Fourth-Quarter 2011 Equity Market Commentary
Another strong corporate earnings season, followed by a string of positive economic data in the U.S., led to a divergence between the fourth quarter performance of U.S. equity markets and international equity markets, with the international equity markets weighed down by the sovereign debt crisis in Europe and an economic slowdown in China. For the quarter, the Standard and Poor's 500, the Russell 1000, and the Russell 2000 Indices returned 11.82%, 11.84%, and 15.47%, respectively, though almost all of the gains came in October as U.S. equity markets were mostly flat in the final two months of the year. On the other hand, the MSCI EAFE and MSCI Emerging Markets Indices returned just 3.38% and 4.45%, respectively. Value stocks outperformed their growth counterparts for the quarter with the Russell 1000 Value Index up 13.11% and the Russell 1000 Growth Index returning 10.61% for the quarter, reducing the growth investment style's performance advantage for the calendar year.
The more cyclical energy, industrials, and materials were the top-performing sectors within the Russell 1000 Index for the quarter while telecommunications, utilities and consumer staples lagged. Even with a "risk-on" fourth quarter, the more defensive utilities, consumer staples, and healthcare finished the year as the top-performing sectors by a wide margin.
European Sovereign Debt Crisis Drags On
The reality of the "one step forward, two steps back" crisis resolution attempts in Europe during the quarter left investors increasingly worried about the potential collapse of the eurozone and its likely disastrous consequences for the financial system in the region, and possibly in the global financial system. The region's economic picture, including macroeconomic and fundamental earnings data, was looking increasingly grim during the quarter with peripheral economies firmly in a recessionary spiral and the entire union likely in a recession already as the retail Purchasing Managers Index (PMI) and consumer spending data were showing significant declines despite slower inflation.
Investors remained unconvinced that the eurozone's problems can be solved through the policy measures presented to date and bond markets were translating the sovereign risk crisis into soaring yields on the sovereign debt of Spain, Greece, Italy, and France, which reached 200 basis points above German bunds at one point during the quarter. With Italian sovereign debt yields blowing through the 7% stress level and reaching 7.5% in November before pulling back, it was quite apparent that if European Union (EU) policy solutions to the crisis were not forthcoming, markets were going to force a solution by making borrowing extremely expensive for countries with poor balance sheets, a lack of fiscal discipline, and bleak economic prospects, thereby facilitating political change. This dynamic helped spur progress toward new, technocratic governments in both Greece and Italy. While this was a welcome development, a more credible, structural, and meaningful integration of the economic and the political will be necessary to keep the monetary union intact. Unfortunately, this outcome seemed more and more remote during the quarter, and markets were reacting accordingly with U.S. Treasuries continuing to benefit from the turmoil in Europe.
Earlier in the quarter, markets were somewhat reassured initially by the tentative package of policy measures designed to address the risk of a disorderly Greek default and contagion risk that were produced at October's European Summit. The package included 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 EU banks to a minimum of 9%.
Despite the equity markets' initial optimistic reaction to the plan, Europe continued to provide a negative global backdrop during the quarter. France suffered a credit outlook downgrade by Fitch in December, a development long anticipated by the markets. A potential downgrade of France's AAA rating, while partially priced in by the markets, would have a further negative impact on French banks (and possibly others) and would severely damage the EFSF's firepower.
Meanwhile, the plan to leverage the EFSF continued to hit obstacles while the European Central Bank (ECB) and Germany remained reluctant to commit to an expanded role for the ECB in capping sovereign debt yields with bond purchases. German Chancellor Angela Merkel instead continued to push for closer economic ties among eurozone countries. The eurozone's move toward increased fiscal integration and fiscal austerity measures will likely create a fiscal drag on the region's economy and hurt the EU economy in the near term, although resulting structural changes should be positive in the long run. Tighter fiscal integration, if achieved, will open the door for more active involvement by the ECB, which should be extremely helpful for market sentiment. This view is supported by ECB President Mario Draghi's move to cut interest rates by 25 basis points in November and by 25 basis points again in December to 100 basis points.
The euro fell to its lowest level against the dollar since January and will likely fall further in 2012, which could provide a boost to European exports in the future.
