Equity Markets Rebound in October
Equity markets rebounded sharply in October on the heels of earnings reports that were stronger than expected, a positive macroeconomic environment in the United States, and a more credible package emerging from the October 26 European summit addressing the sovereign debt crisis in the region. The Standard & Poor’s 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 10.93%, 11.21%, 15.14%, 9.65%, and 13.26%, respectively, for October. Within the Russell 1000 Index, Materials, Energy, and Industrials were the top-performing sectors, while Telecoms, Utilities, and Consumer Staples lagged. U.S. bank stocks recovered significantly during October as well, despite continued pressure on earnings and concerns about exposure to European sovereign debt. The more defensive Utilities, Consumer Staples, and Health Care sectors still remained firmly in the lead for 2011 through the end of October.
Value stocks outperformed growth stocks for the month, with the Russell 1000 Value and Russell 1000 Growth Indices returning 11.45% and 10.97%, respectively. October was the first month in which value outperformed growth in the last five months, and the Russell 1000 Value Index was still significantly behind the Russell 1000 Growth Index for 2011 through October.
Response to European Debt Crisis Takes Shape
Markets were somewhat reassured by the tentative package of policy measures produced at the European summit to address the risk of a disorderly Greek default and contagion risk. The package includes a 50% haircut on Greek government debt held by private investors, an increase in European Financial Stability Facility (EFSF) funds, and an increase in the Tier 1 capital ratio requirement for E.U. banks to a minimum of 9%.
According to the plan, the EFSF would be expanded to $1.3 trillion though a series of leverage mechanisms and deployed to support the debt of peripheral European countries and to recapitalize Europe’s banks. However, such prospects are still meeting resistance on the part of the banks. According to the Bank for International Settlements, the eurozone’s banking system has over $2 trillion exposure to PIIGS sovereign debt, which amounts to 73% of European bank equity in the region.
Despite the initial optimistic reaction to the plan by equity markets, Europe is still providing a negative backdrop. Moody’s warned that it is monitoring France’s AAA credit rating and outlook. A potential downgrade of France’s AAA rating, while partially priced in by the markets, would have a further negative impact on the French banks and would severely damage the firepower of the EFSF. Europe, meanwhile, is slipping into recession. The Eurozone Purchasing Managers’ Index was weaker than expected in October and eurozone unemployment reached a record 10.2% in September.
Despite the European Central Bank’s (ECB) announcement early in October that it would keep interest rates unchanged because of inflation concerns, incoming ECB President Mario Draghi announced a 25 basis point cut in the benchmark interest rate in the face of deteriorating economic conditions after his first ECB meeting in early November.
Additionally, the surprise referendum called by Greek Prime Minister George Papandreou on his country’s bailout renewed worries that Greece could leave the eurozone monetary union and default on its debt. At the time of the writing of this commentary in early November, it appeared that the referendum would not take place, though the potential implications of a “no” vote by the Greek public had equity markets on edge for several days.
Threat of Recession Recedes in United States
U.S. economic data released during October were encouraging, with employment figures surprising on the upside, payroll numbers revised up and continuing on an upward trend, and U.S. industrial production continuing to support the slow expansionary economic trend in the United States.
Gross domestic product (GDP) expanded at a 2.5% annual rate for the third quarter, according to the first estimate released by the Commerce Department, on the back of consumer spending, which was up 2.4% for the quarter and contributed 1.7 percentage points to economic growth.
At the same time, the health of U.S. consumer balance sheets is continuing to improve, with consumer debt as a percentage of income declining, indicating that the consumer is deleveraging successfully. However, after-tax incomes adjusted for inflation fell 1.7% (annual rate) during the third quarter while the savings rate dropped to 4.1%, the lowest since the fourth quarter of 2007.
The quality of the U.S. government balance sheet, on the other hand, continues to deteriorate, with the U.S. budget deficit for the fiscal year ending September 30 reported at $1.3 trillion, the second-highest deficit level on record.
U.S. vehicle sales numbers were also encouraging as losses caused earlier in the year by the aftermath of the earthquake in the Japan are being repaired. Construction spending also provided a boost to GDP growth in the third quarter, while corporate spending on equipment increased 17.4% for the quarter and contributed 1.2 percentage points to growth.
Capital goods new orders excluding aircraft rose 2.4% in September, exceeding expectations and providing another positive sign for the manufacturing sector. Loan activity is also picking up, a very good sign.
However, consumer confidence data were mixed. The University of Michigan Survey of Consumer Confidence Sentiment came in above expectations, while the Conference Board’s Sentiment Index fell to a two-year low. A large portion of the disparity in negative sentiment is likely attributable to the frustration with the political stalemate in Washington, as evidenced by the viral nature of the “Occupy Wall Street” movement.
Housing Market Bottoming Out
The housing market in the United States seems to have found a bottom and, while not showing signs of robust recovery yet, is not deteriorating further. New housing starts were up 15% in September, while purchases of new U.S. homes exceeded expectations by increasing at a 5.7% annualized rate.
The 30-year fixed mortgage rate dipped below 4% during the month for the first time ever, indicating that the Federal Reserve's "operation twist," designed to push longer-term Treasury yields down, is having that effect. Still, high foreclosed home inventories are continuing to dampen the improvements in the housing market.
Strong Earnings and M&A Activity in the Corporate Sector
U.S. corporate profits are at new highs, highlighting the strength of the U.S. corporate sector. Capex is strong and S&P 500 earnings have been better than expectedâ€”of the 65% of S&P 500 companies that reported through the end of October, approximately 75% beat expectations. Top-line growth is also better than expected, up 12% year-over-year, so the improvements we are seeing are not just cost cutting.
M&A activity continued in October with the announcement of one of the largest acquisitions in the energy industry to create the largest U.S. natural-gas pipeline operator as Kinder Morgan offered to buy El Paso Corp. for $21.1 billion, a 37% premium. Also during the month, Cigna acquired HealthSpring for $3.8 billion, also a significant premium above the stock’s closing price, and Oracle acquired RightNow for $1.5 billion.
Global inflation is picking up as a result of increases in commodity prices, a warning sign. In China, the government is struggling to keep inflation in check even as economic growth slows. China’s inflation rate exceeded 6% for a fourth consecutive month, the highest level in the past three years. Food inflation in the country now exceeds 12%, owing to high commodity costs. A hard landing in China is still a possibility with third-quarter GDP coming in at a respectable 9.1%, but below consensus expectations.
Economists estimate India’s inflation to be at 9.75%, which is likely to hamper economic growth in that BRIC (Brazil, Russia, India, and China) country as well.
The silver lining in rising inflation numbers is the additional pricing power that corporations can translate into earnings.
October demonstrated that markets can recover very quickly with some strong earnings reports from U.S. corporations and clarity coming out of the European debt crisis. Confirmation of the sluggishly positive economic recovery in the U.S. was sufficient to prop up the markets.
Stock market improvement should support stronger holiday season spending and retail sales, which should in turn help the economy and the stock market. Automobile supply is recovering and sales are likely to improve.
We believe that a recession in Europe can be offset by economic expansion in the UnitedÂ States and China, and we remain constructive on the U.S. economy and equity market going forward, especially given the strength of corporate earnings in the United States and attractive valuation multiples.
This commentary represents the opinions of the author as of 11/8/11 and may change based on market and other conditions. These 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 Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
Accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
Calvert Investment Management, Inc., 4550 Montgomery Avenue, Bethesda, MD 20814