Economic Forum - Global Economic Analysis & Reports

We believe that the past year, albeit a remarkable series of crises, has helped to set the stage for a possible sustainable upward move in US stocks as we begin 2012. Prices were roughly flat on the year, while earnings continued to move higher, resulting in a lower price/earnings ratio and valuations that look attractive to us when keeping the longer-term horizon in mind. Further helping the valuation case is the easing of inflationary pressures, aided by the reduction in commodity costs.
 
When inflation is low, based on historical tendencies, stocks can typically support a higher price/earnings ratio, while easing price pressures can also bolster consumers' pocketbooks, which has the potential to increase profitability among American companies.
 
US economy also seemingly supportive

Another leg in the supportive stool for stocks has been the largely better-than-expected economic picture that is currently being painted. We've seen recession fears fade as consistently improving data has emerged, but stocks have largely ignored the positive developments in the US picture as international concerns have seemingly dominated attention. But we've seen the much-maligned employment situation steadily, if slowly, improve as jobless claims continue to move lower, recently posting the lowest reading since April 2008, while the lagging unemployment rate has declined, showing an 8.6% reading in the most recent release—still higher than we want to see, but moving in the right direction.

US Government continues to amaze

Given the positive momentum that we believe the economy is trying to gather, it is incredible to us that the government continues to manage to surprise on the downside. The continued political posturing on both sides of the aisle has most recently resulted in what can be described as nothing less than a mess. The payroll tax cut, along with extended unemployment benefits and a Medicare fix for doctors was extended for the grand total of two months—with more negotiations to occur in the hopes of getting to a full year deal. It's something, but this continued political game-playing does nothing to improve the confidence of consumers and businesses. These short-term "fixes" seem to actually harm business confidence and increase costs as they scramble to react to last-minute changes to laws. Businesses can make money in a variety of ways, but they have to know the rules of the game. Until they do, it's difficult to imagine many business owners wanting to risk capital by expanding operations or hiring new worker.

Additionally, we are keeping an eye on the escalating trade tension developing with China, with both sides recently slapping tariffs on certain goods. We are long believers in moving toward freer trade and are concerned what the impact of a trade war with China may have on both economies.

And finally, for now, the populist rhetoric coming out of the Administration, pitting one group of Americans versus another, seems completely detrimental to the stated goal of President Obama of creating jobs and expanding the economy. Targeting those that create jobs and invest capital in businesses as the "problem" with America seems to us to be largely counterproductive and we hope to see a change in the new year, but aren’t holding our breath as the election season heats up.
 
Europe's Lehman moment diminishes, but crisis not "solved"

As frustrating as the problems are in the US, Europe continues to win the prize for being dysfunctional. Recently, the risk of a near-term collapse in the European banking system has likely diminished, but the debt crisis has not been resolved. The European Central Bank (ECB) provided additional support for banks via three-year loans by conducting its first of two long-term repurchase operations (LTROs) on Dec. 21 last year. However, the LTRO is being viewed through a mixed lens.

Negatives include the amount of money and number of banks borrowing from the ECB, 490 billion euros ($645 billion) and 523 banks, respectively. Such high demand and reliance on the ECB indicates dysfunction in the system. The positive aspects of the LTRO include borrowing that exceeded the amount of debt maturing in the first quarter of 2012, removing some uncertainty and allowing for building cash buffers or new lending. Additionally, to the extent peripheral sovereign debt is parked at the ECB in the form of collateral, it may ease selling pressure. However, despite the recent equity rally, bank stress remains high, although year-end factors may be obfuscating things.

Bank stress remains elevated

The crisis has highlighted the major flaw of the euro—monetary union without fiscal union. The ECB is treating the symptom, not the cause of the crisis, but has likely bought time to allow for the possibility of fiscal union. Meanwhile, banks and sovereigns are interlinked, and the banks cannot truly be stabilized until the sovereigns are. Contrary to the hope that banks would use the LTRO to enter a "carry trade" by borrowing at 1% from the ECB to buy sovereign debt yielding over 5%, we believe the funds will be primarily used to pay down debt. We have little faith that an agreement on fiscal coordination can be achieved by the March target.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.