Muddling Through…But for How Long? (Sonders)

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

Key Points

• 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.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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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Are Weak Earnings Already “Baked In”?

Tuesday, July 10th, 2012

I’ve been speaking quite a while about the difficult this earnings period could be. I’ve actually been more concerned about future guidance – Q3 and Q4 seem wildly optimistic in the context of a global slowdown, but as we get closer to the actual reporting period I’ve become concerned with the Q2 data as well. We’ve already had a flurry of high profile warnings and with both an European and Chinese slowdown, a lot of the multinational revenue growth could be in question. The stronger dollar also does not help these firms.

But the stock market is all about expectations. Many times we see a company lowball guidance or reduce expectations over the course of a quarter only to “beat” them on the day of earnings and see the stock surge. That’s just part and parcel with the Wall Street game. And I’m starting to see a lot of stories in the past 2 weeks about the potential for a bad earnings season. So has this become “baked in” at the macro level? That could be the main question to answer over the next 4 weeks.

Story 1: Reuters - Investors Brace for Shaky U.S. Earnings Season

Earnings season begins on Monday with U.S. companies facing a litany of issues that could make second-quarter reports look dismal.

Corporate outlooks are at their most negative in nearly four years and companies that have already reported have shown lackluster growth. Nearly two dozen S&P firms have already cited Europe’s woes – which seem to be worsening – as a concern.

In addition, more than 85 members of the Standard & Poor’s 500 lowered expectations in the last several weeks and the quarter’s expected earnings growth of 5.8 percent is entirely due to Apple Inc and a big earnings gain for Bank of America Corp due to a mortgage settlement last year.

Earnings growth is estimated to decline 0.4 percent without the benefit of Apple and Bank of America.

Revenue is seen up just 1.7 percent, down from 5 percent growth in the first quarter, the data showed.

Corporate outlooks are the most negative they’ve been in years. Negative-to-positive earnings guidance is now at 3.3 to 1, the worst since the fourth quarter of 2008.

Story 2: AP – Get Ready for the End of Record Corporate Profits

For almost three years, no matter what has rattled the financial markets — a debt crisis in Europe, high gasoline prices, a slower economy — investors have been soothed by rising corporate profits.

The storyline became as predictable as a soap opera’s. But when the latest round of corporate earnings starts rolling in this week, look for a twist: Profits are expected to fall.

Stock analysts expect earnings for companies in the Standard & Poor’s 500 index to decline 1 percent for April through June compared with the year before, according to S&P Capital IQ, the research arm of S&P.

That would break a streak of 10 quarters of gains that started in the final quarter of 2009.

Copyright © Market Montage

Tags: Bank Of America, Bank Of America Corp, Earnings Gain, Earnings Growth, Earnings Season, Global Slowdown, Litany, Macro Level, Outlo, Outlooks, Q3, Quarter Reports, Reuters, S 500, Season Earnings, Second Quarter, Stock Market, Stock Surge, Story 1, Street Game, Woes
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The Achilles Heel of the US Economy (Koesterich)

Tuesday, May 22nd, 2012

The Achilles Heel of the US economy may just be that entitlement programs haven’t kept pace with US demographics, a fact that has long-term implications for investors.

According to a recent annual government report on entitlement programs, the Social Security trust fund is likely to run out of money in 2033, three years earlier than previously projected. Meanwhile, both Social Security and Medicare aren’t sustainable in the long term without structural changes.

As I point out in my recent Market Perspectives piece, one reason that these entitlement programs, which rely on current workers to fund current retirees, are facing such problematic outlooks is that they were designed decades ago for a population that looked very different demographically from today’s aging US population.

Social Security, for instance, was formed in the 1930s when there were approximately 40 working age Americans per retiree. Medicare was introduced in 1965 when there were approximately 25 workers per retiree. Today there are roughly 3.3 workers per retiree and at some point before 2050, the ratio is likely to drop to approximately 2 workers per retiree. Due to demographic shifts in the US population, today there are more and more retirees, and fewer and fewer workers.

At the same time, Americans are living much longer and (paradoxically) retiring earlier than previous generations. Back in the 1950s, the average age of retirement was about 67. Today, it’s 62. Longer lives coupled with earlier retirements mean longer retirements that have to be funded by these programs.

