Wednesday, June 12th, 2013
by Ben Eisen, The Tell Blog
Treasury Inflation-Protected Securities, or TIPS, passed the latest threshold in their dramatic yield rise since the beginning of the year when the 10-year note yield turned positive Monday. The yield has been bouncing around 0%, but the “ask” yield registered at 0.068% around 12:15 p.m., according to Tradeweb.
Monday marks the first time since January 2012 that the 10-year TIPS yield turned positive, Tradeweb data show.
Source: June 12, 2013, MarketWatch
Wednesday, May 29th, 2013
by Cullen Roche, Pragmatic Capitalism
Another interesting divergence here via Societe Generale research. Like the commodity trend, we’re seeing a big divergence in US inflation expectations and the S&P 500. If deflation is truly a big risk then there’s an awful lot of faith being placed in the Fed’s hands at present through QE. Me, I’m more in the low inflation camp as opposed to the deflation camp, but it’s hard to ignore these divergences….
Here’s more via SG:
- While the S&P 500 is up 17% YTD, equity inflation is not in sync with the US economy, where inflation expectations fell below 2.3% to reach an 8-month low.
- Inflation has been sinking in the eurozone at an accelerated pace in the past few months, reaching a 3-year low of 1.2% in April
- Inflation has been trending down in many countries, including China where inflation accelerated a mere 2.4% in April 2013.
Chart via Orcam Investment Research:
Tuesday, May 7th, 2013
Subdued headline inflation hides the inimitable rise of prices across the country; but ConvergEx’s Nick Colas examines the pace of inflation in four large cities across the US – Boston, Chicago, New York and San Francisco. All are home to multitudes of urban working professionals, share the same currency and have similar macro economies, though, Colas notes, the trend of price increases varies considerably (particularly with regards to NYC vs. the rest). The cost of living is up in all four cities since 2008. Incomes, too, are generally higher – although not in New York, likely a result of the Big Apple’s unique micro economy. Comparatively, New Yorkers have experienced the steepest price increases in transportation (higher cab and subway fares give this category a boost) and groceries, meanwhile rent, dinners out and cocktails continue to be more and more costly. So what gives? Rising inflation despite lower incomes? The answer lies in the tug of war between less cash pay on Wall Street and a very active foreign investment market that is driving up real estate prices.
Via Nic Colas, ConvergEx,
Note from Nick: New Yorkers often marvel at the low cost of living elsewhere in the country, thinking how “Easy” it would be to just hang it up and live a modest life somewhere in the heartland. Escape fantasies aside, there is much to learn from comparing price trends across the U.S. Beth has done such an analysis here, and what pops out is a fascinating study of how inflation works at the “Micro” levels of an economy.
My favorite cut of meat is the filet mignon at Sparks in Manhattan. It’s $46.95 and well worth every penny. Alfred’s in San Francisco offers an arguably similar dining experience (though missing is the “cool” factor that comes with eating at the location of an infamous Mafia murder) and quality piece of beef for just $37. Chicago Chop House’s chateaubriand for two goes for $99, while the signature steak for two at Abe & Louie’s in Boston is only $88.
Varying prices for similar products in different cities is pretty common economic knowledge; it’s a reflection of the distinct micro economies that exist among cities even with congruent macro economies. Our focus today, however, isn’t on price variations, but rather the difference in price trends. We’ve chosen the four cities mentioned above – Boston, Chicago, New York and San Francisco – because they all represent tightly clustered urban populations of working professionals. They are classic examples of what rural folks refer to as “the big city.”
Below are our findings on price inflation in 6 categories that occupy considerable space in a typical urbanite’s budget – housing, transportation, groceries, dinners out, cocktails and entertainment. All are courtesy of the Consumer Price Index (CPI), except “Entertainment” which we present in the form of Team Marketing Report’s Major League Baseball (MLB) Fan Cost Index, a.k.a. the average cost for a family of four to attend a baseball game.
Category #1 – Residential Real Estate. Housing costs have increased more in New York and San Francisco than in Boston and Chicago.
- Housing costs (which include utilities, furnishings and supplies according to the CPI) in Boston and Chicago are 2.0% and 2.6%, respectively, higher now than in their peak in 2008, having dipped lower from 2009-2011. In New York and San Francisco, on the other hand, housing costs never fell below pre-recession levels and are currently a respective 8.2% and 9.4% higher than they were five years ago.
- More recently, year-over-year increases in housing costs in New York (2.4%) and San Francisco (3.2%) trump those in Boston (1.6%) and Chicago (1.9%). In Manhattan specifically, the average monthly rent for a 1-bedroom, doorman building apartment is $3,900 which is up more than 5% in the past year and more than $600 higher than the recession trough of $3,276 in 2010. A walk-up studio goes for $2,406 a month, up 10% from last year and almost $500 more than the recession trough of $1,930 in 2010. See MNS.com for further details, including rents by Manhattan neighborhood, in case you’re in the market for new digs.
