Key Points
- Economic data has been limited due to the government "shutdown" and questions are growing as to what damage it caused. We believe the economic impact will be limited and that earnings season will shape the market’s direction in the near term, now that the near-term threat of a debt default is past.
- But government uncertainty is likely to remain elevated given the kick-the-can nature of the budget deal into early next year. This fiscal uncertainty further supports ongoing easy monetary policy, particularly given the dovish leanings of Janet Yellen, the presumptive incoming Fed chairman.
- In contrast to the United States, Europe has been calm and economies are slowly improving. We remain hopeful that Japan will be successful in stimulating their economy, although policy missteps are quite possible; while China’s growth has acceleration potential in the short term but we continue to have longer-term concerns.
The last couple of weeks have been dominated by shutdown and debt ceiling wrangling; but the relief rally upon the deal to avert a default was short-lived; likely due to Congress having only kicked the can into January and February of next year.
While certainly impacting many individuals and certain areas of the economy, it seems unlikely that that the shutdown did substantial damage to the economy. First, only about 17% of the government was actually "shut down" with the remaining 83% on automatic pilot or deemed essential. Additionally, furloughed government workers will be paid for the time they were off, resulting in the potential economic drag in the near term being reduced.
But what about confidence? It's true that a drop in confidence among businesses, consumers, and investors…if sustained (which may not be the case this time) can become a self-fulfilling prophecy. Equities pulled back off their highs and than rallied, while the fixed income market has stayed quite calm, although there was some volatility in the short-term T-Bill market. Looking back at the August 2011 debt ceiling fight, both confidence and the economy bounced back sharply after the deal was struck. There's also less fiscal drag coming out of the current deal vs. in 2011, when that deal was followed by sequestration and a major tax increase. In fact, if the budget committee's report—due in mid-December—actually points to real fundamental reform (entitlements and/or tax), that would likely provide a major boost to confidence.
Confidence rebounded quickly following the last crisis
Source: FactSet, Gallup. As of October 16, 2013.
And there seems to us to be even more reason this time around for confidence to return quickly. In 2011, the US debt rating was downgraded for the first time in history; Europe was in the throes of its debt crisis, Japan was struggling in its recession, and China's growth was slowing. Today, the downgrade threat has diminished, Europe has stabilized and moved out of recession, Japan is aggressively attacking its economic malaise, and China seems to be reversing its slowdown, at least temporarily.
Dearth of data, but earnings roll on
Additional encouragement could come from the economic front now that we will begin to get economic releases post-shutdown. Globally, things are improving, as seen in the surge in the Baltic Dry Index, a gauge of global economic activity.
Global growth seems to be improving
Source: FactSet, Baltic Exchange. As of October 16, 2013.
Additionally, we did get some private data indicating activity continues to improve at a modest pace: the ISM Manufacturing Index rose to 56.2 from 55.7, with the employment component jumping to 55.4 from 53.3. The service side cooled a bit but still remained in territory depicting expansion as the ISM Non-Manufacturing Index slipped to 54.4 from the robust 58.6 reading the previous month. Finally, although we missed the government-provided labor report, ADP reported that 166,000 jobs were added during September in the private sector.
And although it's been overshadowed, we are now in the heart of third quarter earnings season, where revenue results and projections will be important guideposts as we look ahead toward 2014. There is also the possibility for upside earnings surprises given a negative/positive preannouncement ratio of 5.22 according to Thomson Reuters. This level of skepticism tends to be beneficial to stocks as the performance in the month following the end of a quarter where the preannouncement ratio was over 2.1 has been an average 2.1% gain. When the ratio has been below 2.1 the return has been a negative 0.1%—both according to our friends at Strategas Research Partners.
New era for the Fed…same old for the Feds
The ambiguity of when the Federal Reserve will begin its pullback of bond buying continues and it seems highly unlikely they'll begin at their meeting on October 29-30. Little time has passed since their most recent meeting where they declined to start the process. And with data absent and distorted due to the shutdown, combined with the unknown impact of the Congressional mess, another meeting with no announced tapering seems likely. Some uncertainty has been removed as the replacement for Chairman Bernanke has been nominated by President Obama. Vice Chairman Janet Yellen was no surprise to the markets and is likely to both continue the general policies of the Bernanke Fed and enjoy a relatively easy confirmation process through the Senate. The current view that she is potentially even more dovish that Bernanke should help to support risk assets in the near term.
Meanwhile, the drama in Washington continues. There is little doubt in our minds that without the brinksmanship that continues to plague Congress and the Administration, confidence and economic growth would be higher. But that appears quite unlikely as short-term solutions continue to be the favored approach, with longer-term problems looming.
Europe in a period of calm
Conversely, the atmosphere in Europe has taken a dramatic turn from just over a year ago, when images of rioting on the streets dominated financial news. Despite occasional bouts of concerns in recent months, such as anti-euro or anti-austerity political parties gaining popularity, there appears to be a period of relative calm in European markets and Europe has generally moved off the front-page headlines.
Calmer markets benefit European recovery
Source: FactSet, iBoxx. As of Oct. 15, 2013.
