Inflammatory statements and proclamations, combined with numerous other headlines constantly bombarding investors, can make it difficult for investors to keep a clear head. The market has taken countless hits over the course of many years, from wars, to recessions, to financial and political scandals, to bubbles, and on and on…but it keeps rewarding those who have a longer-term perspective and don’t panic when the inevitable pullbacks come. A decent-sized pullback, in fact, would not be a surprise, and would be welcomed by us to help set up the next solid move higher. Already, we have seen some of the more frothy names in areas such as biotech and social networking sell off, helping to lessen the talk of a “stock market bubble” without inflicting much actual damage to the broad market. These are referred to as “internal” corrections and they’re typically healthy.
While a broader pullback in stocks in the near term could occur, it doesn’t appear that the concerns raised by the controversy around high-frequency trading and the “rigged” claim by author Michael Lewis will be the start of it. Stock indexes hit all-time highs in the days following the release of Lewis’ book Flash Boys. There are highly-justifiable criticisms (including by Chuck Schwab and Schwab CEO Walt Bettinger) about high frequency trading (HFT)—notably the most egregious practices like “quote stuffing.” We do believe they will be addressed, and it remains the case that the US stock market is the most trusted and liquid in the world, evidenced by the number of foreign and domestic participants. And overall, for investors, the cost of doing business has improved greatly over the past decade, regardless of whether you believe HFT has been behind some of that. Spreads have compressed, execution times have improved, and commissions have been greatly compressed…all to the benefit of individual investors.
Spring thaw in process?
More important, in our view, is economic growth. The weather is finally starting to turn, and economic data is returning to a more trustworthy state. But, it’s early, and first quarter earnings season is just beginning as well. Expectations are relatively low, in large part due to the weather, but there is increased interest in commentary and forward guidance, which could be a catalyst for the next near-term move in the market. With corporate confidence improving and some fiscal concerns receding, we expect a relatively optimistic, yet cautious, tone to prevail.
On the economic front, both versions of the Institute for Supply Management’s (ISM) surveys showed improvement. The Manufacturing Index rose to 53.7 from 53.2, while new orders encouragingly increased to 55.1 from 54.5. The Non-Manufacturing Index, representing the larger service side of the economy, showed a nice gain to 53.1 from 51.6, while the employment component bounced from 47.5 to 53.6. Additionally, auto sales appear to be rebounding from a weather induced pause, indicating that consumer demand is still decent and confidence is improving. One economic concern for us remains the housing market, which doesn’t appear to be bouncing back as quickly as we had hoped. Mortgage applications for purchases continue to languish, while lumber prices, typically a good leading indicator of housing starts, have weakened. As we enter into to the critical spring and summer season, we expect improvement. Aiding our belief in a renewed housing improvement, the labor market continues to improve. ADP reported 191,000 private sector jobs were added in March, while February’s number was revised higher by almost 40,000 jobs. Additionally, the Labor Department’s report showed that 192,000 jobs were added last month and previous months’ were revised higher; while the unemployment rate stayed at 6.7%. March may prove to be the transition month, where we deal with the last remnants of the winter weather, and start to see a pickup in hiring.
Fed finding its footing, government still a hindrance
Jobs continue to be a focus of the Federal Reserve, even under new leadership. After a bit of fumbling during Chairwoman Yellen’s first post-meeting press conference, members have tried to clarify their position, with varying degrees of success. The Fed is trying to find the right tone, and some increased market volatility may result. Ultimately, the Fed is still concerned with elevated unemployment, especially the longer-term unemployed. By some estimates, the short-term unemployed are at levels consistent with relatively full employment, but it is longer-term unemployment that remains elevated, and finding solutions to that problem is more difficult. The Fed’s tapering of its quantitative easing (QE) program continues, but it remains cautious and methodical in its attempt to return to normal monetary policy.
As we get closer to November’s midterm elections, it becomes less likely anything of substance gets done in Washington. Budget ideas have been presented by both sides, with apparently little chance of becoming law, and challenges remain. We believe both sides have an interest in lowering the corporate income tax rate, which is among the highest in the world, but this environment doesn’t seem conducive to getting much done.
Europe: ready, set…will they go?