- As a side note, the CPI calculates the cost of housing to include utilities, furnishings and supplies, but the main component is called owners’ equivalent rent of primary residence (OER). Housing units are not in the CPI market basket. In its survey to determine OER, CPI questionnaire asks consumers who rent their residence simply how much they pay per month in rent, including garage and parking facilities. For those who own their residence, they must estimate how much they think it would rent for monthly, unfurnished and without utilities.
Category #2 – Transportation. The price of getting from one place to another is up sharply in all four cities.
- Including public transportation, car rentals, airfare, car repair, etc., transportation costs nosedived in 2009 across the board only to show consistent increases in every year since.
- Price increases since 2008 in New York (17.9%) and San Francisco (16.9%) are higher than in Boston (13.4%) and Chicago (12.4%), though in the past year transportation costs in each city climbed between 2.6% and 2.8%. It’s worth mentioning that gasoline prices are lower year-over-year in all 4 cities, with NYC and Boston seeing about a 1% decline, while San Francisco and Chicago experiencing declines of more than 5%.
Category #3 – Food. A trip to the supermarket is increasingly costing more in the east coast cities than in their two counterparts.
- Groceries are getting pricier in New York (+15.2% over the past five years) and Boston (+13.0% since 2008) than in Chicago (+8.0%) and San Francisco (+6.1%).
- Currently through February, grocery shopping cost 1.7% more in Boston than in 2012, making it the city with the biggest year-on-year appreciation.
Category #4 – Eating out. Surprisingly, restaurant meals are getting relatively cheaper in New York.
- Meals outside of the home increased the least in NYC over the past 5 years, rising 12.3%, compared with 14% gains in Boston and San Francisco and a 16.2% rise in Chicago.
- As for the past year, the price of dinner in a Chicago restaurant jumped 4.0% on average, versus 3.7% in San Francisco and much lower increases in Boston (2.2%) and New York (1.6%).
Category #5 – Martinis and other adult beverages.
- In the past year alone, the average price of an alcoholic beverage rose 2.9% in New York, versus just 1.0% in the other three cities.
- Over the past five years, the price of beer, wine and spirits rose 10.3% in the Big Apple, topped by an 11.9% increase in Boston. Chicago and San Francisco experienced price increases of 7.2% each.
Category #6 – The national pastime. And as for baseball, it’s more expensive to see the Red Sox than any other team in MLB, but inflation at Fenway is super low.
- Team Marketing Report’s Fan Cost Index, our proxy for entertainment, compiles the price of four adult tickets, two small draft beers, four small soft drinks, four regular-size hot dogs, parking for one car, two game programs and two baseball caps. The cost of all this run $377 in Boston, versus $324 to see the Yankees, $298 to catch a Cubs game, and $238 to watch the SF Giants.
- Over the past year however, the cost of attending a baseball game was unchanged to lower in Boston, Chicago and New York, but gained 6.0% in San Francisco. In the past five years, the price to experience a Red Sox game increased just 5.1%, compared with 17.9% for a Yankees experience, 18.4% to see the Cubs, and 29.5% to watch the Giants.
All of the key ingredients in the cost of big city living are on the rise, but fortunately for Bostonians, Chicagoans and San Franciscans, incomes are increasing too. As you might’ve expected, incomes dipped across the board in 2009 but rebounded by 2011. As of last year, incomes in San Francisco County were 9.7% higher than before the financial crisis. They were 4.1% higher in Cook County (home of most of Chicago) and 3.2% higher in Suffolk County (home of Boston).
For Manhattanites, though, it’s a different story. Average annual pay in New York County was $98,287 last year, or 2.8% lower than in 2008 when the average worker received $101,084. So why is the city experiencing rising inflation in light of lower incomes, especially when other big cities across the country don’t have the same disconnect? Well, incomes are likely lower as a result of less cash pay on Wall Street. In the aftermath of the Lehman collapse, bankers’ bonuses took a hit, and they were not only lower but a greater portion of bonus pay was in the form of deferred compensation. Couple this with a strong foreign investment market that is driving up real estate prices in Manhattan, and you’ve got a tidy explanation for an otherwise curious anomaly.
To make some macro sense of all these data points, we end with three conclusions that highlight the dynamics of inflation in the real world.