Much of the credit goes to easy monetary policy by the European Central Bank, including a conditional bond purchase program, as well as smaller fiscal drags due to past deficit reduction progress. We've also seen a changed view toward austerity, allowing policymakers to back away from overly harsh measures. As a result of a thawing in financial conditions, confidence of businesses and consumers has improved and economies are recovering. In fact, the eurozone as a whole emerged from recession last quarter, and leading indicators point to continued recovery.
As the recovery matures, it could broaden out and pick up momentum. Headlines in recent weeks that caught our attention include:
- Ireland may exit its bailout program on schedule in December.
- Irish home prices are stabilizing.
- Spain issued a 30-year government bond for the first time since September 2009.
- Foreign funds will soon own 30,000 homes in Spain.
- Italy's former Prime Minister Berlusconi does an about face to support current Prime Minister Letta, potentially paving the way for a more stable government.
- Italy unveils a 2014 budget with a different approach to deficit reduction that included spending cuts, which Letta called the "first budget without tax hikes or social cuts in years."
A backdrop of calm can give businesses and consumers better confidence to spend and create a positive feedback cycle that sustains the recovery. Despite the positives, growth is unlikely to be off to the races because lending is still a headwind, falling 2.9% in August from a year ago. Adding to that is a combination of deleveraging by banks and borrowers, and still-weak demand. On this note, the health of bank balance sheets may come under scrutiny again, as the ECB is beginning a multi-stage review ahead of supervising the largest 130 banks next year.
We believe European stocks have likely already priced in a lot of bad news and earnings estimates have further room to recover. Read more in our Europe article.
A complicated picture in Japan
After an initial burst of optimism, sentiment regarding the nascent recovery in Japan appears to have hit a "soft patch." While the economic recovery continues, investors are worried about the sustainability, given the headwinds to consumer spending, which accounts for roughly 60% of the Japanese economy. Consumers' headwinds include:
- Rising food and energy prices as import prices gain with the yen weakening
- Wages falling
- A two-stage increase in the consumption tax begins in April 2014
Missing from the recovery equation has been the participation of businesses. Businesses have taken a tepid approach to the recovery, as the translation effect of a weaker yen has been the main contributor to a surge in corporate profits, while sales have improved only marginally. Businesses likely need more time to experience a sustainable demand recovery before investing, hiring or raising wages.
Meanwhile, corporations have the means to spend, and the incentives to spend are increasing. Japanese companies have over $2 trillion in cash on their balance sheets, equating to almost 50% of nominal GDP. The deflationary mindset of the past encouraged delaying decisions, as well as protecting and hoarding cash. Now that real rates—rates subtracting the effect of inflation—are negative, this can discourage saving, and encourage investing and spending. Supportive changes to corporate taxes could also be forthcoming.
Japanese rates now a disincentive for saving
Source: FactSet, Ministry of Internal Affairs & Communications, Bank of Japan. As of Oct. 15, 2013.
* The Japanese 10-year gov't bond yield less inflation.
Ultimately, the "third arrow" of Abenomics has to come through with meaningful reforms to create a sustainable recovery and the fall session of parliament (the Diet) is expected to tackle many policy initiatives. Despite entrenched vested interests, Professor Barry Eichengreen of the University of California, Berkeley recently discussed the possibility of a "grand bargain" that would request sacrifice from every major interest group for the benefit of all. We are keeping an optimistic view given indications Abe is willing to take on the powerful farm lobby.
The good news is that while the Japanese outlook is complicated, accommodation from the Bank of Japan (BoJ) will likely continue and could even increase further if economic downside risks appear. We believe this could create a floor for Japanese stocks, giving us the adage "don't fight the BoJ."
China's questionable outlook
Amid concerns about a hard landing and a near-mistake of a liquidity crunch in the banking system this June, China's government appeared to defend 7.0% as the "bottom line" GDP growth for 2013 by taking measures to boost the infrastructure and property sectors. Despite the turn, some investors are questioning the momentum of China's recovery as economic readings are giving conflicting signals. For example, exports unexpectedly fell 0.3% from a year ago in September, but electricity consumption gained 10.4%.
We believe growth will continue to be stimulated ahead of the November Third Plenary Session of the 18th CPC (Communist Party of China) Central Committee. Despite policymaker's earlier desire to crack down on speculative lending in the shadow banking system, shadow banking grew to roughly 55% of total lending in August and September, after falling to below 20% of total lending in June and July. This liquidity will likely propel growth in coming months.
China's economy needs to transition away from debt-led construction growth. Hopes are high for both a free trade zone in Shanghai and the potential for reforms at the November planning meeting, but we believe reforms will progress at a slow pace. Chinese-related investments, including emerging market stocks, could rally in the near-term due to China's economic rebound; but we remain concerned about structural headwinds to growth and have a neutral view on emerging market stocks, as discussed in our article.
Read more international topics at www.schwab.com/oninternational.
So what?
It will take some time to gauge the full impact of the government shutdown and data is likely to be somewhat skewed over the next couple of months. However, sitting on the sidelines isn't a great option and stocks still appear to us to be the best place to invest money for the longer term. International growth, although not robust, appears to be more supportive as we head into 2014 than it has since the financial crisis, and we favor developed over emerging markets for the time being.
© Charles Schwab
