Heating Up and Thawing Out

Key Points

  • U.S. equity indicies recently hit record highs, largely ignoring tensions in Ukraine and Russia. Action illustrates why looking longer term is important, but investors should be prepared for the possibility of a more substantial pullback in the near term.
  • Investors have largely dismissed soft economic data as weather-related. Most, but probably not all of the weakness is attributable to weather, but we're starting to get a better read. The Fed remains committed to both tapering and spurring economic growth, while continual changes to the Affordable Care Act have helped dent consumer and business confidence.
  • The European Central Bank continues to stand on the sidelines, but deflation in Europe is becoming more of a concern. China remains committed to growth; but fears of a severe slowdown are growing, which could provide an attractive investment opportunity.

March came in like a lion with the Russia-Ukraine situation exploding, but stock indicies reached record highs. Investor consensus seems to be that the economic hit related to global tensions will be minimal, at least at this point. And with continued low inflation, an accommodative Fed, a declining federal budget deficit, relative calm in Washington, a falling unemployment rate, and few attractive alternative investment options available with fixed income yields again falling, equities look attractive.

Of course, not all is rosy, as sentiment indicators are again reaching concerning levels of optimism, with the Ned Davis Research Crowd Sentiment Poll moving into extremely optimistic territory, which is typically a contrarian/bearish indication. And as we've noted, the last 13 midterm election years have experienced a substantial (typically first-half) pullback, with the average decline for the S&P 500 being 18.7% (thanks to Strategas Research Partners). The good news is that equally consistent has been the rallies that have followed those corrections; averaging 32% for the 12 months after the correction's finale. Our belief is that 2014 could also bring another decent-sized pullback, perhaps in the second quarter if history holds, but that we'll end the year higher than we are now as economic growth accelerates in the United States and stabilizes globally.

The sharp pullback from mid-January through early-February; followed by an even sharper rebound to all-time highs immediately following the escalation of the Ukrainian crisis; illustrates again why trying to time the market is extremely difficult. Global conflicts are almost always an unknown, and often rational decisions are often replaced with political considerations, which are notoriously difficult to predict. Obviously, we don't have any inside line on how the Russian/Ukrainian conflict ends. But we are somewhat comforted by the economic ties Russian oligarchs have with the rest of the world; which may have pushed them to influence Russian President Putin to back off a bit. As with most political conflicts, money often talks loudly.

Data continues to be dismissed as weather-related

At some point, weather will stop being a reason to dismiss weak economic data, but we are also in the camp that much of the December through March data has been distorted by severe weather. One data point to help validate this belief: according to Weather.com, ice coverage on the Great Lakes is close to 92%, the highest level since 1979 and very close to a record. And in February alone, over 600,000 people had a job but didn't work because of the weather, according to the Household Survey of employment. That's double the normal rate. But while we often say we can't predict the future, we can be sure that weather will begin to warm up and economic data could become more reliable.

Somewhat encouraging news came recently via the Institute of Supply Management's (ISM) Manufacturing Index, which jumped to 53.2 in February from 51.3 in January, while new orders ticked up 3.3 points. Also, the Markit Purchasing Managers Index (PMI), which is increasingly replacing the ISM as the manufacturing survey of choice, posted a robust 57.1 reading for February. We believe that companies will increasingly spend on capital improvements this year, which should help both manufacturing and technology companies. Corporate cash balances remain near record -highs, the replacement cycle is extended, and confidence appears to be improving.

Confidence and cash should support business spending

*Cash includes: check deposits & currency, commercial paper, foreign deposits, money market funds shares, mutual funds shares, time deposits & savings, and govt. agency & Treasury securities. Source: FactSet, Federal Reserve. As of Mar. 10, 2014.

Source: FactSet, Gallup. As of Mar. 10, 2014.

Somewhat concerning was the fall in the ISM Non-Manufacturing Survey to 51.6 from 54; while the employment component fell into territory depicting contraction at 47.5. The service sector would seem to be less impacted by weather than the manufacturing side, so these declines are something we are watching carefully. The weak employment reading could indicate that the soft labor reports we've received recently were not solely a due to the weather. That said, job growth for February surprised on the upside, showing 175,000 jobs were added, while the prior two months were revised higher. The unemployment rate did tick slightly higher to 6.7%, driven by an increase in the labor force participation rate. And more recently, we've seen a healthy decline in initial unemployment claims, a leading indicator for the economy.

Fed course consistent, for now

The Federal Reserve has also blamed much of the recent economic softness on the weather; and continues to remain committed to tapering its asset purchases at a pace of $10 billion per meeting. The Fed does remain data-dependent though and would likely change course if it viewed the slowdown as something more serious. Fed Chairwoman Janet Yellen continues to express dovish sentiment, recently reiterating that the Fed will do all it can to ensure the U.S. recovery remains on track, but that the economy is still not as healthy as it could be. This could help to soothe investors' concerns about a premature exit from quantitative easing (QE), although we continue to believe there are risks that may not be recognized regarding the unwinding of unconventional monetary policy.

Down the street in DC, President Obama presented his 2015 budget; which is largely a political and symbolic document, as budget limits were already agreed to through 2015 in the recent budget deal. We were somewhat disappointed, although not surprised, that the Administration is looking to spend even more, while not addressing some of the entitlement programs that surely need changes to make them solvent in the longer term. But in an election year, neither side of the aisle seems likely, nor willing, to get much done other than position themselves for November.

And while we believe the debt and budget deals help to bolster business confidence, we believe the continuing changes being made to the Affordable Care Act (ACA) will have the opposite impact. Additionally, the rule of law is one of the things that makes America attractive to business, but unilateral Presidential-mandated changes to a Congressionally-passed law has helped dent confidence.