- First, real estate prices drag up the prices of other goods. We’ve already covered the residential aspect, but arguably more important is commercial real estate. And according to the Moody’s/RCA Commercial Property Price Indices (CPPI), commercial real estate prices have been on a steady uptrend since early 2010 and climbed 6.5% in the past year. While the primary index has yet to reach its peak level from December 2007, it stands 32.3% higher than its trough in January 2010. And as we’ve seen over the past 5 years, commercial real estate prices move in tandem with residential markets.
- Second, inflation is all about perceptions, particularly at the local level. Examining inflation on a micro basis is a useful construct that highlights how perceptions of future prices vary across the country.
- And last, the mechanics of inflation are far from uniform across the country. Various factors drive inflation, and while the CPI measures price changes on a national level, inflation is just as much about local markets. This implies that inflation is perhaps less of a threat to the nationwide economy since individual places have different micro economies and thus different levels of price appreciation. A whole lot of things have to line up on a national level for there to be widespread inflation.
Tuesday, August 7th, 2012
August 6, 2012
The Wall Street Journal published an article on August 1 headlined: “Bill Gross: Equities are Dead.” In fairness to Gross, what he actually wrote in his August “Investment Outlook” was, “the cult of equities is dying.” We agree with most of Gross’s argument—but not with his unsupported forecast of extremely low stock returns.
Let’s take a look at Gross’s claims:
1) Gross notes that bonds have outperformed stocks for the last 10, 20 and 30 years. With long US Treasuries currently yielding 2.7%, it is unlikely that bonds will replicate the performance of decades past.
We agree. That is why stocks are attractive today relative to bonds. Bonds—having outperformed—are now unusually expensive and have low expected returns going forward. By contrast, stocks—having performed poorly—are cheaper than normal and are likely to significantly outperform bonds over the next 10 years.
2) Gross argues that US stocks can’t maintain their 6.6% average annualized real return over the last 100 years. The 6.6% real equity return was 3% higher than real GDP growth, with shareholders gaining at the expense of labor and government. Labor and government must demand some recompense for wealth creation, and GDP growth itself must slow due to deleveraging.
We agree. We are now in a lower return environment. The question is, how low? Let’s concede that stocks will grow in line with real GDP. Over the long haul, real GDP growth primarily reflects population (growing a little over 1%) and productivity (growing just above 2%). That would give us a projected real equity return of maybe 3%—less than half the historical 6.6% rate.
3) Gross asserts that stocks will have a nominal return of 4%.
This is where Gross’s math gets fuzzy. Why this sudden switch to nominal instead of real returns? Does Gross expect that US population will shrink, productivity gains will disappear, and inflation will remain quiescent forever? That is what needs to happen for long-term nominal GDP growth to be as low as 4%. The scenario is possible, but hardly likely. Just assuming that inflation runs at a relatively tame 3% with below-normal real GDP growth of another 3%, we’d have nominal equity returns of 6% or so. That looks quite attractive when you get just 2.7% for holding long bonds to maturity.
In our recently published paper “The Case for the 20,000 Dow,” we show that with reasonable assumptions we can get returns in the 6% to 7% range and that the Dow hits that target in five to 10 years. We will also lay out our argument in an upcoming blog post.
Most investors today are very concerned about equity volatility, and for good reason. But there is another risk that should concern investors: the risk that their investments will not keep up with inflation and meet their goals. As investors balance short-term market risk against the long-run risk of falling short of their objectives, we think an appropriate allocation to equities continues to improve the likelihood for success.
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.
Seth J. Masters is Chief Investment Officer of Asset Allocation and Defined Contribution Investments at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.
Tags: Alliancebernstein, August 1, Bill Gross, Bonds, Equity Return, Fairness, GDP, GDP Growth, Government Labor, inflation, Investment Outlook, Productivity Gains, Real Gdp, Recompense, Seth, Stock Returns, Treasuries, Wall Street Journal, Wealth Creation
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Friday, August 3rd, 2012
by Russ Koesterich, Chief Investment Strategist, iShares
Elections do matter for the markets, but not necessarily for the reasons that investors tend to believe. Ahead of the US presidential election in November, I’m going to attempt to debunk some of the common myths surrounding markets and elections:
Myth #1: Party affiliation matters when it comes to market returns.
There is little to no evidence to support the fact that the winning candidate’s party makes a difference to markets. Over the past century, which party occupies the White House has had no discernible or consistent impact on US equity markets. Since 1900, when a Democrat has been in the White House, the average return for the Dow Jones Industrial Average has been around 8.5%; for Republicans the average is around 6% (neither average includes dividends). When you adjust those averages for the market’s volatility, the numbers are statistically the same. In other words, the party affiliation of the president has had no consistent influence on stock market performance, though many investors still believe this.
Myth #2: Divided government is good for the financial markets.
