Schwab Market Perspective: Diverging Policies…Converging Economies?

Key Points

  • Global central banks have dominated investor attention, with diverging policies contributing to an increase in volatility.  Meanwhile, earnings season has been mildly disappointing, while the US economy continues to shine relative to much of the rest of the world.
  • The Federal Reserve is not wavering from raising interest rates; but lower commodity prices and a continued strengthening of the US dollar could delay those plans, adding to investor uncertainty around monetary policy.
  • The European Central Bank (ECB) finally embarked on a quantitative easing (QE) program of its own, but we question the resultant Eurozone equity rally’s staying power.  Meanwhile, the Greek political drama will likely drag on, but we place small odds on the country’s split from the Eurozone at this point.

Global central bank policies are diverging.  The Federal Reserve, although taking no action at its recent meeting, has a decidedly different tone than the others, all of whom are easing monetary policy—highlighted by a surprise interest rate cut from the Bank of Canada, and the announcement of QE by the ECB.  It’s no wonder that there has been an increase in volatility in equities, a trend which we believe will continue in the near term. Key questions are whether the actions by the ECB will boost economic growth in the Eurozone;  might the US get dragged into Europe’s economic malaise; or will the divergences we’ve seen continue?

We lean toward the latter.  Eurozone prospects are discussed more in Jeffrey Kleintop’s article “Eurozone Economy: The ECB Can't Save It“, but from the US perspective it’s important to remember that only about 13% of its gross domestic product (GDP) is accounted for by exports, while only about 11% of that 13% is exported to the Eurozone according to Trading Economics.  Given those relatively low percentages, the US economy may experience a bit of a drag from Eurozone weakness, but seems unlikely to be derailed in a substantive way.

As a result of both relative economic strength and monetary policy, the US dollar has been on a tear over the past year, making foreign goods cheaper for US buyers—a deflationary impulse for the US economy.

US dollar strength not a no-brainer?

US dollar strength not a no-brainer?

Source: FactSet, Bloomberg. As of Jan. 26, 2015.

However, when everyone lines up on one side of a trade, investors should approach that trade with caution—and that’s what we may be seeing with the strengthening dollar trade.  While we remain dollar bulls longer term, there is the possibility of a countertrend move due to one-sided sentiment.

Dollar strength has been blamed for some of the disappointments so far during earnings season.  Fourth quarter 2014 reporting has been decidedly underwhelming with currency translation, regulatory costs, and the sharp fall in oil (and other commodities) all being blamed for soft results.  Uncertainty seems to be rising in the corporate sector, much as it is with the investor segment, as executives try to discern the impact of these trends in the quarters ahead.

We see the possibility for a decent sized correction in the US stock market for the first time in several years.  We believe the secular bull market remains intact, but believe we are in a phase of heightened volatility not unlike the late-1990s.  Valuation expansion has likely gone as far as possible in this environment, leaving earnings to do more of the heavy lifting.  But with the aforementioned pressures on earnings, the market may have a tougher time generating the kind of gains investors have grown accustomed to.  

Along with the uncertainty regarding global growth and  US Fed policy, the potential spark for a selloff could come from a crisis associated with the fall in the price of oil.  With oil down well over 50% in the past six months, there are likely to be short-term negative dislocations, even if the majority of US businesses and consumers are beneficiaries.  Some dislocations are becoming evident,  with capital spending plans being slashed and layoffs announced—both in the energy space as well as by companies that provide equipment and services to the oil industry.  There also appears to be growing odds of defaults within the energy space of the high-yield market; and possible crises within countries most tied to oil.  Remember, the plunge in oil prices in 1986 helped trigger the Savings and Loan crisis in Texas, while the dramatic drop from 1996-1998 was associated with both the Russian crisis and the Long-term Capital Management (LTCM) debacle.  Lastly, we also want to note that there is the potential that the fall in oil is signaling something more serious in the global economy, with a nod toward the fact that many other growth-sensitive commodities have been sinking as well.

Could commodities be signaling something more sinister?

Could commodities be signaling something more sinister?

Source: FactSet, Commodities Research Bureau. As of Jan. 26, 2015.

* The Raw Industrials Index comprises the spot price movements of the following: burlap, copper scrap, cotton, hides, lead scrap, print cloth, rosin, rubber, steel scrap, tallow, tin, wool tops, and zinc.

US economy still plugging along

Although largely overshadowed recently by dominating headlines from overseas, the US economy continues to behave admirably, with an apparent rebound in housing and surging consumer confidence adding to the positive tone. The move down in US interest rates courtesy of low inflation and low global rates is providing a boost to housing: Mortgage rates have fallen, mortgage applications have risen, and the December housing starts number was quite solid when it came to single-family homes.