Without significant reform, US entitlement programs are likely to pose a growing economic strain on the economy. For example, without a change to current laws, federal spending on Medicare and Medicaid combined will grow to almost 10% of gross domestic product by 2035, up from roughly 5% today. If left unchecked, Social Security and Medicare will eventually help crowd out all other government spending.

And if the United States continues to fail to tackle unfunded liabilities, the economic strain from entitlement spending is likely to be greater in the United States than in other developed countries.

For investors, especially those who don’t believe the strain is going to be alleviated anytime soon, here are three long-term implications:

1.) Consider raising allocations to equities in emerging markets with younger populations such as Brazil, Mexico, India, Indonesia and the Philippines. Developed world countries with aging populations are likely to grow slower, and trade at lower valuations, than younger, faster growing economies (potential iShares solution: the iShares MSCI Brazil Index Fund (NYSEARCA: EWZ)).

2.) Remain underweight Treasuries. The massive spending pressure on the federal government from unreformed entitlement programs will likely mean a larger supply of Treasuries. In the absence of the Federal Reserve or other public institutions buying the larger supply, yields should rise, a negative for Treasury bonds.

3.) Opt for certain sectors. If rates rise thanks to a larger supply of Treasuries, certain segments of the equity market are likely to get hurt more, while others should prove more resilient. Typically sectors such as healthcare, energy, and technology hold up the best when rates rise. Meanwhile, sectors such as consumer discretionary, financials and utilities suffer the most (potential iShares solution: the iShares S&P Global Energy Sector Index Fund (NYSEARCA: IXC)).

To be sure, there’s always the chance that Congress will figure out a way to fix the programs. One potential solution, probably the easiest and most obvious, is to gradually raise the retirement age one must reach to take part in the entitlement programs. Raising the retirement age could shorten the retirement period that has to be funded, which would shorten the funding burden on the programs and on the government.

What do you think of this potential solution? What do you think should be done to extend the longevity of US entitlement programs and why?

Sources: Bloomberg, Congressional Budget Office

Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

The author is long EWZ and IXC

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 narrowly focused investments may be subject to higher volatility.

Tags: 1930s, Achilles Heel, Brazil, Demographic Shifts, Economic Strain, Federal Spending, Gove, Government Report, Gross Domestic Product, Market Perspectives, Medicaid, Medicare, Outlooks, Retirements, Security Trust Fund, Social Security And Medicare, Social Security Trust, Social Security Trust Fund, Term Implications, Time Americans, Us Population
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Goldman on the Three Risk World

Friday, April 20th, 2012

Three key issues remain at the heart of current markets: the strength of the US growth cycle; the sovereign and financial risks in the Euro area; and the risks of ongoing deceleration in Chinese growth. Goldman has created proxies for these various risks and the sensitivities of different assets to those risk factors. They further note that looking at those three proxies over time confirms what general qualitative commentary has also spelled out. From late November to early February, the market relaxed about all three risks, as better global data and the impact of the LTROs on European financial risks provided a strong tailwind. From February until mid-March, China fears reappeared and the market downgraded its views of China significantly while still relaxing about European and growth risk. Since then, both European – and to a lesser degree – US growth risks have re-emerged, but at the same time there are some very tentative signs that the market is becoming a little less worried about China. They, however, remain increasingly cautious on them all: Europe seems increasingly in the hands of governments, not the ECB, raising volatility; unspectacular growth trajectory in the US continues as outlooks adjust down; and even thouigh China’s risk has stabilized they have avoided active exposures ‘given the muddiness of news’. Understanding which assets are more sensitive and how these risks evolve might help prognosticators understand the need to pay attention to Europe – as opposed to merely Apple’s earnings.

Tracking the Three Risk Perceptions Through Time…

And asset sensitivities to these risk factors…

Charts: Goldman Sachs

Tags: Assets, Chinese Growth, Deceleration, ECB, Exposures, Global Data, Goldman Sachs, Growth Trajectory, Late November, Mid March, Nbsp, Outlooks, Prognosticators, Proxies, Qualitative Commentary, Risk Factors, Risk Perceptions, Risk World, Tailwind, Volatility
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Spain Forecasts 24.3% Unemployment In 2012, 1.7% GDP Contraction