Following the halcyon days of the 1990s, many investors have come to believe this myth. While divided government was certainly good for markets in the 1990s, that seems to have been an anomaly. The 1990s were unusual and were a function of many factors, including a secular drop in interest rates, a productivity surge, and the taming of inflation. Unfortunately, conditions are very different today.
Looking at the last century of data, there is no evidence that divided government produces better returns. In fact, in the past equities appear to have actually done better when one party has controlled both Congress and the White House, though the numbers backing this better performance aren’t statistically significant and should be taken with more than a grain of salt.
What Does Matter: Policy
None of the above implies that the outcome of this election is irrelevant for financial markets. While politicians cannot fix much of what ails the global economy, sensible economic policy would help mitigate the damage. There is also quite a bit that politicians can do to make matters worse. In short, as I write in my new Market Perspectives piece, the election will matter a great deal.
There are a number of issues, both long and short-term, which can only be solved in Washington. The absence of progress will likely worsen the economic malaise and in the case of the fiscal cliff push, the United States back into recession. On the other hand, real progress on taxes and entitlements could remove at least some of the headwinds holding back growth.
Both the fiscal cliff and the entitlements issue are extremely important to the capital markets. Evidence that we’re not doing everything we can to resolve them is likely to push stocks lower and volatility higher. To state the obvious, should we allow this to occur it would be a game changer for US financial markets.
If we wake up on the morning of November 7 with continued divided government and no consensus on reform and then no consensus is reached before the fiscal cliff hits in January, investors may want to consider opting for these five portfolio moves:
1.) Less equity exposure
2.) A higher allocation to defensive sectors like consumer staples and healthcare, accessible through the iShares S&P Global Consumer Staples Sector Index Fund (NYSEARCA: KXI) and the iShares S&P Global Healthcare Sector Index Fund (NYSEARCA: IXJ).
3.) Less credit exposure in the fixed income section of their portfolios
4.) A smaller allocation to commodities
5.) A higher weight to dollar-denominated assets
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.
Copyright © iShares
Tags: 1990s, Anomaly, Chief Investment Strategist, Common Myths, Democrat, Dividends, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Financial Markets, Grain Of Salt, Halcyon Days, inflation, Ishares, Koesterich, Myth 2, Party Affiliation, Russ, Stock Market Performance, Us Presidential Election, Volatility
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Friday, August 3rd, 2012
by Wolf Richter, www.testosteronepit.com
The strongest and toughest creatures out there that no one has been able to subdue yet, the inexplicable American consumers, are digging in their heels though the entire power structure has been pushing them relentlessly to buy more and more with money they don’t have, and borrow against future income they might never make, just so that GDP can edge up for another desperate quarter.
But it’s been tough. Despite the Fed’s insistence that inflation is “contained,” or its periodic fear-mongering about deflation, consumers have been hit with rising costs. Tuition has been ballooning—up 21% in California in 2011 alone! Student loan balances exceed $1 trillion. Some parents who are still paying for their own student loans are now watching their kids piling them up too [read.... Next: Bankruptcy for a whole Generation]. Healthcare expenses have seen a meteoric rise. And so have many other items that cut deep into the average budget.
Inflation is a special tax. It’s not that horrid if it’s small, if higher yields compensate investors and savers for it, and if higher wages compensate workers for it. But that hasn’t been the case. The Fed’s Zero Interest Rate Policy has seen to it that entire classes of investors and savers get their clocks cleaned; and wages haven’t kept up with inflation since the wage peak of 2000—with the very logical but brutal goal of bringing wages in line with those in China.
But for a welcome change, disposable income adjusted for inflation, reported earlier this week, actually rose 0.3% in June from May. So spending should have gone up as well. It didn’t. The inexplicable American consumer spent less in June than in May. And April. The decline was focused on goods, the lowest since January.
And instead of buying goods with the additional money they’d earned, they saved! What temerity! It wasn’t a one-month fluke. The savings rate reached 4.4%, after a fairly consistent uptrend from the November low of 3.2%. An unusual and courageous act of rebellion in face of the punishment the Fed inflicts on savers.
There’s other evidence: while new car and truck sales weren’t great in July at a seasonally adjusted annual rate of 14.09 million units—down from June’s 14.38 million and February’s 14.50 million, the high of the year—they concealed ominous undercurrents. Honda’s sales jumped 45.3% and Toyota’s 26.1% over July 2011. After the March 11 earthquake last year, supply-chain problems created shortages, which the flood in Thailand made worse. Brand-loyal buyers who couldn’t find the right model, option package, or color, rather than switching to other makes, delayed their purchase—thus creating pent-up demand. Now, supply problems have been resolved, and buyers are swarming all over their favorite dealerships. This specialized pent-up demand obscured a huge problem: GM’s sales dropped 6.4% and Ford’s 3.8%. The two leaders taking a simultaneous turn south! This doesn’t bode well for total vehicle sales once Honda’s and Toyota’s pent-up demand has been satisfied. Another act of rebellion by the inexplicable American consumer.