Europe: will growth slip?

In the eurozone, leading economic indicators point to continued recovery. However, risks are building; such as the situation in Ukraine, emerging markets slowing, subdued inflation, a de facto tightening of monetary policy by the European Central Bank (ECB), a strong euro, and lending contracting. We don't believe it is in any country's interest to shutoff energy flows to Europe through Ukraine from Russia, but slowing emerging market growth could pressure companies that export to these countries.

However, subdued inflation bears close monitoring; as deflation, or a broad-based decline in prices, could become self-fulfilling, if inflation expectations fall to a level that postpones demand. We believe the ECB may need to provide more stimulus to stave off the threat to growth posed by the prospect of a long period of low inflation or deflation. Additionally, both France and Italy need reforms to bolster stagnant growth. Italy's new Prime Minister Renzi has an ambitious 100-day reform plan, but Italy's historically-divided government has had difficulty making progress; and French President Hollande's "responsibility pact" with businesses has been underwhelming thus far.

Monetary policy is essentially tightening, because the ECB's balance sheet is contracting as banks pay back loans received under the long-term refinancing operation (LTRO). This reduction in capital, along with bolstering balance sheets ahead of stress tests, has resulted in banks restricting lending. Loans to non-financial companies fell 2.9% in January from a year earlier. However, the most recent bank survey may indicate lending stabilizing, becoming less of an obstacle. Private sector loans in the eurozone gained 0.2% in January from December, the first uptick since May 2012, and the largest increase since September 2011.

Meanwhile, the strength in the euro has mystified investors. Reasons include divergences in monetary policy; with the ECB effectively reducing money supply; as well as a current account surplus for the eurozone. While a strong currency can hurt export demand, Germany's unique skills and products have somewhat insulated it; while some peripheral countries such as Spain have reduced unit labor costs, improving competitiveness. These may be the reasons the rise in the euro has yet to hold back European stocks.

Stronger euro hasn't hindered European stocks yet

Source: FactSet, Reuters. As of Mar. 11, 2014.

We believe the eurozone's recovery will continue, albeit at a sluggish pace. Despite the risks and the potential for volatility, we remain positive on European stocks, due to the prospects for economic and profit margin improvement.

China's "Bear Stearns moment?"

Uncertainty about China is becoming feverish, with distortions from the timing of the Lunar New Year resulting in wide swings in monthly economic data. While the quality of some economic releases has long been in question, some investors are wondering if the threat of a $495 million trust default in January, and the first corporate bond default in March, are "canaries in the coal mine."

The headline of a "Bear Stearns moment" in China garners attention, but we caution against making this comparison. The complexity of products in China is not comparable to the derivatives issued during the pre-Lehman days in the U.S. financial system, and China's government has levers to stem a collapse.

Higher-risk Chinese companies face rising borrowing costs

Source: FactSet, Bloomberg. As of Mar. 11, 2014.

That said, debt defaults are likely to slow new credit issuance and increase borrowing costs, slowing economic growth further. This could result in the closure of higher-risk "zombie" companies that are on life support and result in a "Lehman moment" in the coming year. This could happen if liquidity dried up too quickly; where companies that need credit are unable to access it without paying exorbitant rates; resulting in bankruptcies that ripple through supply chains to related companies. However, we believe this is a small possibility, as the government would step in if this became a threat. Growth is clearly still a priority given the maintenance of China's 7.5% growth target for 2014.

Bears also point to market signals of an imminent hard landing in China; such as copper prices hitting multi-year lows; and a drop in the currency, counter to a previous multi-year increase. We note that "market signals" from China aren't always what they appear, as the hand of government distorts normal market functioning. After years of appreciating, the government began to set a lower level for the currency; possibly to thwart "one-way" speculators betting on a sure thing, as well as to provide help for exporters.

Scrap copper in China has been used as a financing mechanism; with speculators using short-term loans to buy copper, only to post it as collateral to secure access to larger, longer-term loans for speculative investment. The combination of economic slowing, rising default risks, the drop in the yuan, and the continued crackdown on shadow banking has resulted in an unwinding of the copper scheme. Selling has pressured prices, prompting those with loans using copper as collateral to post more collateral, or close their positions, similar to a "margin call."

China's government has the tools to stem a financial and economic collapse by using a combination of liquidity injections into the banking system, devaluing the currency, and/or stimulating growth via fiscal spending. Part of the recent slowing in China may be due to a reduction in government spending. Infrastructure spending in particular began to slump in December 2013, and 21 of 25 provinces released 2014 investment spending targets below 2013 levels. At the same time, government deposits at the central bank have swelled; growing by 40% from a year ago, to 2.9 trillion yuan at the end of 2013. This may constitute a war chest for future fiscal stimulus programs, which might be necessary to meet the government's 7.5% growth target for 2014.

We are expecting China's growth to slow further in coming months, but believe a lot of bad news is already reflected in stock prices. i.e., the worst fears may be overblown. We believe Chinese stocks could outperform the emerging market (EM) universe as we discuss in Emerging Market Stocks: Stay or Go?, Why New Reforms Make Chinese Stocks Attractive and at www.schwab.com/oninternational.

So what?

Concerns over growth and geopolitical issues have largely been set aside by investors in the United States, but complacency can be dangerous and another pullback in the near term could unfold if history holds. Investors should keep longer term goals in mind and remember that trying to time the market is an extremely difficult task. The weather is turning and economic data will be watched to see if recent softness was temporary or something more serious. We lean toward the former, but a retrenchment in bond yields would cause some concern about the potential for something more than weather.

© Charles Schwab


© Charles Schwab

Read more commentaries by Charles Schwab