Archive for October 1st, 2012
The Glidepath Illusion (Arnott)
Monday, October 1st, 2012
The Glidepath Illusion
by Robert Arnott, Research Affiliates
Young adults should buy stocks; mature adults should favor bonds. Or so we’re taught. It makes intuitive sense. Young people have modest savings and lots of time to recover losses from any bear markets. People approaching retirement have more to lose and less time to recover from bear markets. Typically, they want greater certainty as to how much they can safely spend in retirement and less risk that a decline in the value of their investments will demolish their retirement plans.
This type of logic has spawned a huge retirement planning industry, with a wide array of target-date strategies whose Glidepath mechanisms systematically ramp down portfolio risk as an investor approaches retirement. These products are, for many people, the default option in their 401(k) and other defined contribution pension portfolios. Shockingly, the basic premise upon which these billions are invested is flawed.
Does a Glidepath Lead to Retirement Bliss?
Glidepaths feature equity-centric allocations for younger investors transitioning to bond-centric allocations for retired participants. The basic premise of a Glidepath approach is that a systematic increase in the allocation to bonds over time leads to less risk in our planned spending power in retirement. But does it?
To test the Glidepath premise, we simulate how the approach would have worked in the past. Of course, we do not think it wise to plan for the future by extrapolating the past, but it can be illustrative, particularly on the risk side. We use the 141 years of stock and bond market returns from 1871 to 2011, so our first breadwinner starts working in 1871 and retires at the end of 1911 and our last starts in 1971 and retires at the end of 2011. This gives us 101 worker bees with 101 different investment experiences.1
Consider an investor, Prudent Polly, who plans to save for retirement by investing in a standard Glidepath portfolio. Prudent Polly starts working, fresh out of college, at age 22 and plans to retire at age 63, after working for 41 years. Polly saves $1,000 a year in real terms for each of the 41 years, ramping up contributions with inflation. The first panel of Table 1 shows the ending retirement assets for each option. With classic Glidepath investing, Polly finishes with an average portfolio of $124,460, better than three times the $41,000 that she actually set aside. Because these numbers are adjusted for inflation, Polly has tripled the real purchasing power of her investments. But, there’s a range of outcomes, as evidenced by the $37,670 standard deviation in the results. The standard deviation doesn’t begin to cover the potential range: Polly could have finished with as little as $49,940—scant reward for foregoing $41,000 of spending over her working life—or as much as $211,330. The same savings program gives us a range which offers us 2.4 times more wealth at the 90th percentile than at the 10th percentile.
Because actuaries tell us that Polly should live 20 additional years from age 63, it’s much more important to know how large a lifetime inflation-indexed annuity she can buy than to know the size of her nest egg. The second panel of Table 1 shows the average Ending Retirement Real Annuity—an important measure of Polly’s success. On average, by saving $1,000 per year, indexed to inflation, history suggests that she should expect to have a retirement portfolio that will pay her $7,730 per year for life, also indexed to inflation. Sounds anemic… but then again she was only saving $1,000 per year. Unfortunately, again, there’s a big range. Over the past 141 years, she and her counterparts from past generations could have retired on anywhere from $2,390 to $13,130 per year.
If the Glidepath doesn’t lead to greater retirement assets, perhaps it at least provides Polly with more “visibility” into her likely retirement income, a few years before she retires, because the allocation is becoming far less aggressive (another argument advanced in favor of a Glidepath solution). If this transparency were true, people could plan their retirements with greater confidence. Looking at the last panel of Table 1, we can see that Polly’s annuity at age 63 is 154% larger than it would have been at 53. This is partly because the portfolio nearly doubles in size in that last decade and because she can buy a richer annuity with 20 years’ life expectancy than with 30 years. Unfortunately for Polly, the higher expected annuity is associated with considerable variability around that outcome. Her annuity at age 63 could be 54% less or 1302% greater at 53; the 10th percentile shows almost no change from age 53. This is basically the situation for those who turned 63 in 2011; they could have retired with roughly the same lifetime inflation indexed annuity at age 53 as they would now be able to buy at age 63. Sad, but true.2
What’s the Alternative?