But the Commerce Department, in its press release on income and spending, had a convenient answer: blame “the economic turmoil in Europe.” For everything. And then it added what was practically a campaign ad: “Therefore, it is critical that we continue to push for policies that will grow our economy and support our middle class, such as abolishing the Fed (sorry, my screw-up) the remaining proposals in President Obama’s American Jobs Act.” And it goes on to praise Obama’s tax proposal. Priceless! Expunging the last vestiges of objectivity from our government agencies, such as the Department of Commerce whose Bureau of Economic Analysis had collected the numbers.
The cellphone in your pocket is NASA-smart, write Alex Daley and Doug Hornig. Yet it costs just a couple hundred dollars. So why is it that these rising technical capabilities are leading to drastically falling prices in tech products, but not in your medical bill? The answer may surprise you. Read…. “Why Your Health Care Is so Darn Expensive.”
Tags: American Consumers, Clocks, Disposable Income, Fear Mongering, Fluke, GDP, Healthcare Expenses, inflation, Insistence, Interest Rate Policy, Many Other Items, Meteoric Rise, Power Structure, Richter, Student Loan Balances, Student Loans, Temerity, Trillion, Wages, Zero Interest
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Monday, July 30th, 2012
by Patrick Rudden, AllianceBernstein
A famous Business Week article, “The Death of Equities,” concluded, “Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.” Sound familiar? The article was published in August 1979.
The Business Week article discusses how, with “stocks averaging a return of less than 3% throughout the decade,” investors were fleeing equities in favor of cash and real assets such as property, gold and silver. “Further,” it states, “this ‘death of equity’ can no longer be seen as something a stock market rally—however strong—will check. It has persisted for more than 10 years through market rallies, business cycles, recession, recoveries and booms….For better or worse, then, the US economy probably has to regard the death of equities as near-permanent condition.”
The primary economic problem back then was high inflation, which had devastated returns for stocks and bonds but had greatly buoyed the value of real assets such as gold. Of course, Paul Volcker, then Chairman of the Federal Reserve, was soon to unleash his war on inflation, which set the stage for a prolonged period of strong equity and bond market returns.
But the article says other factors contributed to the death of equities: “The institutionalization of inflation—along with structural changes in communications and psychology—has killed the U.S. equity market for millions of investors. We are all thinking shorter term than our fathers and our grandfathers.”
Inflation (at least of the consumer-price variety) has not been the problem it was in the 1970s, but I would argue that structural changes in communications and psychology have been, if anything, more severe. We are all subject sooner and sooner to more and more information. And, as a consequence, we are thinking shorter term than our fathers and grandfathers and, I should add, mothers and grandmothers.
Equities are no more likely to be dead now than they were in August 1979. Indeed, the expected return advantage of stocks versus government bonds is unusually high at present, in our opinion. However, shorter-time horizons may require us to revisit our investment portfolios. In addition to longer-horizon strategies like value and growth, investors may need to consider shorter-horizon strategies, such as equity income or low-volatility stocks.
Finally, for those investors worried about the return of the inflation bogeyman, holding some exposure to real assets is a good insurance policy.
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.
Patrick Rudden is Head of Blend Strategies at AllianceBernstein.
Copyright © AllianceBernstein
Tags: Bond Market, Booms, Business Cycles, Business Week Article, Chairman Of The Federal Reserve, Economic Problem, Federal Reserve, Gold And Silver, Grandfathers, Grandmothers, inflation, Institutionalization, Market Rally, Paul Volcker, Prolonged Period, Real Assets, Recession, Rudden, Stock Market, Stocks And Bonds
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Sunday, July 15th, 2012
July 13, 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
- Equity markets rebounded from their lows, but the move has been less than enthusiastic and convincing. Earnings season is upon us and corporate commentary and outlooks may take the focus away from the macro world—at least for a time.
- Muddling through is the popular phrase on the Street for what’s occurring in the US economy. But how long before a break is made one way or the other—both in the economy and the markets?
- Any progress made at the most recent European Union (EU) Summit appears to have been short-lived and any credible long-term solutions remain illusive. Additionally, Chinese growth continues to slow and concerns over a “hard landing” are growing.
