Developed Equity Markets Strong, Emerging Markets Lag in February
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Asset Management Company, Inc.
For the month of February, U.S. equity markets continued to climb, with the Standard & Poor’s 500, Russell 1000, and Russell 2000 Indices returning an impressive 3.4%, 3.5%, and 5.5%, respectively. In the international arena, the MSCI EAFE Index also performed well, posting a 3.3% return for the month, while the MSCI Emerging Markets Index lagged, falling 0.92% on investor concerns surrounding rising commodity prices, inflation, and political unrest in the Middle East and North Africa.
The top-performing sector for the month was Energy, largely due to the rise in oil prices that accompanied turmoil in Egypt and Libya. The Consumer Discretionary sector was another top performer, while the Utilities and Information Technology sectors were the major laggards for the month. Value stocks slightly outperformed growth stocks, with the Russell 1000 Value Index returning 3.7% for the month versus 3.3% for the Russell 1000 Growth Index.
Inflation Becoming a Concern Worldwide
Inflation is becoming more of a focus for investors worldwide as food and energy prices increase globally, causing concerns about economic growth, especially in emerging economies. One of the elements impacting prices is extreme weather conditions around the world, from extreme heat in Russia to floods in Australia to severe snowstorms in Europe and North America. Whether this is caused by El Nino or the on-going climate change is yet unclear, but if this is a longer-term trend, emerging-market economies will be most severely affected since they rely more on commodity inputs for their fast economic growth. Emerging-market stocks underperformed their developed-market counterparts for each of the three months through February.
To fight inflation, many governments around the world are implementing higher reserve requirements for banks as well as interest-rate increases. China in particular is in the process of trying to tame inflation using multiple policy measures including appreciation in the country’s currency (the renminbi), interest rates, and bank reserve requirements. These policy measures, however, will likely slow the economic growth rate in China, which would negatively impact global economic growth.
In the U.S., despite the increases in the prices of many commodities (wheat, corn, energy, etc.) over the past several years, the Federal Reserve (Fed) continues to focus on core inflation, a statistic that does not account for changes in food and energy prices. So far, core inflation in the U.S. has remained stable and low, allowing the Fed to maintain its stimulative policy of a near-zero percent interest rate. Inflation expectations in the U.S. remain low and the consensus opinion seems to indicate that, based on the current employment picture, wage inflation is not yet a concern, which means that the accommodating interest-rate policy could remain in place for some time.
Positive Market Sentiment
Recent positive market sentiment seems to be driven primarily by healthy earnings reports coming out of U.S. companies this earnings season, with some of the bellwether companies like McDonald’s reporting higher-than-estimated sales. M&A activity is also continuing to be quite strong, benefiting small- and medium-capitalization stocks.
Consumer confidence is also improving, rising to its highest level in eight months. In February, consumers’ outlook on employment and the overall economy turned positive for the first time in seven years. This improvement, supported by more optimistic job prospects and rising equity markets, has driven increases in consumer spending over the past several months and is likely to continue to do so. We believe that this trend, if it continues, will be the primary driver behind potentially better-than-expected economic growth this year.
Geopolitical Tensions Continue
As political tensions in Africa and the Middle East continued toward the end of the month, investors increased purchases of safer assets like gold, silver, and U.S. Treasuries, pushing prices of these assets up. The price of silver reached a 30-year high during the month, doubling in the past 12 months.
The European Union summit was convened in Brussels early in the month to review a potential increase in funds earmarked for bailouts and a reduction in interest rates on rescue loans, along with a discussion of broader economic policy coordination among member states. There remains, however, a strong sentiment among investors that some of the eurozone’s member nations are likely to leave the union in the next several years and to default on their sovereign debt despite the austerity measures put in place by many of these nations, including Ireland, Spain, Greece, and Portugal.
Given the strong run-up in equity prices in the last several months and current valuations, it is likely that once the earnings season subsides, equity markets will be vulnerable to negative news or further deterioration in geopolitical tensions and could see a sell-off.
We still think, however, that an upside surprise in gross domestic product (GDP) growth in 2011 is possible in light of the current 3.2% consensus expectation. GDP growth could accelerate above 3.7% in 2011 given the better consumer confidence numbers and now stronger top-line growth in the corporate sector of the economy. This may cause the Fed to increase interest rates sooner than expected. We are also concerned that inflation expectations may be negatively impacted by higher food and energy prices, also increasing the probability that the Fed will raise benchmark interest rates sooner than expected. If the move comes sooner than the markets anticipate, it could precipitate a sell-off in Treasuries and dampen economic growth in 2012. We also believe that under this scenario growth equities are likely to underperform their value counterparts.
We expect M&A activity to continue to be strong in 2011, a trend that should continue to benefit small- and medium-capitalization stocks.
If the relative underperformance of emerging-market stocks continues, negative fund flows may exacerbate that downward trend, especially given the relatively low liquidity in these markets. Prompt reallocation of assets in investment portfolios, especially generic international and global portfolios with large exposures to emerging markets, could further exacerbate the underperformance of the emerging markets asset class.
As of 1/31/2011, several index funds advised by Calvert Asset Management Company, Inc. held securities issued by McDonald’s. Calvert may or may not still invest in, and is not recommending any action on, companies listed.
This commentary represents the opinions of its author as of 3/4/11 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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Effective 4/30/2011, Calvert Asset Management Company, Inc. will be renamed Calvert Investment Management, Inc., Calvert Distributors, Inc. will be renamed Calvert Investment Distributors, Inc., and Calvert Group, Ltd. will be renamed Calvert Investments, Inc.