Friday, March 2nd, 2012

Nothing good here for our Spanish readers: while speaking at a news conference, Deputy Prime Minister Soraya Saenz de Santamaria said that Spain’s economy will contract by 1.7 percent this year as the government carries out drastic austerity measures. The forecast matched the International Monetary Fund’s outlook for Spain’s economy this year and was less optimistic than the outlooks from the country’s central bank and from the European Commission. Earlier, Spain also defied the European Union, setting a 2012 deficit target at 5.8 percent of gross domestic product, a far softer goal than the 4.4 percent agreed with Brussels. More importantly, the country now anticipates that its unemployment rate will hit 24.3%. Frankly, while horrendous and worse even than in Greece (as it also implies a youth unemployment rate well into the 50%s), this is an overoptimistic number, because as noted before, Spain’s unemployment soared from 21.5% to 23.3% in Q4 alone. When all is said and done, look for Spain’s 2012 YE unemployment to be well over 25%. So as the economic deterioration across the PIIGS accelerates, at least the banks are “safe.”

Spain’s historical unemployment:

And other forecast highlights via Bloomberg, citing Spain’s De Guindos:

• *SPAIN GROWTH MAY BE NEGATIVE UNTIL THIRD QUARTER INCLUDED
• *SPAIN HOUSEHOLD SPENDING TO DECLINE IN 2012, DE GUINDOS SAYS
• *SPAIN GOVERNMENT FORECASTS 24.3% UNEMPLOYMENT RATE IN 2012
• *SPAIN GOVERNMENT FORECASTS 24.3% UNEMPLOYMENT RATE IN 2012
• *SPAIN HOUSEHOLD SPENDING TO CONTRACT 4 PERCENT IN 2012
• *SPAIN 2012 SPENDING LIMIT SET AT EU118.6BLN
• *SPAIN 2012 SPENDING LIMIT DOWN 4.7% FROM 2011

As we said, nothing good.

Tags: Austerity, Contraction, De Santamaria, Deficit Target, Deputy Prime Minister, Economic Deterioration, Government Forecasts, Gross Domestic Product, Household Spending, International Monetary Fund, Outlooks, Q4, S Central, Saenz, Soraya, Spain Economy, Spain Government, Spanish Readers, Unemployment Rate, Youth Unemployment
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The Economy and Bond Market Radar (February 27, 2012)

Sunday, February 26th, 2012

The Economy and Bond Market Radar (February 27, 2012)

Treasury bond yields were mixed this week as the short end of the yield curve rose slightly while the long end fell by a similar amount.

Global economic data remains mixed as the February eurozone Purchasing Managers Index (PMI) fell back into contraction territory. The HSBC February “flash” PMI for China also indicated contraction. On the other hand, U.S. economic data remains positive as housing indicators continue to recover. The chart below shows existing home sales continuing to grind higher and months of supply for existing homes fell to 6.1 months, the lowest level in five years.

Strengths

• Initial jobless claims continue to point to a recovery and remain near a four-year low.
• The University of Michigan Consumer Confidence Index rose to 75.3 from 72.5 in February.
• Consumer confidence in the eurozone increased for the second month in a row.

Weaknesses

• Retailers that reported earnings this week generally gave cautious outlooks, likely driven by higher gasoline prices.
• Key global manufacturing PMIs out of the eurozone and China are indicating weakness.
• Gasoline prices have surged by about $0.40 in the past two months as oil prices continue to climb.

Opportunities

• The “risk on” trade started to show a few cracks this week and a reversal of sentiment would be good for bonds.

Threats

• Coordinated global easing from the world’s central banks would eventually create inflation.

Tags: Bond Market, Central Banks, Chart Below Shows, Consumer Confidence Index, Contraction, Economic Data, Eurozone, Existing Home Sales, Gasoline Prices, Initial Jobless Claims, Market Radar, Michigan Consumer Confidence, Oil Prices, Outlooks, Purchasing Managers Index, S Central, Treasury Bond Yields, University Of Michigan Consumer Confidence, University Of Michigan Consumer Confidence Index, Yield Curve
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True Reflections … on 2011 and 2012 (Sonders)

Friday, January 6th, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The Dow Jones Industrial Average (DJIA) managed a gain for the year in 2011, but very few investors were cheering.
• With inflation settling down, the upward boost to real gross domestic product (GDP) is likely being underestimated.
• Although the eurozone crisis may keep volatility elevated short-term, 2012 is looking like a better year.