Leading through talk instead of action continues to be the story across the pond as growth in the eurozone has yet to be strong enough to generate inflation. Instead, a prolonged period of low inflation is predicted by the European Central Bank’s (ECB), while some experts have questioned whether the euro zone will enter a period of deflation like Japan. Deflation, or a broad-based decline in prices, is a risk because falling prices could become self-fulfilling if consumers and businesses postpone purchases and investments on the expectation that prices will be lower in the future. Thus far, eurozone inflation is still in positive territory and inflation expectations have recently rebounded, but the ECB is not forecasting hitting its target of “at or below 2%” inflation for several years – the 2016 forecast is 1.8%. The ECB at its April meeting confirmed that there was now “unanimous commitment” to using “unconventional instruments.” The most rumored unconventional instrument is a U.S.-style quantitative easing (QE) program. Unlike the Fed, the ECB’s asset purchases are “sterilized,” wherein liquidity injections are offset by asset sales. While the ECB appears to be increasingly open to the prospect of “non-sterilized” QE, the ECB is prohibited from “monetary financing,” or financing the fiscal spending of individual countries, so assets would need to be bought across all eurozone countries or by purchasing foreign assets such as U.S. Treasuries.
There has even been talk that the ECB modeled a one trillion euros ($1.38 trillion) asset purchase program, which would possibly purchase bank loans in the asset-backed securities (ABS) market. However, the ECB would be unlikely to undertake this type of program until completing its “Comprehensive Assessment” on the banks, which is not expected until this fall. Additionally, the size of the ABS market may not be large or active enough for the ECB to carry out this type of program. While ECB President Mario Draghi’s words have swayed markets in the past, markets may become doubtful the longer talk is not followed up with action. Un-sterilizing the current asset purchase program is possible, but we are skeptical the ECB will take significant action in the near term, and it is possible that lending begins to thaw and deflation risks subside before any broader program could even be implemented. We believe the eurozone’s recovery will continue, albeit at a sluggish pace. Risks include additional moves by Russia that could threaten energy imports into the region, as well as the potential for renewed anti-euro sentiment ahead of the European Parliament elections in late May. Despite the risks and potential for volatility, we remain positive on European stocks, due to the prospects for economic and corporate profit margin improvement.
Japan: short-term or longer-term drop in growth?
After an explosive start, Prime Minister Abe’s plan to revive Japan has stalled. In fact, one of the three “arrows” of his plan, fiscal stimulus, appears to be more of a boomerang, now a hindrance to growth. Fiscal spending is tightening; expected to add only 0.2% to growth in fiscal 2014 according to the government, down from the 1.1% in fiscal 2013 and 0.3% in fiscal 2012. Additionally, the sales tax was raised to 8% from 5% on April 1. Japanese policymakers appear satisfied with their results thus far, with a lull in new measures over the past year, but consumers don’t share the sentiment. Consumers, which represent roughly 60% of the economy, were struggling even before the tax hike took effect, as wages have not kept up with inflation, reducing consumers’ purchasing power. While most economists expect a magnification in the size of the Bank of Japan’s (BoJ) QE program in July, we believe this arrow alone will be insufficient to bring lasting growth to Japan. Structural reforms are needed, but have been nearly absent thus far.
Is China the next shoe to drop?
Concerns about the potential for China to have a Lehman moment also need to be put into proper perspective. China’s current situation and that of the United States in the pre-Lehman days are apples and oranges by comparison. Big differences are that China over-saves, with domestic savings of about 50% of GDP, translating into new savings of $4.5 trillion every year. And China is in a current account surplus position, not reliant on foreign capital for growth. As China has an immature equity market, debt issuance is the main method by which the savings pool gets put to work. Other differences are that a majority of bank assets are government controlled, China has a closed capital account that restricts money moving in and out of the country, and has $3.8 trillion in foreign exchange reserves to fight a liquidity crisis.
That said, we believe imbalances in China’s economy have been built due in part to the heavy influence of the government, which necessitates structural change and slower growth to repair. In light of this, the reforms announced last fall are a positive development, but policymakers have a fine line to walk – implementing reforms and reducing credit growth, while keeping growth from falling too much. We believe part of the slowdown at the turn of the year was due to tighter credit and a reduction in government spending. Fiscal coffers may now be loosening, with announcements including stimulus to redevelop shantytowns, increased rail spending, tax breaks for small- and medium-sized businesses, and new funding sources in the form of development banks.
One area we are closely monitoring is the recent property market slowdown, which could have repercussions for the overall economy if it deepens or is lasting. However, forthcoming stimulus amid pervasive pessimism could provide a base for Chinese stocks to recover. Meanwhile, the recent rebound in the broader MSCI Emerging Market Index may not be sustainable, as potential new leaders in India, Indonesia and Brazil may not be able to implement the hoped-for reforms. We believe China will outperform the emerging market universe.
Getting caught up in the weeds is easy in this 24-hour news cycle where everyone is looking to make a splash, but successful investing requires staying above the fray. The U.S. economy is growing and equities appear fairly valued, Europe has issues to deal with but has come a long way from the depths, Japan may be working against itself but improvement has been seen, and the threat of a Chinese debacle at this point seems minimal.