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Schwab Market Perspective: Stable and Sustainable?by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research November 13, 2009 Key points
In fact, we view a sideways-to-up path as a positive, allowing economic development and earnings improvement to catch up with the forward-looking equity markets. Many market watchers and investors have been expecting sharper corrections, crying "too far, too fast," but given the severity of the downturn, a similarly sharp move upward is not all that surprising. While we still believe there will be periods of profit-taking, we remain relatively optimistic. Some reasons why:
The unemployment rate is one of the most lagging economic indicators, with the rate typically peaking at, or well after, the end of recessions (with a six month average lag). At 10.2%, the headline number of the labor report for October—the highest unemployment rate since 1983—received an outsized share of investor and media attention, but we don't think you should worry too much about that number with regard to future market possibilities. Given the market's tendency to bottom well before recessions have ended, the path of the market this year has not been terribly unique. Stocks bottomed in March, the economy likely bottomed in the second quarter, yet the unemployment rate is still rising … a progression that's actually quite in line with historical tendencies. US unemployment rate and recessions  Click to enlarge Source: FactSet and the U.S. Labor Department as of November 9, 2009. The lagging nature of the employment report certainly makes sense and relates back to some "coiled springs" that we believe have developed and may be getting ready to pop. Inventories remain at depressed levels, while the third quarter's astounding (and unsustainable) 9.5% productivity reading suggests employers continue to squeeze more output out of their workers. However, neither of these things is sustainable for a long period. Any increase in consumer demand—which is more likely as retail sales numbers have shown surprising strength—will require companies to increase their workforce in order to restock depleted inventories and meet demand. Real private inventories and recessions  Click to enlarge Source: FactSet and the U.S. Bureau of Economic Analysis as of November 9, 2009. In fact, some leading employment indicators indicate that dynamic. In the October employment report, temporary employment jumped as companies tip-toed into the labor pool before committing to permanent hires. Additionally, initial jobless claims continue to trend lower, while various manufacturing surveys are also showing improvement in their employment components—leading us to believe that we will see employment gains by early 2010. When do the training wheels come off? Given the continuing improvement in economic data, and the apparent impending rebound in employment, the big question is when do the massive stimulus measures currently in place end—and what happens to the economy when they do? During the most recent Fed meeting, rates were maintained at near-0% with only limited changes to the language in the Fed's accompanying statement. The Federal Open Market Committee (FOMC) members noted three focus areas that give investors a hint as to the triggers for future Fed policy. Two represent long-standing Fed mandates, and the third represents a more nuanced version of the second that helps keep their options open. The FOMC members cited:
Remember: The current monetary policy was put in place during emergency conditions. It's difficult to argue that we remain in a true economic emergency, suggesting the Fed might tighten sooner that most are expecting. However, even a series of moves during the next year would likely leave rates at historically low levels since we're coming off a base of 0%. A worse scenario, in our opinion, is if the economic fundamentals continued to justify 0% rates for an extended period. Indeed, some "normalization" of rates would have some economic benefits, including higher money market rates, which would benefit prudent savings, and the potential to stabilize the weak US dollar. Fiscal stimulus is in full force with the federal government continuing to insert itself into the market economy; fearful that a continued rising unemployment rate spells doom for the economy (and possibly incumbents in 2010). They did allow cash-for-clunkers program to expire, and some data shows the program pulled demand forward rather than significantly stimulating new demand. But, Congress did pass an extension to the first time homebuyers credit, added a credit for some existing homeowners that move, extended unemployment insurance, and provided another "one-time" cash payment to seniors. While the purpose of these programs is to stimulate the economy, many (us included) are gravely concerned about the burgeoning debt burden that comes along with them. Global outlooks and monetary policies begin to diverge G-20 countries maintained a commitment to stimulus but emergency measures are beginning to be removed in some nations. Countries slashed rates nearly in lockstep, but now some economies have the potential to overheat, while others remain stagnant, causing monetary policies to diverge. Strong growth has resumed in commodity-oriented economies, particularly Australia, Norway and Brazil, with corresponding capital inflows and asset price increases. Authorities in Australia are concerned about rising real estate prices, and Brazilian officials have cited the possibility of speculative investment bubbles. As a result, these countries are starting to rein in liquidity, with Australia and Norway raising interest rates, although future moves will likely be measured. Brazil enacted a 2% tax on stock and bond investments by foreigners in an attempt to slow inflows, and may make additional moves. Valuations for equities in commodity-oriented markets are mixed, with Australia appearing attractive, while Brazil seems expensive relative to historical averages. Weak outlooks for Europe and Japan Elsewhere, recoveries