So, the Glidepath strategy gives us a pretty uncertain retirement nest egg after 40 years of careful savings, with a pretty uncertain spending stream. Even as retirement looms near, it doesn’t give us much confidence about our retirement prospects or lifestyle. So what? Markets are uncertain. At least we can have more confidence and a safer outcome by ramping down our risk late in life than by any other plan, right? Not true.
Consider another investor, Balanced Burt, who is uncomfortable choosing between equities and bonds and thus decides to maintain a steady course at 50/50, for life. Looking at Table 1, we see that Burt winds up with an average outcome that is 10% better than Polly’s, with an average portfolio of $137,870 (versus $124,460) and an average annuity of $8,550 (versus $7,730). In addition, his worst case is better than hers, as is his 10th percentile outcome, and median outcome; only the single best outcome doesn’t improve in portfolio value, but even that outcome improves in the annuity that he can buy. It is no surprise that Burt’s final 10-year change in retirement income becomes less stable than Polly’s; he is finishing his career with more money in the riskier market. The ratio between 10th and 90th percentile outcome jumps from a 3.5 ratio for Polly to a 3.9 ratio for Burt. This improvement happens entirely from the best outcomes getting better; the worst outcomes do not get worse!
Now consider another investor, Contrary Connie, who is skeptical of the standard retirement strategies—either a balanced portfolio or a Glidepath approach. Connie rationalizes that if a static 50/50 strategy is better than a Glidepath strategy, an Inverse-Glidepath strategy might be more appropriate for meeting her goals than either of the “standard” options. It should come as no surprise that this counterintuitive strategy beats a static 50/50 portfolio by essentially the same margin that static 50/50 beats Glidepath. Contrary Connie beats Prudent Polly by ramping up her risk late in life when the portfolio is already large. Connie finishes with an average portfolio of $152,060, versus Polly’s $124,460. Connie’s worst, median, and best outcomes all trump Polly’s. Connie has to accept more uncertainty late in life as to how much she can spend in retirement—but it’s upside uncertainty!
Critics may argue—correctly—that past is not prologue. This outcome is presumably due to higher real returns for stocks and bonds later in the 141-year period (for example, during the immense bull market from 1982 through 1999), leading to a slight tendency for investors to benefit from ramping up risk later rather than earlier in life. To address this criticism, we put the 141-year history into a lottery, with each year’s returns randomly drawn. It delivers the same relative ranking for the merits of Glidepath versus static 50/50 versus Inverse-Glidepath. The inverse finishes on top again!3
Note, if we systematically replace equities with bonds every year so that we are a 50/50 investor at the midpoint of our career, our returns will fall into the same return distribution, over time, whichever path we pursue. Our average allocation will be 50/50 in all three cases! Markets certainly don’t care about our Glidepath, so we’re as likely to have our best stock market returns late in our career as early. If the best stock market returns come early, it’s self-evident that we’ll finish richer with a Glidepath strategy. And, if the best stock market returns come late in our career, we’ll do well to ramp our risk up as our career evolves. But, in our 20s, how can we know whether stock returns will be better early or late in our careers?
Past is Not Prologue
We’ve written extensively about the “3-D Hurricane” that’s bearing down on us, about the importance of ratcheting down return expectations in a world of lower yields, and about the perils of extrapolating the past in order to shape future expectations. Much of this work has proven to be very relevant to investors in recent years. Can we transform this historically rooted test of various formulaic approaches to retirement planning into something that might be relevant today? We probably can.
Rather than hoping for a repeat of the past, with substantial returns earned on a foundation of far higher yields than today’s yields, we should probably shape expectations based on the current outlook. Table 2 seeks to transform the “What if past is prologue?” scenarios of Table 1 to answer a different question: “What if risk in the future resembles risk in the past, but returns in the future are lower to the extent that yields are currently lower than the past norms?” It’s a subtle question, but it’s awfully useful to anyone thinking about setting aside reserves for some future retirement.
Accordingly, we make the following adjustments to the data, before we drop it into our lottery tumbler:
- Cut the average annual historical notional bond return by 2.0% to 1.9%. Long bonds have had an average duration of 15 years. Multiplying the 15 years by the 180 bps yield difference—the gap between the past average and the current real yield—gives us 27% of price appreciation, embedded in the 141 years of history, about 20 bps per annum. This means that bond returns over the last 141 years enjoyed both 180 bps of higher real yield and 20 bps of capital gain from falling yields.