“I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place.”
—Winston Churchill

It’s that time of year again, when we review the year that was and look ahead to the year that is. It’s a time rife with forecasts, outlooks and predictions. At Schwab we do our part, but not quite like the others. At our company’s core is the belief that disciplined investing is the key to long-term success, and that investing based on forecasts—yours, mine or anyone else’s—is gambling in disguise. That is why we don’t publish year-end price forecasts … I haven’t a clue where the market will close the day I’m writing this and that’s only a few hours away, let alone where it will close on December 31, 2012.

Expect the unexpected

What we do try to do is review trends, scenarios, possibilities and probabilities, while always keeping a close eye on the contrarian view. As Oscar Wilde said, “To expect the unexpected shows a thoroughly modern intellect.”

Last year was a doozy. From the start of 2011 to the end of April, the S&P 500 Index rallied nearly 10%, only to plunge nearly into bear-market territory (-20%) by early October. It rallied back nearly that much by the end of October, giving back another 10% by Thanksgiving, but finishing with a nearly full recovery of that 10% over the holiday season.

The real trouble erupted in August thanks to a dysfunctional Congressional debate about the debt ceiling, a subsequent US credit-rating downgrade and the re-eruption of the eurozone debt crisis. The DJIA averaged a daily intraday swing of 270 points between August and November, more than double the spread over the same period in 2010.

A market full of “sound and fury, signifying nothing”

When all was said and done, the S&P 500 and the Dow did eke out gains for the year (though only thanks to dividends for the S&P). But that performance belied the turmoil of the year and few investors have been celebrating save for maybe those who stuck with US Treasury bonds over the year. Even the so-called smart-money hedge funds had a tough year: the average return was -5% according to Hedge Fund Research. There’s little worse for a hedge fund than posting a negative sign before returns with the major indices in positive territory.

You can see the array of returns across many of the key global indices below:

2011 Asset Class Performance

Source: Bloomberg, Thomson Reuters, as of December 30, 2011.

Key to the year’s initial surge into late April was the expectation that the economic recovery was picking up momentum. Those hopes, along with the market’s rally, were dashed with a very weak second-quarter GDP report that was not only weaker than expected, but brought significant downward revisions to prior quarters’ growth rates (including a whopping revision to 2011′s first quarter from 1.9% to 0.4%). What we ultimately learned about the year’s first several months was that a sharp increase in inflation took a big bite out of “real” (inflation-adjusted) GDP.

The $30 surge in oil prices in the five months through April 2011 likely carved about 1.5% out of GDP growth. There were also major weather disruptions to crop production that caused a spike in food inflation, and ushered in the Arab Spring. Add to that the March earthquake and tsunami in Japan, which wreaked havoc with the global supply chain, and we had the recipe for a brutal first half of 2011. The mistake some made was extrapolating this weakness into the future and assuming the weakness was secular, not cyclical and reversible.

Inflation takes over from Federal Reserve policy

Inflation has been, and will remain, a big driver on the margin of growth. In cycles past, Fed policy and its influence on short-term rates would move the needle on growth with nearly every tick. But with short rates pegged at zero since the end of 2008, this is no longer the case. What appears to now move the needle, given other growth constraints, is consumer inflation, which can make a big difference given limited income gains. Here’s where there’s some good news recently, and as we look ahead to 2012.

Tags: Bear Market, Charles Schwab, Chief Investment Strategist, Congressional Debate, Contrarian View, Debt Ceiling, DJIA, Doozy, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Gross Domestic Product, Liz Ann, Oscar Wilde, Outlooks, Price Forecasts, Senior Vice President, Term Success, True Reflections, Winston Churchill
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Goldman’s Economists Score 7 Out Of 10 For 2011 (Retrospective)

Thursday, December 22nd, 2011

Since the 2012 Outlooks have now slowed to a drip, its appears retrospectives are the stocking-filler of choice for the week. Goldman’s economist group reflects on their ’10 Questions for 2011′, released at the end of December 2010, and finds they were correct seven times. The tricky thing about judging the ‘score’ is the magnitude of the error – or more importantly the magnitude of the question’s impact on trading views. Jan Hatzius and his team have had their moments this year, for better or worse, in economic sickness or health but they have largely been accurate at predicting Fed policy (or should we say ‘directing/suggesting’ Fed policy), but were significantly off (along with emajority of the Birinyi-ruler-based extrapolators from the sell-side) on growth (high) expectations and inflation (low) expectations. Nevertheless, the lessons learned from over-estimating the speed of healing from the credit crisis and the disin- / de-flationary effects of a large output gap (which BARCAP would argue is not as wide) when inflation is already low and inflation expectations well anchored are critical for not making the same overly-optimistic mistake into 2012.