Muddling through. Not the most inspiring phrase and we must admit that we are already tired of hearing it, even as we use it ourselves. But it appears to be the best description of what’s occurring in so much of the world currently. In Europe, policymakers continue to take one step forward, followed relatively quickly by one step back; avoiding a complete collapse, but really coming no closer to an actual resolution to their debt crisis and economic problems—muddling through. In China, growth has slowed and policymakers have been slow to respond and appear willing to accept a lower pace of improvement in exchange for deflating a real estate bubble and containing inflation—muddling through. And in the United States, stocks appear to be largely trading in a range, with neither the bulls nor the bears able to grab the reins and establish a trend; while economic data is mushy, but not overtly negative—muddling through.
The question is how long before the muddling stops and a sustainable direction is established? Unfortunately, while we believe a day of reckoning is drawing nearer and the ability of policymakers to use slight of hand to “fool” the markets into thinking solutions may be forthcoming is growing thin; it appears to still be at least a few months away, and the largely sideways action in stocks is likely to persist.
That doesn’t mean that investors who need to add to their equity exposure should wait until a definitive trend is established. By that time, much of the move will likely be passed and there is always the possibility of unforeseen events impacting the markets to a substantial degree—the so-called fat tail scenarios discussed in the last Schwab Market Perspective. For investors that have a time horizon of five years or longer, we continue to believe equities are attractive here. Valuations appear reasonable, but there are ample near-term hurdles, including the “fiscal cliff,” China’s growth, the US slowdown and the ongoing eurozone debt crisis. If the expectations hurdles have been set low enough , we could see some sharp rallies unfold among riskier asset classes, but there remain negative tail risks as well, and volatility and uncertainty are not likely going away in the near-term.
As we head into the peak of second quarter earnings season, corporations have the spotlight as the macro picture has entered a quieter zone. Judging by the elevated preannouncement ratio for the quarter, we expect to hear uncertainty and caution in the outlooks, as tax policy remains uncertain, the ultimate outcome in Europe continues to be illusive and China’s growth is slowing. With many companies having preemptively announced negative developments with their second quarter performance, expectations have been lowered, which would traditionally set up the possibility of upside surprises. However, we’re concerned that there may be further disappointments to come as the global economy continues to weaken. Regardless, it’s hard to imagine the corporate picture driving action for long as macro developments will likely again take hold as fall approaches.
Recession increasingly likely?
As mentioned above, the US economy appears to be muddling through, but concerns over a return to a recession have grown. Chief among the disappointing reports was the Institute for Supply Management’s (ISM) Manufacturing Index, which came in at 49.7, down from 53.5 and below the 50 level that denotes the dividing line between an expanding or contracting manufacturing sector. This was the lowest reading since July of 2009, but it’s important to note that the index traditionally doesn’t start to indicate recession for the broader economy until it drops below 44.
ISM indicates softness but no recession-yet
Source: FactSet, Institute for Supply Management. As of July 6, 2012.
More concerning was the new orders component-the more forward-looking part of the report-collapsing by 12.3 points, which was its biggest monthly drop since October 2001.
New orders are more concerning
Source: FactSet, Institute for Supply Management. As of July 6, 2012.
However, the service side of the ledger was a bit more positive. Although weakening, the ISM Non-Manufacturing Index remained above 50 at 52.1.
Additionally, the labor market continues to disappoint, although we do continue to see job additions. The ADP Employment report surprised on the upside at 176,000 new jobs for June but the broader government labor report was again disappointing, as only 80,000 new jobs were added. In contrast to the previous month, the unemployment rate remained unchanged at a still-elevated 8.2%. Remember, the unemployment rate is one of the most lagging of all economic indicators, and we have recently seen a positive reversal in unemployment claims, a leading economic indicator.
There are some automatic stabilizers that can help to stimulate economic growth when it slows. One that has been working quite well lately is the reduction in oil prices as demand growth has slowed, helping to put more money in consumers’ pockets. Additionally, other commodity costs have eased as well, although there is growing concern that the heat wave hitting much of the country is causing corn crop problems which has resulted in elevated corn prices. With corn used in so many food items, as well as in ethanol and other products, it is something we are keeping an eye on moving forward.
Government…muddling is thy name!
It’s difficult to imagine employers gaining a lot of confidence and willing to take additional risk by hiring a lot of new workers when they have so much uncertainty surrounding taxes, regulations and ongoing healthcare costs…exacerbated by the looming fiscal cliff. And while politicians on both sides of the aisle appear to recognize the problems this uncertainty is causing, definitive action still appears unlikely. At this point, we believe the most likely scenario is that the lame duck Congress following the elections will pass a three-to-six month extension of current policy so the new Congress can deal with it in 2013—thus avoiding the worst case scenario, but still leaving it hanging out there. One important note, however, due to the WARN Act, government contractors have to preannounce potential job cuts ahead of time. So if we still don’t have a deal before the election, we will likely have multiple mass layoff announcements made, especially from defense contractors, which could have a negative drag on sentiment.