- Cut the average annual stock return by 2.9% to 5.4%. Stocks have seen dividend yields tumble from an average of 4.5% to 2.1%. This corresponds to a 114% rise in valuation levels. Even though this rise largely occurred over the past 30 years, let’s spread it out over the full 141 years, which gives us 0.5% per year. This means that stock returns over the past 141 years enjoyed both 240 bps of higher dividend yield and 50 bps of capital gain from rising valuation multiples.
- Cut the real bond yield, which forms the basis for pricing our real annuities, by 180 bps to 90 bps. We hope this doesn’t hold true, because it means that the retirement annuities will be more expensive and our annuities skinnier as a result. But it is the naïve “random walk” assumption from current real TIPS yields.
Some might consider these results bleak. We consider them realistic. We can see in Table 2 that today’s newly minted college graduate, choosing to invest on Prudent Polly’s Glidepath, saving $1,000 per year for 41 years, seems likely to deliver a retirement annuity of $2,130 to $5,230. On Contrary Connie’s Inverse-Glidepath, our college grad can plausibly expect a retirement annuity between $2,090 to $6,630, with some slight hope for better results and some small risk of worse.
For those weighing a choice of retiring today versus funding their nest egg for 10 additional years, there’s little difference from the evidence: If we work for a decade longer, we can expect to retire on twice the annuity that we could buy today, give or take a wide range. And there’s less than a 10% likelihood that markets will be so bad in the next 10 years that we’re likely to retire poorer than we could today.
Conclusion
The late economic historian and consultant Peter Bernstein was fascinated by the distinct difference between risk and uncertainty. Risk is, to borrow from former U.S. Secretary of Defense Donald Rumsfeld’s decision tree, the “known unknowns.” Uncertainty is the “unknown unknowns,” the black swans, the fundamental changes that can’t be anticipated. The dispersion in outcomes in Tables 1 or 2, the spread between best and worst outcomes, exemplifies risk. We can quantify it; we can predict the breadth of the range; we cannot predict where, within the range, our own experience may lie.
For most investors, the difference between Table 1 and Table 2 exemplifies uncertainty. The implications of a structural change in our starting yield are just too jolting to bear thoughtful consideration. Today’s world of negative real yields is, for most of us, a black swan, an “unknown unknown.” We want to draw our lottery samples from the past, rather than to think about the implications of a starkly different world. But a world of lower yields—and negative real yields on “riskless” assets—is neither risk nor uncertainty. It simply is our current reality. We can choose to accept this new reality, and accept that Table 2 more accurately spans our current reasonable return expectations in a low-yielding world, or we can choose to pretend that the investing world hasn’t changed in this profound way. For investors who prefer to pretend that the old norms have not changed, this “new normal” will feel like a black swan, and they will suffer accordingly.
Our message remains largely unchanged. Investors who are prepared to save aggressively, spend cautiously, and work a few years longer (because we’re living longer), will be fine. Those who do not follow this course are likely to suffer perhaps grievous disappointment. Glidepath—with less risk taken late in our working lives—is inferior to its counterintuitive inverse. But it is entirely secondary whether we choose a Glidepath strategy, an Inverse-Glidepath, or a simple 50/50 rebalanced blend. No strategy can make up for inadequate savings or premature retirement.
As always, please don’t shoot the messenger.
Endnote:
1. During this period, stocks averaged an annual 8.3% return and bonds 3.9%.
2. This example is based solely on investment returns, paired with a program of regular contributions, over the 41 years.
3. Results available on request.
Copyright © Research Affiliates
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How Can Balanced Investors Mitigate Their Equity Risk?
Monday, October 1st, 2012
by Daniel J. Loewy, AllianceBernstein
Over the past three decades, bonds have provided balanced investors with the best of both worlds. As 10-year Treasury yields fell from a high of 13.7% in 1980 to less than 2% today, bonds provided both strong returns and a great cushion in times when equities were weak. Bonds are still important, but investors shouldn’t expect more of the same.
Future bond returns are likely to be much lower, since Treasury yields are at their lowest levels ever. Low yields also reduce the likely diversification benefit from bonds.
Bond yields have fallen most sharply during equity-market drops. In these periods, concerns about economic growth and deflation drove markets, so investors fled assets with uncertain cash flows (think stocks) and flocked to more reliable assets (think bonds). Demand for bonds’ steady income drove up bond prices and pushed yields lower. For balanced investors, bond gains helped offset stock losses, stabilizing overall portfolio values in turbulent times.