US Daily: A Retrospective on “10 Questions for 2011″

Today’s comment reviews the 10 key questions for 2011 that we posed a year ago, our answers at the time, and what actually happened.

It has been a mixed year. On the positive side, our views on Fed policy have proven accurate. On the negative side, we were too high on growth and too low on inflation. Adverse supply shocks, including the upheaval in the Middle East and the Japanese earthquake in March, explain part of these misses. But we also overestimated both the speed of healing from the credit crisis and the disinflationary effects of a large output gap when inflation is already low and inflation expectations are well-anchored.

In the last US Economics Analyst of 2010, published on December 31, we posed “10 Questions for 2011.” In today’s comment, we review each of the questions, our answers at the time, and what actually happened.

Question 1: Will we finally see a “real” economic recovery?

Our answer: Yes.

Verdict: Incorrect. Ultimately, 2011 felt much like 2010. A strong performance in the winter was followed by a sharp slowdown in the spring, renewed recession worries in the summer, and some signs of reacceleration in the fall. From the perspective of our forecasts, the main difference was that we predicted the slowdown of 2010 but failed to predict the slowdown of 2011. In fact, we thought that growth would accelerate to a 3.5%-4% annualized pace in the course of 2011.

However, real GDP grew just 1.2% in the first three quarters of 2011 and our current activity indicator (CAI)–an alternative measure of growth that takes into account a broader range of data–grew 1.9% in the first eleven months of 2011. Depending on which of the two measures we use, this implies that growth has fallen short of our forecast by 2 to 2-1/2 percentage points.

What explains this miss? We see three factors:

1. Adverse supply shocks account for a 3/4-point miss. We estimate that the nearly 30% increase in seasonally adjusted gasoline prices between November and April–largely due to increased supply worries in the wake of the “Arab spring”–shaved 1-1/2 percentage points from real disposable income growth in the first half of the year. With little change in the saving rate at the time, most of the real income hit fed through into weaker consumer spending growth. In turn, with little change in net trade, most of the consumption hit fed through into real GDP. (Note that this implies a real GDP hit of about 1 percentage point, since the level of consumption is about two-thirds that of GDP.) The supply-chain disruptions following the East Japan earthquake of March 2011 also weighed on growth for a while. For the first three quarters of 2011, we believe that adverse supply shocks may have subtracted 3/4 percentage point from growth.

 

2. Fiscal retrenchment accounts for a 1/2-point miss. When Congress extended the 2001-2003 tax cuts for another two years and passed the temporary fiscal measures–especially the payroll tax cut–at the end of 2010, we thought that this meant a roughly neutral fiscal stance in 2011, with slight net stimulus from the federal government offset by slight net restraint from state and local governments. However, we now believe that fiscal policy has subtracted about 1/2 percentage point from growth in 2011 so far. The official GDP data show that a reduction in government spending, concentrated in the state and local sector, has subtracted 1/2 percentage point from growth; meanwhile, there seems to have been little change in overall tax rates after accounting for income, payroll, and sales taxes. Overall, this suggests that fiscal policy subtracted 1/2 points more from growth than we expected.

 

3. A longer “hangover” may account for the remaining 1-point miss. The preceding two points explain perhaps 1-1/4 points of disappointment, but this still leaves approximately another 1 percentage point. An obvious candidate explanation is the European crisis, which has intensified beyond most people’s expectations (including ours) this year. But we think that this explains only a small part of the miss. Instead, a more plausible story is that the “healing” in private domestic demand has simply progressed more slowly than we had expected at the end of last year, when measures of underlying final demand had started to pick up at a fairly impressive speed. In other words, the “hangover” from the bubble seems to be lasting even longer than we thought.

Question 2: Will the housing market recover meaningfully?

Our answer: No.

Verdict: Correct. Although housing starts and home sales did rise slightly through 2011, the increase has fallen short of what we would call “meaningful.” Moreover, house prices have fallen on net, and some measures show a reacceleration in the pace of decline in recent months. We expect a somewhat better performance in 2012, with starts and sales growing more noticeably and home prices stabilizing late in the year.

Question 3: Will the trade deficit shrink substantially?

Our answer: No.

