 17.6%. A benefit is that the bar has been lowered. We believe the lower threshold is likely to be at least modestly exceeded as demand in much of the economy has not fallen off a cliff and economic indicators continue to suggest at least sluggish growth. A positive earnings season, combined with some marginal signs of progress on resolving the eurozone debt crisis, could aid a fourth quarter rally in stocks. Additionally, sentiment indicators suggest a better market. These indicators tend to be contrarian in nature, so when consumers and investors increasingly despair, the outlook for stocks tends to improve. Recently, the Ned Davis Research Crowd Sentiment Poll reached pessimistic levels not seen since the 2008 financial crisis, which preceded a nice short-term rally in the market. Also, Consumer Confidence as reported by the Conference Board remains well below the 66 level that has been an indicator of positive stock market performance in the past. The average gain for the Dow when confidence has been below 66 has been 12.5% annualized. Remember, the stock market is a leading indicator and many economic indicators reflect what’s already happened in the economy (i.e., are lagging indicators). It is always vital to maintain a diversified portfolio that is appropriate for your time horizon and risk tolerances. If you are under-exposed to equities, we recommend taking advantage of market volatility to add to positions. Valuations are attractive given low interest rates; if a recession is avoided, estimate cuts have probably been sufficient; and the aforementioned sentiment conditions are a positive. Soft Growth Continues While the US economy still seems to be well short of firing on all cylinders, data suggests that at least modest growth continues and that a recession is not in swing. The Institute for Supply Management's (ISM) released both their manufacturing and non-manufacturing surveys and both remained in territory depicting economic expansion. The Manufacturing Index improved from 50.6 to 51.6, while the employment component also bounced from 51.8 to 53.8—indicating at least modest improvement in employment. The Non-Manufacturing Index, which captures the much larger service side of the economy, dipped slightly from 53.3 to 53.0 but still remained in territory depicting expansion. ISM Surveys continue to point to growth  Source: FactSet, Institute for Supply Management. As of 10/10/2011. However, the surveys are still conveying a mixed picture as the backlog of orders component within manufacturing dipped to 41.5, the lowest level since April 2009, a potential warning of waning demand. The employment component of the service index fell to 48.7, depicting worsening employment conditions and its lowest reading in 15 months. Of concern to many investors has been the decline in commodities, especially traditionally economically sensitive copper.. Are commodities telling a concerning story?  Source: FacSet, Commodity Research Bureau. As of 10/10/2011. However, this can be somewhat beneficial as well, as lower commodity prices allow consumers more discretionary money to spend and have helped retail sales stay relatively strong despite continued low consumer confidence readings. Employment conditions remain mixed, too. The leading indicator of initial jobless claims have encouragingly trended lower over the past several weeks, bringing the four-week moving average closer to the key 400,000 mark. Also, the ADP payroll report showed private payrolls expanded by 91,000 in September. Further confirmation came from the September payroll report that showed 103,000 jobs were added, while private sector payrolls improved by 137,000. While these numbers are better than expected, and the previous two months were revised higher, they aren’t enough to bring down the unemployment rate of 9.1%. While encouraging that the labor market isn’t falling off a cliff as some had been predicting, we still need greater gains in order to eventually bring down the unemployment rate. Fed impact in question, while Washington solutions remain doubtful The Federal Reserve continues to try a wide variety of actions in an attempt to stimulate the economy. The latest iteration has been "Operation Twist" which involves using proceeds from shorter-maturity securities to invest in longer-maturity maturities. Since the announcement, the yield curve has indeed flattened, which was at least partially the goal, but we have yet to see mortgage applications pick up substantially, suggesting the impact may be limited. The Fed's frustration with Congress was fairly evident in Chairman Bernanke's testimony as he noted that each policymaking arm had a part to play in trying to stimulate economic growth. Confidence among businesses and voters in Washington remains extremely low and businesses continue to point to uncertainty with Washington policies combined with increased regulatory burdens as to reasons why corporate spending remains stymied. While it appears the jobs bill proposed by President Obama has little chance of passage and we question the effectiveness of it even if it should pass, we are now looking toward the November deadline for the recommendations from the debt committee. We remain hopeful that something meaningful and substantial results from their meetings, but given the current environment, aren’t holding our breath. Tide turns on eurozone debt crisis? There has, however, been some positive movement in Europe and the eurozone debt crisis may have turned in a positive direction, as policymakers' discussions about a "euro TARP" is a sharp reversal from recent denials that banks need additional capital buffers. The possible turn toward coordination and action by policymakers brought relief for global markets. We remind investors that the most significant moves in stocks often come as trends change direction. While orderly solutions appear more likely than disorderly chaos and a collapse of the eurozone banking system, or Lehman 2.0, it cannot be dismissed outright. A "euro TARP" still has obstacles, policymakers have disappointed in the past, and a detailed plan is at least several weeks away. On the sovereign side, while EFSF 2.0 (the July amendments made to the European Financial