The display below shows that this hedging benefit has been quite substantial at times. For example, after the technology bubble burst in March 2000, the S&P 500 Index’s 44% cumulative loss through September 2002 was largely offset by the Barclays US Treasury Index’s 30% return as its yield fell from 6.6% to 3.0%. But with Treasury yields so low today, bond yields simply can’t fall enough to provide much of a hedge to equities.
What’s an investor to do? There are other strategies available for managing overall portfolio risk in a low-interest-rate world:
- Managing equity exposure dynamically has the potential to limit downside risk in periods of equity market declines.
- Option strategies that provide protection against spikes in equity volatility can be used on an opportunistic basis, when the cost of that insurance looks cheap.
- An allocation to real assets, such as real estate and commodities, could provide an equity market hedge if inflationary pressures build as a result of massive expansion of balance sheets by central banks around the world.
- Some alternative investments may provide a weakly correlated source of returns that complements equities.
Make no mistake: bonds are still likely to be a critical source of income for most investors. But in an uncertain world with the lowest interest rates on record, investors should consider additional ways to hedge their equity risk.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Daniel J. Loewy is Co-Chief Investment Officer and Director of Research for Dynamic Asset Allocation Strategies at AllianceBernstein.
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Goldman’s Clients Are Skeptical About The Effectiveness Of QEtc., Worried About Inflation
Monday, October 1st, 2012
While it is just as perplexing that Goldman still has clients, what is most surprising in this week’s David Kostin “weekly kickstart” is that Goldman’s clients have shown a surprising lack of stupidity (this time around) when it comes to the impact of QEtc. Shockingly, and quite accurately, said clients appear to be far more worried about the inflationary shock that endless easing may bring (picture that), than what level the S&P closes for the year. Incidentally with Q3 now over, and just 3 months left until the end of the year, Goldman’s chief equity strategist refuses to budge on his year end S&P forecast, which has been at 1250 since the beginning of the year, and remains firmly there.
From Goldman’s “Conversations we are having with clients: QE has equity investors asking about inflation“
QE has succeeded in increasing asset prices and inflation expectations but has not convinced investors to raise their US growth expectations. Instead, equity investors have expressed concern about inflation risks while both gold prices and implied inflation rates show similar shifts. During the 1970s, US core inflation averaged 6.5% and impacted equity performance: the S&P 500 rose in 7 of 10 years by an average of 8% per annum, Energy and high yield sectors outperformed, and consumer sectors lagged.
The response to open-ended QE has been mixed. While asset prices have risen, so have inflation expectations and the performance of growth-sensitive assets shows skepticism about QE’s effectiveness.
Asset markets are giving the Fed credit for being able to reduce risk premium and inflate asset prices but have been unwilling to increase growth expectations. Equity investors have benefitted from higher asset prices, are concerned about slow growth, and are beginning to fret about inflation risk. A 1970s case study of equities and inflation is generally intuitive: equity prices rise in nominal terms, Energy and high yield sectors outperform, and consumer sectors lag the market.
Declining risk premium has driven the S&P 500 rally as negative earnings revisions continue and growth expectations have not improved. We estimate the S&P 500 Equity Risk Premium (ERP) has declined 20 bp to 7.2% this month (Exhibit 4). All else equal, that move equates to a 5% move in the index. Not surprisingly the Europe ERP has also fallen significantly. Investment Grade Credit Risk Premium (CRP) has also declined to 1.5% from 1.7% in June with a much larger 80 bp move in Financials.
Implied volatility is down sharply, including longer-dated maturities. The VIX fell below 14 in September, a level it has not sustained since pre-2007. In addition the relative demand and price of put options has fallen sharply with 3-month skew reaching a two-year low and the put-call ratio continues to show high demand for upside call exposure relative to put hedge positions. Perhaps most telling, long-term implied volatility has moved lower suggesting investors view recent global Central Bank actions credibly over the medium- to long-term.
Retail mutual fund flows show nascent signs of investor confidence. Our Rotation Index measures whether retail fund flows favor more or less “risky” fund types relative to choices such as money market or Treasury bond funds. The past four weeks show some early signs that individual investors may be comfortable with more risk even though equity flows in general have been negative (Exhibit 3).