Europe struggles to make progress
Speaking of a negative drag on sentiment, European policymakers have taken squabbling to an art form. More than two years into the sovereign debt crisis, progress remains disappointingly slow. Yet another European summit to curb the sovereign debt crisis has come and gone, and despite unveiling another “grand plan,” doubts remain, and muddling along continues.
The aim for the recent summit was to break the vicious cycle between weak peripheral countries and their weak banks. Low expectations were exceeded, but market relief was short-lived amid lack of details and still-missing components that are likely needed to quell the crisis. Meanwhile, each successive “grand plan” has had a shorter relief rally, as market participants are becoming less patient, while policymakers appear to lack urgency.
Market relief remains tenuous
Source: FactSet, iBoxx. As of July 10, 2012.
Spain remains a concern because its banking system needs capital, estimated at 37 billion euros by the International Monetary Fund (IMF), and 51-62 billion euros in stress tests conducted by consultants hired by the Spanish government. A separate audit on an individual bank-by-bank basis is due in late July.
The problem is the source of capital infusions for Spain’s banks:
- If banks are bailed out by the Spanish government, the Spanish government itself may need a bailout.
- One outcome of June’s summit potentially allows bailout funds to directly recapitalize banks. However, common eurozone-wide bank supervision is required first, and this is a complicated process that may not happen until the second half of 2013.
- The latest “plan du jour,” is to give Spanish banks 30 billion euros in emergency funding without expanding Spain’s government balance sheet. However, this stop-gap plan will not bolster confidence definitely in our opinion, as it not large or quick enough and lending nations remain resistant.
Incompatible cultures and politics hamper agreement on broad solutions and time has been wasted. As the debt crisis has become a crisis of confidence, each successive failure increases the risk that market confidence cannot be restored – once confidence is lost, it is difficult to gain back. From a long-term perspective, a break up of the euro remains an increasing possibility, which could improve the longer-term outlook, but would likely be accompanied by extreme volatility at the time of occurrence.
However, we don’t believe Europe will achieve either full union or break-up in the near-term, resulting in muddling through as the most likely scenario. As such, the rollercoaster loop of sentiment is likely to remain in place, and we continue to believe European stocks will be under-performers.
Global synchronized slowdown
The economic slowdown has gradually spread from Europe in the fall of 2011, to China in the first quarter of 2012, and now the United States appears to be joining. As a result, the JPMorgan Global Composite Purchasing Manager Index (PMI) shows global economic growth falling perilously close to contraction territory.
Global economy losing steam
Source: FactSet, Bloomberg. As of July 10, 2012.
A look under the hood is even more concerning, as the JPMorgan Global Manufacturing PMI has fallen to 48.9. The service economy has been a source of relative strength, but manufacturing has dropped, and manufacturing tends to lead economic trends, as it is more tied to the business cycle. Additionally, the new orders component of global PMIs dropped significantly in June, evident not only in the US ISM report mentioned earlier, but even China cited the United States as a new sign of weakness in June. Lastly, with inventories falling at a slower pace than orders globally, the implication is that an inventory destocking cycle could be upon us, which could result in lower economic activity in the future.
Is there a hard landing in China?
The gloomy sentiment stick appears to have been handed off from Europe, where slow growth appears to be “accepted” by markets, to China. The definition of a hard landing in China is debatable. We think of it as roughly a 3% decline from the potential growth rate of the economy, similar to the decline to zero growth in the United States. This would equate to roughly a 6% level for a hard landing in China, in our opinion.
If China’s gross domestic product (GDP) is still growing more than the 6%, what’s the fuss? We want to redirect the conversation away from “China hard landing” to the “stall speed” concept, where growth slows enough to become self-reinforcing. While an imprecise science, particularly in an immature economy, it feels to us like we are hovering around stall speed in China, much like we are in the United States.
We believe more fiscal stimulus needs to begin quickly to stave off the economic downturn in China. China’s response has been underwhelming thus far, either because growth hasn’t fallen enough, aging demographics have resulted in slower tolerable growth, the desire to not repeat prior mistakes and bubbles, or a desire to prudently allow steam to come out of the economy as it transitions to a consumer-based economy. Regardless, slower growth is likely to be the new normal for the Chinese economy in our view, a concept with which markets are still grappling.
China’s growth has global stock investment implications. Unrelated to economic growth, we believe the Chinese stock market has become less attractive over the intermediate term due to profit-reducing bank reforms, and the large weight of the financial sector in Chinese indexes.
However, we are still believers in the growth story of emerging markets (EM) as a group relative to developed markets. A more forceful fiscal stimulus in China has the ability to stimulate economic growth and stock performance in many Asian nations, which constitute the largest portion of the EM universe.