Verdict: Correct. The trade deficit has been essentially unchanged in 2011, as both exports and imports have grown at impressive 10%+ rates through the year. We expect more of the same in 2012.

Question 4: Will the unemployment rate fall?

Our answer: Yes.

Verdict: Correct (but partly for the wrong reasons). The unemployment rate fell from 9.8% in November 2010 to 8.6% in November 2011, which is actually somewhat below the 9% we expected a year ago. The larger-than-expected decline occurred despite weaker-than-expected GDP growth, as the labor force participation rate fell by another 1/2 percentage point to 64.0%, the lowest since 1983. Going forward, we expect the unemployment rate to move sideways to higher as growth stays sluggish and participation stabilizes.

Question 5: Will inflation move back toward 2%?

Our answer: No.

Verdict: Incorrect. Both core and headline PCE inflation rose significantly in 2011 and now stand at 1.7% and 2.7%, respectively. Part of our error was due to the bigger-than-expected increase in the prices of oil and other commodities, as well as the surge in automobile prices following the Japan earthquake. But we also underestimated the upward pressure on rents in an environment of still high but gradually declining excess supply of housing; in particular, our expectation that excess supply in the owner-occupied sector would also hold down rents in the renter-occupied sector (via an arbitrage relationship between the two sectors) proved incorrect. More broadly, we probably overestimated the disinflationary effects of a large output gap at a time when inflation is already very low and inflation expectations are well-anchored. All that said, inflation now does seem to be slowing again, and we see the core PCE deflator back at 1.3% by the end of 2012.

Question 6: Will profit margins rise further?

Our answer: Yes.

Verdict: Correct. When measured as after-tax profits as a share of GDP, profit margins rose from 6.8% in the third quarter of 2010 to 7.3% in the third quarter of 2011. When measured as S&P 500 earnings per share in percent of revenue per share, margins rose from 8.3% to 9.0%. Going forward, we expect margins to flatten out both on a top-down and bottom-up basis.

Question 7: Will QE2 end on schedule, i.e., in June 2011 with total holdings of $600bn?

Our answer: Yes.

Verdict: Correct. Fed officials did stop the program on schedule at $600bn. Since then, they have embarked on “operation twist,” whose effects on financial conditions are similar to QE in our view, and we expect them to return to QE in the first half of 2012.

Question 8: Will Fed officials start to “exit” from their current policy stance by raising the funds rate or shrinking their balance sheet?

Our answer: No.

Verdict: Correct. Despite some hawkish signals early in the year, Fed officials ultimately embraced a “lower for longer” view and are currently indicating no rate hikes until “at least mid-2013.” With the short-term rate discussion settled for the time being, we moved to a view of further easing in August, which occurred in September via “operation twist.”

Question 9: Will the 10-year Treasury note yield end 2011 above the current level of 3.4%?

Our answer: Yes.

Verdict: Incorrect. Despite our bullish call at the front end of the yield curve, we predicted an increase in rates at the longer end (albeit a moderate one that was below the forwards at the time of our “10 Questions” note). At least part of this was due to the worse-than-expected domestic growth performance and the greater “flight to quality” in the wake of the intensifying European crisis.

Question 10: Will the state and local budget crisis derail the recovery?

Our answer: No.

Verdict: Correct. The widespread fears about state and local finances at the end of 2010 did not materialize. Municipal governments have not defaulted in large numbers, and municipal bonds outperformed most other sectors of the fixed income market in 2011. While continued fiscal tightening was responsible for much of the improvement, the negative impact on GDP growth from state and local spending has actually diminished a bit in the last few quarters and should continue to do so in 2012.

Tags: Birinyi, Credit Crisis, Disin, Drip, Economist Group, Fed Policy, Gap, Goldman, High Expectations, Inflation Expectations, Japanese Earthquake, Low Expectations, Outlooks, Output Gap, Retrospective, Ruler, Seven Times, Supply Shocks, Upheaval, Us Economics
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Bob Janjuah: The 6 Biggest Questions for 2012, Answered

Monday, December 19th, 2011

As Bob Janjuah, of Nomura, notes in his final dissertation of the year, our in-boxes are stuffed with all the good cheer of sell-side research outlooks. However, the bearded bear manages to cut through all the nuance to get to the six questions that need to be addressed in order to see your way successfully in 2012. With the US two-thirds of the way through the post-crisis workout phase while Europe remains only half-way through, and China a mere one-third through the necessary adjustments to less global imbalance, he is not a global uber-bear on every asset class as the net effect is modest global underlying demand and plenty of savings sloshing around looking for a home. The market will have to adjust further to an extended period of weakness in Europe, which will impact EM growth expectations and so the existential ursine strategist is skewing his macro expectations to the downside and with the market pricing a ‘softish’ global landing, there remains a considerable gap between downside risk potential and current expectations. Furthermore, Janjuah believes the upside is relatively self-limiting on the basis of commodity price pressures and the potential for property or asset bubble bursts – leaving upside limited and downside substantial.