Growth expectations have not risen this month. The equity market’s view on US GDP growth is at similar levels as during the middle of August despite an increase in inflation expectations and a rally in equity markets. Understandably, the primary cause of flat growth expectations has been weak US economic data that has also remained below consensus forecasts (Exhibit 2). A positive note on the growth side is that higher equity prices and lower corporate bond yields have helped ease financial condition that would spur GDP growth in the future if sustained.
Oil prices have declined in September after a 10% move over the summer. Lower prices are somewhat surprising given the large rally during QE2 (oil futures rose 50% from Aug-2010 through Apr-2011) but are consistent with the muted change in equity growth expectations. Our Commodity Strategists credit some of the recent move to soft growth data and market concerns over the potential for a release of strategic petroleum reserves.
Measures of inflation have moved higher. The spread between 10-year US Treasury bond yields and TIPS has widened by about 20 bp in September and nearly 100 bp over the past year (Exhibit 4). Evidence of rising inflation concerns are also visible in inflation swaps and the University of Michigan surveys, which are up over the past few months and accelerate recently.
Recent inflation data does not support a rise in expectations as core inflation dipped below 2% in August and has averaged just 1.6% since 2008. However, gold prices have soared 10% since the end of June and have marched steadily higher since mid-August as QE expectations intensified. Equity investors are looking back to the 1970s for a guide to equity performance in high inflation environments. Our US Economists do not expect inflation to rise markedly in the near term and forecast core PCE inflation of 1.4% in 2013. However, our conversations with equity investors show a shift in attention to previous periods of high inflation.
During the 1970s the S&P 500 had an average annual return of 8% during a period when core inflation averaged 6.5%. At the sector level performance was also impacted by rising prices. Consumer Staples and Consumer Discretionary shares consistently underperformed the S&P 500 while Energy, Utilities and Industrials reliably outperformed the market (Exhibit 1).
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Disrespected Rally…Can It Continue? (Sonders)
Monday, October 1st, 2012
Disrespected Rally…Can It Continue?
September 28, 2012
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,
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research
Key Points
- US equities are trading near five-year highs but numerous measures show investors remain skeptical. Economic data remain mushy but we believe the positive trend will continue, with some blips along the way.
- The enthusiasm following the Fed’s announcement of more quantitative easing was short-lived, although the summer rally in stocks could be at least partially attributed to anticipation of more stimulus. Now, however, the Fed likely steps to the side and the election and fiscal situation take center stage.
- Spanish feet-dragging is raising concerns in Europe over the ultimate impact of the latest ECB plan. Economic growth continues to be almost nonexistent and differences between countries remain. China’s economy is becoming more of a concern, as growth continues to slow and the infamous shadow-lending market may be cracking.
Despite substantial headwinds and bumps in the road, stock indices in the US are now at or near their highest level in roughly five years. Since the height of the financial crisis in 2009, the S&P 500 has more than doubled, while posting an approximately 14% gain to this point in 2012, despite the recent pullback. And, this has occurred in the face of, among many other things, a European debt crisis, the downgrading of the credit rating of the US, fiscal debates in Congress, numerous natural disasters around the world and an apparent slowing of global economic activity.
Impressive move by stocks
Source: FactSet, Standard & Poor’s. As of Sept. 21, 2012.
Can it continue? We believe so. Nothing goes up in a straight line, of course, and you can see in the chart above that within the upward trend there were several relatively substantial pullbacks. With earnings season, European events, a US election, and the potential “fiscal cliff” approaching, we believe we’ll see an increase in volatility, which continues to be at low levels. As a result, it seems likely that there will be some pullbacks in equities, a dose of which we’ve seen recently, that will allow investors who would like to increase their stock allocation an opportunity to do so. A warning: Don’t try to time the bottom on a pullback. No one can consistently pinpoint when that will be, and as visible in the chart above, waiting can result in missing the next potential move higher. That’s why, for many investors, dollar-cost averaging is a way to add to exposure to equities without trying to time the market.
