Calvert  News & Commentary

Third Quarter Market Commentary: Equity Markets Post Strong Finish Amid Slower Global Economic Recovery


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By Natalie Trunow, Chief Investment Officer, Equities, Calvert Asset Management Company, Inc.

Natalie Trunow, Head of Equities Natalie Trunow,
CIO, Equities

The equity markets were volatile in the third quarter of 2010 but ended on a positive note, with the large-cap S&P 500 Index and Russell 1000 Index up 11.3% and 11.6%, respectively. International equities outperformed their U.S. counterparts, with the MSCI EAFE Index up 16.5% for the quarter and the MSCI Emerging Markets Index up 18.2%. Mid-cap stocks were the best domestic equity asset class with a 13.3% return, while small caps performed in line with large-cap names, as the Russell 2000 Index rose 11.3%.

Growth stocks outperformed value stocks by a significant margin during the quarter. The Russell 1000 Growth Index returned 13% versus the Russell 1000 Value Index’s 10.1% return.

The equity markets experienced large swings during the quarter: rising in July, falling in August, and rebounding in September. Market gyrations reflected uncertainty around the sustainability of the economic recovery and the fears of a double-dip recession. However, the equity markets ended the quarter strongly, largely in response to more upbeat economic news that the U.S. economy is in fact recovering, although slowly.

All equity sectors finished the quarter in positive territory. Telecom was the big winner for the quarter, advancing 21% for the period. Materials and Consumer Discretionary were not far behind, returning 18% and 15%, respectively. The laggard for the quarter came from the Financial sector, which advanced 4%, highlighting that Financials  globally remain weak, with  long-term profitability challenged by a new regulatory environment and the unwinding of the leverage in the global financial system.  European banks are likely to need to raise reserves under new regulatory rules aiming to improve the health of financial institutions.

As we anticipated earlier in the year, economic recovery in the second half of 2010 has proven to be slower than originally forecast by a majority of market participants. Early in the third quarter, the Commerce Department cut its second quarter estimate for U.S. economic (GDP) growth to an annual pace of 1.6% from the initially reported 2.4% pace. At the end of September, the Government announced that in second quarter the U.S. economy grew slightly faster than the revised estimate at an annual rate of 1.7%.

Economic Recovery Moves Ahead Slowly

The slow economic recovery is a result of several conflicting trends. The equity markets have rebounded as recent jobless claims have shown signs of leveling off, creating more cause for optimism, and the probability of a double-dip recession is more remote. Corporate earnings reports for the quarter came in strong with more than 75% of companies in the S&P 500 Index reporting higher-than-expected earnings. Strength in the corporate sector continues to boost corporate balance sheets and cash flow, providing further support for the merger and acquisition (M&A) activity that has been strong throughout the year. Unfortunately, while beneficial to many businesses and stock prices of some companies involved in the M&A activity, the nature of M&A is such that more often than not the net outcome is the rationalization of business lines and a reduction in the workforce.

Business and Manufacturing Strength a Positive

Nevertheless, private businesses, especially in the manufacturing sector, increased hiring during the quarter. The increase is a welcome sign but was not enough to bring the unemployment rate down, partially because of the re-entry of previously discouraged workers into the workforce. The unexpected increase (the most in two years) in U.S. wholesale inventories in September indicates that U.S. companies are willing to accumulate additional inventory in response to stronger demand. The overall strength of the manufacturing sector, however, gives us comfort that the economy as a whole, despite weak consumer and service sectors, is unlikely to fall back into the negative growth territory, which would constitute a double-dip recession. As financially sound companies continue to re-invest in their businesses, they will have to re-invest in human capital and hire new workers.

Consumers Continue to Rebuild their Balance Sheets; Housing and Unemployment Concerns Persist

On the negative side, consumer confidence remains shaky. U.S. consumers are continuing to rebuild their balance sheets by taking out less debt, spending less, and saving more. These trends have pushed credit-card debt to its lowest levels since 2005. Constrained consumer spending was evident in slower-than-expected sales growth in the Retail sector for most of the quarter. However, consumer spending is showing some positive signs. U.S. retail sales improved in July and August by 0.3% and 0.4%, respectively. Consumer confidence numbers reported at the end of August improved more than was originally forecast, up from an eight-month low. We continue to expect that consumer spending will start to recover as soon as the fourth quarter of this year, although consumer confidence may continue to be disappointing.