Q1: Where are we in the post-crisis work-out?

The US economy is proceeding with its excess capital stock work-off when measured against either the labour force or GDP. It still looks to us like it will take another 12-18 months for the excess capital to be cleared. During this phase it remains a truism that aggregate net investment will remain modest, corporate cash holdings remain high, and that the private sector will still generate higher savings than investment. It is still unclear if the “clearing” level of the capital stock has actually fallen owing to changes in banking and financial regulation. Nevertheless, that backdrop remains supportive of quality non-financial credit, low real yields and weak aggregate equity performance. It’s worth noting that high private sector net saving should be offset by high government sector dissaving during this phase. The US policy mix, while generating a lot of angst, has allowed the US to hold things steady while this background adjustment occurs. Note: demand management policies are not able to generate a return to pre-crisis growth rates until the supply-side work-out is complete; hence the sequential aborted risk market take-offs.

The problem now is that parts of the euro area are in a very similar position but are being forced to adopt what we consider inappropriate policies from a macro point of view. Spain is a good example: who would doubt that the capital stock is some way above the long-run suitable level? As such, Spain and others are likely face only modest private sector demand for several years. A policy of fiscal tightening will only serve to increase the national saving/investment balance as the current account moves into surplus and international debt is paid down. We see this as a good thing but still think gradualism would be better than cold turkey. The added complexity is that the “clearing” level in the euro area is no longer well defined: a combination of rapid banking reform, Basle 2.5/3 and major uncertainty about supply-side and macro policy makes for an open-ended period of capex spending falls.

The final point on background work-out is about EM. China has built a lot of infrastructure since 2008 and we would argue is running some way ahead of the current warranted level. Capital deepening in EM is a good thing, but a period of modest capex looks more likely than a continuation of hyper capex growth. We don’t know as a market whether that will be sufficient to trigger non-linear balance sheet effects and a Chinese credit crunch, but certainly think Mr Market will have to romance the idea in the next 12 months.

Our conclusion is that we are two-thirds of the way through the adjustment in the US, half way through in the euro area (but without knowing the clearing level it’s impossible to be too precise) and one-third through in places like China. Net effect is modest global underlying demand and plenty of savings sloshing around looking for a home.

Q2: Where are we in the business cycle?

Clearly, while this period of work-out is going on, the global economy and its markets are particularly vulnerable to new shocks given current policy settings and the state of weaker paticipants’ balance sheets. For a while now we have been talking about an EM slowdown and hard defaults in the euro area. Both risks are now centre stage for investors.

Two themes emerge from a detailed reading of our economics team’s year-ahead forecasts. First, that the global economy is slowing, led as much by domestic demand in emerging economies as the outlook for the euro area. Fiscal drag, the echo of higher commodity prices and tighter EM policy combined with banking sector deleveraging, has led our economics team to move its forecasts toward weak H1 2012 growth before a reasonably robust recovery in H2 2012. Naturally, this would lead one to be overweight rates and underweight risk now.

But the second overarching theme that emerges is one of contingent risk. Almost every country forecast highlights the evolution of the euro-area economy as the key foreseen risk. And importantly, the gap between the muddle-through shallow recession scenario and full-blown hard landing and cost of capital shock is substantial in the simulation runs provided not just for the euro area but for all economies. Our house opinion is that the euro area does not matter a great deal to global fundamentals, until it matters a great deal. This is classic non-linear gap risk.

One area that is useful to think about is how deleveraging in the euro area will play out in terms of the aggregate data and the euro area’s surplus. It seems to us that a cross-border deleveraging against the backdrop of high multinational corporate cash balances and modest funding requirements should primarily play out through the banking sector seeing a substantial and persistent jump in its funding costs in the current account deficit economies. And it is through this channel that the economy should be influenced via the household and SME sectors seeing a sequential tightening of credit availability and increased funding costs. Naturally if I have 100 large corporates that make up my equity market and I hit their funding costs I would expect a rapid impact. But if I have 5 million SMEs and 30 million households not all of them are looking to refinance at the same time and so I would expect a staggered impact on their effective cost of capital (it’s a bit like duration considerations for governments). Confidence and market pricing of course will not respond slowly.