Stability Facility) is being finalized, further changes are likely needed. In our view, a still larger-sized bailout fund is needed to "ring-fence" the sovereigns, Spain and Italy in particular. Ideas include using the EFSF to absorb a portion of losses on European Central Bank (ECB) purchases, or to provide other guarantees. Policymakers seem to be buying time to put in place mechanisms to backstop both banks and sovereigns in preparation for the likelihood that a Greek debt restructuring could occur later this year. Implementing these complex plans and coordinating across 17 nations and other organizations may not be a smooth process. European banks could experience further downside from possible additional sovereign write-downs and ownership dilution from capital infusions. Excluding banks, we believe European equities have an upward bias short-term due to the potentially lessened Lehman-type risk. However, we are neutral intermediate-term on European stocks, as there may be more downside risk to eurozone earnings estimates than elsewhere globally due to a probable eurozone recession, as well as a longer-term drag due to low growth prospects in the PIIGS. The eurozone economy may become a victim of the prolonged debt crisis, and may already be entering a recession. Even before the chaotic third quarter began, eurozone gross domestic product (GDP) grew only 0.2% in the second quarter, below the 1.3% pace in the United States. Banks are facing a credit crunch, having difficulty accessing funding, need more capital in our opinion, and are likely to rein in lending and/or charge higher rates to borrowers. Eurozone businesses are already talking about tighter credit and may begin to protect cash by freezing or cutting employment, capital investment and discretionary spending, reducing production or reducing inventory. Industrial production has started to weaken and even the stronghold of Germany is being pulled into the mess. Europe may already be in a recession  Source: FactSet, IMF, IFO, Eurostat. As of October 11, 2011. Meanwhile, the PIIGS (Portugal, Italy, Ireland, Greece and Spain) are a likely drag on eurozone growth longer-term due to austerity and likelihood of significant downward pressure on household incomes. Concerns shift East to China While all eyes have been on Europe, concerns may shift to China. The global slowdown is impacting manufacturing in China, pressuring the purchasing manager index (PMI) to levels below historic averages in 2011. Chinese manufacturing below average  Source: FactSet, Bloomberg. As of Oct. 11, 2011. Seasonal average over a six-year period excluding a one-year period from May 2008—June 2009. Downside risks to the Chinese economy have increased, centered on three areas: a continued narrow focus on inflation by policymakers while ignoring growth, a reduction in exports is exposing the potential for an underground lending crisis, and a hit to growth from a slowdown in property and infrastructure spending. Many exporters are small and medium-sized enterprises (SMEs) who rely heavily on the underground bank market, where interest rates are 30-50% per year and higher. However, SMEs are under strain as their already thin margins have been squeezed due to lack of pricing power, rising labor and raw materials costs and a slowdown in exports, and defaults have begun to rise as a result. We’re monitoring this situation, as SMEs account for 80% of employment in cities and contribute to more than 50% of China’s GDP. The extent of the risk is unknown, but China Confidential, the research service at the Financial Times, indicates the shadow banking system now supplies more credit to the economy each month than formal banks. The risk is a credit crunch should cash flow problems reverberate throughout the economy. Additionally, property and infrastructure construction, which constitutes nearly 50% of the economy, is slowing. A property slowdown is not unexpected, but developers are experiencing a cash squeeze, as the cash faucet from the underground lending market has increasingly turned off. Property developers have begun to discount prices to reduce inventory, discouraging new builds. Elsewhere, infrastructure construction has wound down as stimulus projects are coming to completion, and concerns about local government debt and corruption have prevented new projects from starting. Despite the negativity, a hard landing would probably require a US, and therefore global recession to occur. During the depths of the recession, Chinese exports tumbled by 40% between September 2008 and February 2009. The great recession resulted in calendar year 2009 GDP in the United States falling 3.5%, eurozone GDP declining 4.3%, and Japan’s economy slumping by 6.3%, while China’s economy grew by 9.2%. We don’t expect that type of drop-off in growth in the US and the eurozone to be repeated right now. Furthermore, while a roughly 3% contribution from infrastructure construction to 2010’s 10.4% GDP growth in China is likely to decrease, growth will likely still be robust enough to avoid a hard landing. Chinese policymakers have many levers they can quickly implement to arrest a growth slowdown. On the policy front, stock purchases of the four large state banks by Central Huijin, the domestic arm of China's sovereign wealth fund, could be a symbolic shift and signal that monetary tightening is ending. But it needs to be followed by more concrete action. Emerging market stocks may be on the verge of outperforming. Of the three conditions we cited as necessary for emerging market outperformance in Emerging Markets, A Bright Spot?, food prices have fallen in the past month and many global central banks are pausing their tightening campaigns. However, we need China to move more concretely toward an easing bias and loosen credit access for SMEs. Lastly, we need general market volatility and subsequent high correlations to subside. Please visit www.schwab.com/oninternational for more international perspective. Important Disclosures The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey. The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. Past performance is no guarantee of future results. Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (1011-6859) |