While a lot of negativity appears to be priced into EM stocks, the impact of the global slowdown is still being priced into developed market stocks, where earnings misses and negative stock reactions indicate that the extent of the weakness may not yet be priced in.
Lastly, we’d be remiss if we didn’t mention nuggets of good news, including inflation falling globally, a change in attitude from austerity to growth, and global central bank easings. Our base case is a global slowdown, not a crash, and investment opportunities remain. Read more international research at www.schwab.com/oninternational.
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.
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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.
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Tags: BRICs, Charles Schwab, Chief Investment Strategist, Chinese Growth, Collapse, Debt Crisis, Earnings Season, Economic Data, Economic Problems, European Union, inflation, Liz Ann, Long Term Solutions, Lows, Macro World, Outlooks, Real Estate Bubble, Reins, Research Key, Sector Analysis, Senior Vice President
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Saturday, July 14th, 2012
The Federal Reserve and other central banks manipulate interest rates every day, James Grant of Grant’s Interest Rate Observer told CNBC’s “Closing Bell” on Thursday. “The Fed is in the business of trying to manipulate markets, the macro economy, interest rates, unemployment and inflation through various monetary means, including the twisting around of yield curves and interest rates,” Grant said. Grant added, “The Federal Reserve fixes rates on principle. They have ‘operation twist’ that manipulates the credit markets. They have quantitative easing that manipulates bond yields.”
Tags: Bond Yields, Central Banks, Closing Bell, Cnbc, Credit Markets, Federal Reserve, Grant Federal, inflation, Interest Rate Observer, Interest Rates Unemployment, James Grant, Macro Economy, Principle, Quantitative Easing, Yield Curves
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Thursday, July 12th, 2012
Last month, in my Investment Directions monthly commentary, I predicted that we’d see further stimulus from China this yearas officials try to keep Chinese growth at a respectable rate ahead of a fall 2012 leadership transition.
And as I suggested would happen, the Chinese central bank last week announced its second surprise rate cut within a month. The action from the central bank was an acknowledgement that the world’s second largest economy is slowing. In the first quarter, China’s growth decelerated to 8.1% year over year, the slowest pace since the summer of 2009 as a slowing United States and ongoing European sovereign debt crisis took a toll on Chinese exports.
Still, despite China’s economic slowdown, I continue to hold an overweight view of Chinese equities for the following four reasons:
1.) Valuations: Chinese stocks are selling at a significant discount to both other Asian emerging market countries and to their own history, especially when you consider that Chinese inflation is decelerating. In addition, current discounted valuations appear to be already reflecting the risk of a hard landing, which I don’t believe is the most likely scenario for China.
2.) Growth Expectations: While China is experiencing a slowdown, it’s important to put China’s growth in perspective. I expect second quarter Chinese growth to come in around 8%, a level consistent with a soft landing scenario, and not anywhere near the United States’ truly slow 2% growth. In addition, the preponderance of evidence – and the few bright spots among weak recent economic data — still suggest that China can engineer a soft landing and even if China ends up growing at 7% to 7.5% next quarter, Chinese equities still look cheap.
3.) Economic Policy: That China lowered interest rates twice within a month suggests that Beijing is refocusing on, and is willing to go the distance to stabilize, growth. In fact, I continue to expect more stimulus from China as it tries to ensure a smooth upcoming leadership transfer and as cooling inflation in the country gives the government more room to focus on growth. In addition, the gradual liberalization of the financial industry is also a plus for long-term growth.
4.) Relatively Low Risk: Based on my team’s analysis, China is not one of the 15 riskiest markets. In addition, China enjoys a relatively stable currency, which reduces the volatility of its USD returns.
To be sure, Chinese equities, along with other risky assets, are still vulnerable to the fortunes of the global economy, and an exogenous shock, such as a worsening eurozone crisis, could certainly knock China off of its trajectory. But in the absence of such an event, most evidence suggests that China can engineer a soft landing and its outlook seems more positive than investors may be discounting. I prefer to access Chinese equities through the iShares MSCI China Index Fund (NYSEARCA: MCHI) and the iShares MSCI China Small Cap Index Fund (NYSEARCA: ECNS).
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and investments in smaller companies may be subject to higher volatility.
Tags: Acknowledgement, Chinese Central Bank, Chinese Exports, Chinese Growth, Chinese Stocks, Debt Crisis, Economic Data, economic policy, Economic Slowdown, Emerging Market Countries, First Quarter, Growth Expectations, inflation, Investment Directions, Leadership Transition, Preponderance Of Evidence, Sovereign Debt, Stimulus, Surprise Rate, Valuations
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