The double-dip in the housing market has arrived and depressed home prices may be here to stay in the short-term. Home prices moved lower during the month and shrinking home equity levels continue to weigh on consumer confidence. Although default and foreclosure rates fell in July, too many homes are still in foreclosure or in default and offered at depressed prices. Despite historically low mortgage rates, sales of new and existing homes fell to the lowest levels on record in July, as buyers wait for better deals with supply still exceeding demand. In the long run, if prices accelerate at a 3% annual rate, it will take about 10 years to reach the previous peak for housing prices.

The fall in housing prices contributes to the fear of deflation. However, recent data showed that gasoline and food prices have seen increases, helping keep inflation numbers positive, albeit low, and away from deflationary territory.

The overall employment picture is still shaky. Private businesses, especially in the manufacturing sector, are cautiously increasing their hiring although not enough to bring the current run of 26-year highs in the unemployment rate down. The unemployment rate actually rose to 9.6% in August and stayed at that level in September as more discouraged workers re-entered the workforce. The under-employment rate increased to 17.1% in September from 16.7% in August and 16.5% in July, although long-term unemployment fell.

Administration Seeks to Stimulate the Economy

The Obama Administration continues to look for ways to stimulate the economy and improve the employment picture. A $180 billion bill providing business tax breaks and infrastructure investment is being proposed to boost spending and job growth. These long-term investments could produce positive long-term effects in the economy in the years to come. At the end of the month, President Obama signed into law a $30 billion small- business lending bill that sets up a lending fund for small businesses and includes an additional $12 billion in tax breaks for small companies. While this should help stimulate employment in the long run, budget deficit levels are at unprecedented highs and will need to be addressed soon.

Sovereign Debt Issues Remain

The European sovereign debt crisis continues to evolve. During the quarter, Hungary’s talks with the International Monetary Fund and European Union for support did not succeed and the country’s credit rating may be cut to junk at Standard & Poor’s. Moody’s Investors Service also warned that it may lower Iceland’s credit rating to junk and cut the outlook on Iceland’s Baa3 foreign currency debt to negative. At the end of the quarter, the Irish government announced that the total cost of saving Ireland’s banks could rise as high as US$69 billion, more than a third of the country’s national income in 2009. As a result, Ireland’s budget deficit would rise to 32% of gross domestic product this year. Moody’s ratings agency warned that it might downgrade Ireland’s Aa2 debt rating, further highlighting that the debt crisis in Europe continues to loom.

The European Union has been performing stress tests of European financial institutions, similar to the ones done on U.S. financial institutions a year ago. As a result, the Basel Committee of Banking Supervision established a new set of rules to toughen banks’ capital and liquidity requirements in September.


China’s economic growth data seem to indicate that the Chinese government is seeing some success in engineering a soft landing and getting growth rates down from the 11%-13% range of the past several years to a more manageable 9-10% level. Second-quarter GDP data showed that China surpassed Japan to become the world’s second-largest economy, so it is important that the cooling-down process continues to be gradual. A hard landing for an overheated Chinese economy would have strong negative implications for global economic growth. During the quarter, China produced the world’s largest-ever IPO when The Agricultural Bank of China went public, raising $22.1 billion on the offering.

During the quarter, the U.S. has become increasingly vocal against China’s unwillingness to let its currency appreciate. Some fear that, if political rhetoric becomes too heated, China may retaliate by purchasing fewer U.S. Treasuries. If this scenario unfolds, there will likely be less support for Treasury prices at existing levels. At the moment, however, it seems unlikely that the political rhetoric will lead to an outright trade war.


We believe that, given relative valuations and capital flows, the sharp outperformance of bonds versus equities of the past several months is bound to reverse, with equities outperforming bonds over the next 6-18 months. The economy has slowed, but sustained economic recovery continues. As we commented in August and early September, the equity markets seem to present an attractive buying opportunity relative to other asset classes. In September, equities looked more attractive relative to bonds than they have since 1993 (except for the market bottom in March of 2009), with 10-year Treasuries yielding 2.51% vs. the Dow Jones Industrial Average’s dividend yield of 2.6% and an attractive forward price/earnings multiple of 12.2.

As we have commented in the past, we don’t believe that negative GDP growth, which would constitute a double-dip recession, is likely. While we anticipate a somewhat more challenged earnings environment later this year, we believe that the strength in the corporate sector is likely to persist and continue to support the overall economic recovery. Our outlook continues to call for a slow, gradual pace to economic recovery and a generally positive environment for stock picking, barring any major geopolitical calamities.

This commentary represents the opinions of its author as of 10/6/10 and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.

The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Asset Management Company, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.

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