Our optimism regarding equities comes from various sources. The current rally seems to us to be one of the most disrespected in recent memory. Volume remains low and fund- flow information indicates that money continues to move into bonds and out of equities. So although near-term sentiment may get overly optimistic at times, it currently appears as if the underlying market sentiment toward stocks remains relatively negative. But this skepticism contributes to our optimism. We believe investors will slowly begin to recognize that stocks could continue to move higher, while the meager returns on cash investments and the historically low yields on many fixed income products become more unattractive. With the massive amount of cash on the sidelines, we believe even a gradual change in sentiment could contribute to another strong run in stocks over the intermediate term.
Still sluggish
Also helping contribute to our optimism is the “Wall of Worry” that appears to remain firmly in place. First, the US economy continues to muddle through, raising concerns that a return to solid growth may be only a hope and a dream. The latest round of data from the summer did little to dispel that notion as industrial production fell 1.2% in August, the Empire Manufacturing Index hit its lowest level since April 2009 at -10.41, and the Philadelphia Fed Index posted its fifth-straight month of negative readings, at a level of -1.9, although that was up from -7.1 the previous month. Unemployment remains elevated and energy prices have risen again, meanwhile, pinching already tight consumer pocketbooks. There is hope on that front, however, as oil prices have retreated lately, and Saudi Arabia seems intent on keeping the price of crude below $100 per barrel.
On the other side, however, small-business optimism ticked up in the most recent month, which could help to spur job creation. Also, retail sales were positive and jobless claims remain well below the key 400,000 mark.
And, perhaps the most encouraging economic development to us, which also appears to be getting little respect, is the improvement in the housing market. The National Association of Homebuilders builders index rose to 40 in September, which, although still below the key level of 50, was the best reading since June of 2006. Additionally, housing starts rose 2.3%, indicating rising confidence among the insiders in the housing industry, while existing home sales rose 7.8%. And perhaps even more encouragingly, the number of sales attributable to distressed homes fell to 22%, down from 29% in March.
Housing prices up-inventories down
Source: FactSet, Nat’l Association of Realtors. As of Sept. 21, 2012.
There are likely to be bumps in the housing recovery road, but with the Federal Reserve now focusing its new round of easing on mortgage-backed securities, it appears that rates will stay near their historic lows, allowing more time for buyers who may have been delaying a purchase to finally act.
Fed focus may lessen as election season looms
With the Fed decision at its most recent meeting and its commitment to pour money into the economy until it sees “substantial improvement,” investors may now be turning their attention to the election and potential action surrounding the impending fiscal cliff.
We have no desire to wade into the political waters beyond saying that the outcome of the November election could go a long way in determining how the fiscal cliff is ultimately addressed, in both the near and longer term. It seems as if both sides agree that something needs to be done in the near term to at least soften the blow of the scheduled cliff at year end, while also apparently singing the same tune about the need for a longer-term solution. That’s where the agreements between the two parties appears to stop, thus leading to the need for us to see the outcome of the election before any real accurate prediction can be attempted with regard to the details of how these problems may be addressed.
Déjà vu all over again in Europe?
The situation is even more complicated across the pond. The implementation of monetary policy is hindered in the euro-zone due to concerns about the economic health of peripheral governments. As such, the European Central Bank (ECB) has offered to purchase bonds in its plan named Outright Monetary Transactions (OMTs), but the ECB cannot act alone—countries must ask for assistance and then commit to politically unpopular fiscal austerity and reforms.
Spanish yields: “ECB plan bought temporary relief”
Source: FactSet, Tullett Prebon. As of Sept. 26, 2012.
The ECB’s plan bought time and short-term government debt yields have fallen, as discussed in our article. This means Spain does not yet have incentive to ask for assistance. With economic growth slipping, deficits rising and banks needing capital, however, it may only be a matter of time before concerns heat up again, resulting in a debt market riot that forces Spain to ask for help reactively. This is a disappointment for those who are hoping for a planned request, as it likely increases costs and reinforces uncertainty. We view late October as a crucial time for Spain, when auctions to refinance existing debt pick up.
Additionally, more uncertainty in Spain stems from calls for independence by the region of Catalonia, which accounts for roughly 20% of Spanish GDP, as well as finance ministers of a German-led group that is apparently trying to roll back an agreement reached in June. The group said the permanent bailout fund, the European Stability Mechanism (ESM), cannot provide bank recapitalization until eurozone-wide bank supervision is in place, which is unlikely until 2013, putting plans to inject money into Spanish banks in November into question.