in European economies have diverged, with UK weakness continuing, while France and Germany have experienced auto manufacturing rebounds related to incentives, and better retail sales due to healthier consumer balance sheets. Hurdles for growth in the UK include a hobbled banking sector, rising taxes and spending cuts necessitated by deficits and ballooning government debt, which resulted in a credit outlook downgrade in June and another warning in November. The UK is the only G7 country to recently add stimulus, with the Bank of England expanding the size of asset purchases in November, and indicating further stimulus has not been ruled out. With auto subsidies waning, Europe's outlook is weak. In contrast to the United States, European companies have not cut jobs as fast as output, and credit is only now beginning to contract. The International Monetary Fund (IMF) estimates gross domestic product (GDP) growth in 2010 in Europe to be the lowest in the developed world, at 0.3%, lagging even Japan's moribund economy, estimated to grow 1.7%. Equities in the UK reflect negative sentiment, while other European markets remain mixed, with French equities appearing expensive. The only consistent source of growth in the Japanese economy during the past 20 years has come from the government, which finds growth increasingly costly to fund. While sentiment toward Japan is negative, valuations remain unattractive. Economic weakness is exemplified by the Bank of Japan's expectation of deflation in the country to last through at least the end of 2011. Despite this, yields on government debt have started to increase, as investor appetite is waning due to the ongoing massive capital required to fund growing deficits and to refinance current debt. Lastly, the shift from the yen to the dollar as the funding currency for "carry trades" is buoying the yen, which in turn hampers exports. With the dollar now in this role, global investors borrow in cheap dollars, then sell those dollars to invest in higher-risk/higher-return asset classes (gold, other commodities, emerging-market equities, and so forth). Any countertrend rally in the dollar could force an unwinding of some of these carry trades. Chinese risks are rising, positive outlook remains While risks are increasing, and recognizing higher volatility of emerging-market equities, we remain constructive on China for three reasons:
 Click to enlarge Source: FactSet and Bloomberg as of November 11, 2009. New loans of $1.3 billion in 2009 have the potential to lay the foundation for an asset bubble and inflation. Chinese lending growth strong  Click to enlarge Source: FactSet and the National Bureau of Statistics of China as of November 11, 2009. China's housing market is robust: Is that a good thing? China's property sales have jumped 79% in 2009 and by 48% in floor space. Prices in some cities have soared; Shanghai prices rose 19% from March to July 2009 and prices in Beijing increased 27% from January to June 2009. These types of increases might be welcomed by some US homeowners, but prices in some areas of China are rising faster than incomes while vacancy rates are increasing, indicating the possibility of excessive speculation. While high vacancy rates are partly attributable to the cultural preference for new homes (homes not lived in), state-owned enterprises (SOEs) have contributed to the problem. They received funds from the massive loan issuance in 2009 from state-owned banks and used some of the proceeds to invest in real estate. The supply of new homes has lagged demand, contributing to rising prices. According to a 2006 survey by the National Development and Reform Commission, the average ratio of house prices to incomes was approaching 12:1 in many of China's large and mid-size cities; much higher than the World Bank's suggested affordability ratio of 5:1 and the United Nations' 3:1. The market may pause, as rapid price rises have tended to slow sales, and supply is increasing, which could reduce prices. Regulators are attempting to moderate speculative activity by increasing the down payment for secondary home purchases to 40% from 30% and may soon issue additional measures to limit the use of debt. However, the government is loathe to clamping down too hard, as property taxes comprise large portions of local government revenues and are only collected on transactions, not on property holdings. Additionally, many banks are partly state-owned. Low interest rates have improved housing affordability, and officially prices are up less than 5% year-over-year nationally. But the World Bank noted that official statistics lack clarity and detailed breakdowns, and added that a housing slowdown would affect the overall economy. Whether these concerns transpire into a real problem in China is unknown, as is the timing and outcome. Areas tied to housing, including materials and retail sales such as home furnishings, would be affected, as would banks. Chinese banks may have issued poor-quality loans, and a housing slowdown could incite write-offs. However, banks appear to be well-funded and government ownership implies that the state can use its power and balance sheet to institute policies to alleviate any actual damage incurred. Lastly, if banks perceive rising balance sheet risks, growth in economic activity in general for China could slow if banks pull back on new loans too rapidly. Emerging-market stocks benefitted from the resumption of risk-taking since the market low, and might stall if risk aversion resumes. Important Disclosures The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. 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 2005, the MSCI EAFE Index consisted of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, 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 2005, the MSCI Emerging Markets Index consisted of the following 26 emerging market country indexes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela. 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. (1109-11449) Return to Top |
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