Calvert  News & Commentary

December Market Commentary: Equity Markets Remain on Hold as Consumers and Businesses Retrench

Longer term, consumer de-leveraging may help set stage for sustainable economic recovery


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By Natalie Trunow, Senior Vice President, Head of Equities
Calvert Asset Management Company, Inc.

At the end of December, markets got some encouragement from bold Federal Reserve action: the Fed cut the benchmark Federal Funds rate to an unprecedented 0% to 0.25%—triggering a 2% relief rally in the broad U.S. equity market and taking an otherwise flat monthly performance into positive territory. The Fed action also had the desired effect of pushing down both TED spreads (the difference between the London InterBank Offered Rate, or LIBOR, and the yield on the U.S. Treasury Bill) and LIBOR rates, as well as the 30-year mortgage rate. However, consumers seemed to have taken advantage of the more favorable interest rate environment, mainly to refinance existing loans and de-leverage their balance sheets, rather than to take out new loans for home purchases.

This behavior may reflect a developing theme in U.S. consumer spending patterns and one with the potential to counterbalance regulatory efforts to spur the economy. Specifically, even as credit becomes less expensive, although still less available than it was in 2006 and 2007, U.S. consumers—even those with high enough credit scores—likely will be reluctant to take on additional debt, de-leverage where they can by re-financing, save more and spend within their means. The net effect likely will be reduced spending and stronger consumer balance sheets. While this consumer behavior would not help the economy recover in the short run, it should help build a much healthier foundation for sustainable future economic growth.

The November unemployment report was among the worst in the last two to three decades. The U.S. economy lost over half a million jobs in November alone, for a total job loss of close to 1.25 million in the three months ended November 30. That brought the rate of unemployed and under-employed Americans to close to 19% of the work force. As jobs continued to disappear and total wealth was reduced, consumer spending weakened further, as consumers pared back spending and increased their savings. Indeed, consumer spending declined at a quarterly rate not seen since World War II. The pace of the deterioration is especially worrisome in light of the sharp decline in oil prices over the past few months. While the global economic recession depressed prices for commodities in the second half of 2008, expectations of a protracted global recession and a greater-than-anticipated deceleration in emerging markets have exacerbated the price decline.

During the month, the prospect of automaker bankruptcies contributed to higher returns in the already red-hot Treasury market. This resulted in the largest quarterly return for Treasuries in 26 years, pushing yields on all maturities to near record lows. The Treasury rally was halted with the passage of the government’s auto industry bail-out package, which consisted of a $14 billion emergency three-year loan with substantial strings attached. Automakers will have to restructure their operations, curb executive compensation, cut worker benefits, pay and jobs and freeze dividends until the loans are repaid. The companies also will be required to give the government access to their financial records, along with warrants and priority over all other creditors. This is a significant, and likely final, opportunity for the U.S. auto industry to reinvent itself.

In December, Standard & Poor’s, the credit rating agency, cut the senior debt ratings and outlooks for 12 large global banks. The change in the outlook reflected slowing economic growth and heightened bank industry risk. The outlook for bellwether GE also was cut from stable to negative. The cuts reflected the rating agencies’ effort to take a more conservative approach to ratings and to provide greater transparency, largely in response to regulatory inquiries over the past several months.

For the month, health care related stocks rose 7%, with managed care and biotech shares performing best within the sector. The energy sector declined 4%, excluding refiners, whose shares climbed 15%. Shares of oil drilling and exploration companies fell 18% and 10%, respectively. The financial sector edged up 0.9%, masking a significant divergence in returns within the sector, including a significant bounce in real estate investment trusts (REITs) of 15% and continued deterioration in banks and diversified financials, which fell 4%.

At month-end, equity markets staged a relief rally, despite the bad economic news. Higher beta markets and market sectors rebounded most. As discussed in previous commentaries, this kind of positive trend may emerge when markets shrug off negative news and trend higher, as was the case in December. However, Wall Street analysts’ consensus earnings forecasts for 2009 still appear too optimistic and do not reflect the sharp deceleration in the real economy. These forecasts are likely to be adjusted down further, as consumers retreat further and manufacturing activity and corporate capital expenditures contract at a faster pace, negatively impacting business investment in 2009.  This means that if the market pays attention to earnings in 2009, we may see additional volatility in the equity markets.

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