Another consideration that hasn’t been given much air time is the supply-side flexibility of the euro area in comparison with other major economies. We can get a handle on this issue by comparing how long it takes for changes in growth to have their maximum impact on unemployment and in turn unemployment on inflation. The results are shown in Figure 3, with the maximum lag shown in months. The basic message is that taken over the past 20 years a movement in growth has taken six months to have its maximum impact on unemployment in the euro area and in turn it takes around 16 months for changes in unemployment to have their maximum impact on inflation. It therefore takes over two years for a growth shock to have its maximum impact on inflation, working via the labour and product markets. To put this in context, the US gets there in nine months, while the UK has fairly rapid labour market reactions but relatively slow wage/inflation reactions to unemployment.

What does this mean practically? The policy framework the euro area has adopted excludes high growth or high inflation as a way out of its debt/excess capital stock burden. Instead, we are moving toward a competitive realignment via supply-side adjustment. This is where the “sacrifice ratio” comes in – simply the output loss required to generate a 1% fall in inflation. The sacrifice ratio in the euro area is still higher than in the US and UK, and is particularly high in the periphery (not Ireland, though). Thus, if Spain et al are to compete their way into growth they will face a larger increase in unemployment than others before economic growth returns. Leaving aside the policy and political implications of this, the growth implications are clear – it should be weaker than that of other countries faced with a similar problem. Once the euro area starts adjusting its supply-it exhibits a super-tanker-style turning circle. In this scenario the euro area would shift into a current account surplus – another source of excess savings to the world.

Tags: asset class, Backdrop, Capital Stock, Commodity Price, Dissertation, Downside Risk, good cheer, Growth Expectations, Labour Force, Necessary Adjustments, Nomura, Nuance, Outlooks, Price Pressures, Q1, Stock Work, Strategist, Truism, Ursine, Workout
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The Economy and Bond Market Radar (December 12, 2011)

Sunday, December 11th, 2011

The Economy and Bond Market Radar (December 12, 2011)

Long-term treasury yields ended the week modestly higher as European leaders came together on Friday to form a fiscal pact that placated the market for the time being and led to a sell off in the long end of the Treasury curve.

While there was considerable anticipation and discussion regarding the outcome of the European Central Bank (ECB) meeting on Thursday and Friday’s European Union (EU) summit, the most important piece of data may have come from the other side of the world. The chart below depicts year-over-year inflation in China, which fell to the lowest levels in 14 months. The reason this may be so significant is that this could be a precursor to full-fledged easing in China, which has been the incremental global growth driver in recent years. If China were to cut interest rates, that would be a strong signal that global reflationary policies are back in force and boosts prospects for both global economic growth as well as appreciation in risky assets.

Strengths

• The EU leaders came to an agreement, in principle, on a fiscal pact that will hopefully lead to real reform and stabilize markets in the near future.
• China’s November CPI fell to 4.2 percent and opens the door to more aggressive easing policies in China.
• The University of Michigan Confidence Index rose more than expected in the preliminary December release.

Weaknesses

• Weakness is several Chinese indicators also increases the probability of an interest rate cut as China’s export growth and service sector PMI slowed.
• S&P put negative outlooks on 15 of 17 eurozone countries and the EU may lose its AAA rating as well.
• Factory orders in the U.S. fell 0.4 percent in October and September’s data was also revised lower.

Opportunities

• The Federal Open Market Committee meets next Tuesday and, while expectations are low for a significant change in policy, the Fed could surprise the market.

Threats

• The situation in Europe remains extremely fluid and negative news is almost expected at this point; unfortunately, it is politically driven and difficult to predict outcomes and ramifications.

Tags: Bond Market, Confidence Index, CPI, European Leaders, Eurozone Countries, Federal Open Market Committee, Global Economic Growth, Global Growth, Inflation In China, Market Radar, Open Market Committee, Outlooks, Pact, Precursor, Risky Assets, Service Sector, Strong Signal, Treasury Curve, Treasury Yields, University Of Michigan Confidence
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