Euro-zone economic growth, meanwhile, is likely to be subdued at best due to continuing fiscal austerity measures, debt deleveraging by banks and households, wage reductions, and a hobbled banking sector. Discouragingly, business sentiment continued to fall despite the ECB’s plan, with the expectations component of the German Ifo Business Climate Index falling to 93.2 in September, the lowest level since May 2009. Additionally, the preliminary eurozone composite PMI for September fell to a 39-month low of 45.9, and PMI data provider Markit noted that headcounts were falling at the fastest rate since January 2010.
We outline our neutral stance on euro-zone stocks in our article, noting the challenges and continued volatility along with reasons for optimism and significant underperformance by euro-zone stocks over the past two years.
Is China tightening?
We’ve been noting the problem of high growth expectations in China, both by investors as well as foreign and domestic businesses. Businesses seemed to believe growth would stay robust and any slowdown would be followed by a snap back, therefore necessitating continued production so that inventories would be available to meet future demand.
In the vacuum of large-scale stimulus and after several months of orders falling, some businesses have acquiesced, fulfilling orders from existing inventories and cutting production, making the slowdown “feel” worse than actual end demand. Additionally, the slowdown has resulted in a cash squeeze for businesses across a broad range of sectors, as falling sales, rising labor and electricity costs and lack of pricing power due to excess inventories have resulted in lower profits.
As such, borrowers are having difficulty making payments and the number of bad loans is rising, which may result in banks having to raise capital and/or reduce lending. In the opposite of credit expansion, which generates “multiples” of economic growth for each dollar lent, also called the money multiplier, credit constriction has a negative impact on economic activity.
The slowdown is also exposing a potential credit bubble in China. A shadow banking sector was born as an unintended consequence of China’s immature and controlled economy, whereby lending restrictions and lack of access resulted in some small businesses “finding a way” to get capital. The size of the shadow banking problem is unquantifiable, as reported figures exclude lending transacted outside of the formal banking system.
In order to get capital, some businesses and individuals bought assets such as copper, steel and construction equipment on credit, then used these assets as collateral to obtain longer-term loans that were several times larger than the value of the underlying asset. Additionally, households with money to invest and unsatisfied with low-returning traditional investments were attracted to the double-digit rates earned by lending in the gray market. When these complex financing webs work in reverse, borrowers sell underlying assets, lenders lose their savings, lending slows down and confidence falls.
Freight volumes fall as economy slows
Source: FactSet, National Bureau of Statistics of China. As of Sept. 26, 2012.
Meanwhile, excluding some infrastructure projects restarting and residential property construction improving, many economic indicators continue to deteriorate. Combined with the tightening by default that is occurring, we believe a reacceleration in China’s growth is further out than most expect, and there is a risk that the slowdown has been allowed to persist too long and growth could be entering a negatively reinforcing phase.
The government thus far has been either unable or unwilling to forcibly enact stimulus, and even a long-awaited 1 trillion yuan ($158 billion) infrastructure stimulus was disappointing because it will be implemented over four to eight years and may have included projects already contemplated or started. It is unclear whether the government leadership changeover that begins in mid-October will bring either stepped-up stimulus or continued restraint.
We believe continued caution is warranted for the Chinese stock market and our concern about China has now spilled over to the broader emerging-market stock asset class.
Geopolitical risks creep higher
There are signs of growing assertiveness by China, highlighted by territorial disputes in the East China Sea and South China Sea. Without a significant escalation, we believe the main consequence will be to temporarily restrict trade. Japan is likely to suffer the biggest negative impact, as China constitutes a large end market for Japan.
Read more international research at www.schwab.com/oninternational.
So what?
Risks remain elevated around the world but central banks are acting aggressively to put a floor under assets and stimulate economic growth. While there are risks with this approach as well, we believe risk-based assets will benefit from these actions. And with skepticism toward the bull market apparently remaining high, we believe there’s further to run and suggest investors consider adding to their stock positions during market pullbacks. For investors who are seeking a stream of fixed payments, however, the bond market remains the place to be. While low yields can be frustrating, greatly increasing the risk profile of your portfolio in a search for higher income can be detrimental. For more information on fixed income investing, go to the Bonds Article Library.
Important Disclosures
The S&P 500 Composite Index® is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.
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.
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