Housing getting a boost

Housing getting a boost

Source: FactSet, Mortgage Bankers Association, Federal Reserve. As of Jan. 26, 2015.

Additionally, the National Federation of Independent Business (NFIB) Small Business Optimism Survey rose to its highest level, at 100.4, since October 2006, with both earnings trends and employment plans increasing.  This will be key in the coming months as the last leg of the economic recovery to take hold—rising wages—should  begin to rise as the labor market continues to tighten.

But the news has not been all good.  The latest durable goods report was well-below expectations, with the key core capex reading weak; the Dallas Fed survey showed signs of cracks in the Texas economy; and retail sales have been underwhelming (albeit volatile).

Fed maintains course…for now

Which brings us back around to the Federal Reserve.  They believe conditions are going to continue to evolve to the point in the coming months that will allow them to raise interest rates off of the “emergency” levels in place for some time.  However, a further decline in commodities, more dollar strength, and a paucity of wage gains would likely delay that first move, especially considering the apparent dovishness of the voting block in 2015.  Regardless, uncertainty regarding the Fed’s action will likely result in continued volatility in the market—so buckle up and keep the long-term picture in mind.

Europe’s Optimism is Vulnerable to Disappointment

The ECB’s highly anticipated decision on January 22 to make large-scale government bond purchases has helped to lift European stocks, and consumer and business confidence indicators. The STOXX Europe 600 Index is leading major markets higher in 2015 with a gain of nearly 8% as of January 28, which compares to the over 2% loss for the S&P 500. The related drop in the value of the euro has shaved the European stocks market’s gain to a mere 1% in dollar terms.

Importantly, the gain in euros has lifted the STOXX Europe 600 forward price-to-earnings ratio to 15.4—the highest level since 2002—in the face of sluggish economic growth, deflation, and high unemployment. We believe the ECB’s actions alone are insufficient to resolve Europe’s problems—due to the lack of comprehensive structural reform, and recent political shifts, as seen in Greece, towards unwinding the small progress on reform that had been made in recent years. Therefore, we view Europe’s recent equity market rally as vulnerable to a pullback.

Europe’s Stock Market Valuation at 13-Year High

Europe’s Stock Market Valuation at 13-Year High

Source: Charles Schwab, Factset data as of 1/28/15.

Greece: the long and painful negotiations ahead

After the victory of Greece’s SYRIZA party in the January 25 parliamentary elections, it is hard to deny that there is a mandate from the Greek people to renegotiate the terms of its bailout with its lenders—the  so-called “troika” of the European Commission, International Monetary Fund, and ECB. If the new government goes too far and is inflexible in the negotiations, Greece would run the risk of being expelled from the currency union, something that most Greeks oppose. Yet it is equally clear that European authorities cannot simply reward voters for favoring an anti-austerity party, for fear of fuelling support for similar parties such as Podemos in Spain. Therefore, a difficult period lies ahead.

The head of the Eurozone finance ministers is meeting with Greece’s new Prime Minister this week, prior to the start of any formal negotiations. Greece will probably not get everything it wants, and the negotiations will likely stretch out for months before reaching a deal. A deal will likely be reached by the end of June when another tranche of needed bailout funds will be unlocked.

Greek Banks Caught Up In Negotiations

Greek Banks Caught Up In Negotiations

Source: Charles Schwab, Bloomberg data as of 1/28/15.

In the meantime, the Greek banks are likely to continue to suffer. The banks have lost more than 50% of their value since the decision on December 9 to call for a snap Presidential election, measured by the FTSE/Athex Banks Index. ECB head Mario Draghi has already indicated that the ECB will not provide liquidity to banks if Greece defaults on its debt—a move he threatened in 2012 ahead of the prior election. If the ECB were to stop funding the liquidity of the Greek banks, the banks could collapse. Greek banks are also hesitant to buy short-term Greek government bonds, which limits the Greek government’s options to try to fund itself if a standoff with the troika were to run past June.

We expect that in the end, European officials are willing to offer Greece an extension on the maturity of its debt, a reduction in interest rates, and more flexibility on reforms. We see only a small risk that this ends with a Greek exit from the Eurozone; an outcome that would be a significant negative for the Eurozone as a whole—and something the polls show the Greek people want to avoid.

So what?

The US economy should continue to expand but faces headwinds with weak global growth and a strengthening dollar leading to diverging central bank policies.  Volatility has risen  and the potential for a correction in the near term appears more likely.  Nonetheless, timing the market in the shorter-term is dangerous, while the longer-term picture still looks positive for US equities. Across the pond, we remain skeptical much can be accomplished with the ECB’s QE program and continue to favor emerging markets over developed internationally. We also believe global diversification is becoming increasingly important in a more fragmented and divergent global landscape.

 

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