In response to the pressures facing the financial industry, the Fed, the ECB, and the central banks of Canada, Switzerland, Japan, and the United Kingdom made a coordinated move to cut the premium on overnight dollar borrowing from OIS (overnight indexed swap rate) plus 100 basis points to OIS plus 50 basis points, making borrowing U.S. dollars cheaper for banks. The move was received favorably by the markets. The ECB lending program initiated towards the end of the quarter also seemed to be successful and was received positively by investors. The ECB provided 489 billion euros in cheap three-year loans to European banks and lenders in the first tranche of "longer term refinancing operations," with additional funds available at the end of February. However, the belief that banks would use the cheap financing to purchase sovereign bonds, thereby pushing sovereign yields down, did not seem to play out in the quarter.
U.S Economic Recovery Gains Momentum After Another Strong Earnings Season
The third-quarter corporate earnings season in the United States produced very impressive results. Nearly 70% of companies in the S&P 500 Index beat earnings expectations and 62% beat revenue forecasts. What was different in the fourth quarter is that the top-line growth was 11% year-over-year, an important improvement over the past several quarters.
Cash-rich U.S. companies continued to look for sources of growth. Merger and acquisition activity continued during the quarter with the announcement of one of the largest acquisitions in the energy industry as Kinder Morgan offered to buy El Paso Corp. for $21.1 billion (a 37% premium) to create the largest U.S. natural-gas pipeline operator. Also during the quarter, Cigna acquired HealthSpring for $3.8 billion, a significant premium above the stock's closing price, and Oracle acquired RightNow for $1.5 billion.
Despite the European sovereign debt crisis, the U.S. economy continues to proceed on the path of gradual recovery. The falling unemployment rate is boosting consumer confidence, which showed much better than expected readings throughout the quarter. Improving consumer confidence also translated into solid "Black Friday" sales. In the fourth quarter, retail sales indicated stronger, although not stellar, consumer spending. However, the increased spending seemed to be coming at the expense of a lower U.S. savings rate, which reached its lowest level in nearly four years.
Improvement in the household employment and temporary employment numbers was another welcome, positive sign, though the impressive decline in the unemployment rate from 9% to 8.5% during the quarter was, unfortunately, primarily due to a drop in the labor force participation rate. Unemployment claims in the U.S. were also slowing. The initial jobless claims four-week moving average was down to 375,000—the lowest level since June 2008. Continuing claims dropped throughout most of the quarter. We believe that these marginal improvements in the employment picture helped drive continued improvement in consumer confidence.
U.S. inflation continues to be low, exports and trade data surprised on the upside, bank lending is improving, a weak U.S. dollar is supporting strong exports, and the national PMI is firmly in an expansionary mode. Vehicle sales and production both look encouraging as well, with production losses earlier in the year due to the earthquake in Japan being recovered. Capital expenditures are improving with corporate spending on equipment increasing 17.4% in the third quarter, contributing 1.2 percentage points to GDP growth. The Federal Reserve's accommodative policy stance is also helping the U.S. economy. Most data now point to a likely higher-than-expected U.S. GDP this quarter.
Unlike their European counterparts, U.S. banks are recapitalized and have been increasing lending, which is helping the economic recovery here. At the same time, regulatory pressure on the banking sector is unlikely to abate any time soon, which should continue to inhibit the financial sector's long-term profitability. During the quarter the Fed announced its intent to adopt the bank capital plans laid out in the Basel III ( an international regulatory framework for banks), which includes conducting annual stress tests.
The health of U.S. consumer balance sheets also continued to improve, with consumer debt as a percentage of income declining, indicating that the consumer is deleveraging successfully. Improvements to balance sheets were also supported by mortgage delinquencies data which showed a decline to 7.99% in the third quarter.
However, after-tax incomes (adjusted for inflation) fell 1.7% (annual rate) during the third quarter and the savings rate continues to drop.
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, 2011 reported at $1.3 trillion, the second highest deficit level on record. Moreover, the policy stalemate in Washington continued to be frustrating and disappointing for both its country's citizens and market participants. The congressional "super committee" (the Joint Select Committee on Deficit Reduction) failed to forge a sufficient agreement on a package of spending cuts and tax increases by its target date (November 23), Â which disappointed the market. It remains to be seen whether the previously agreed-upon automatic spending cuts will indeed be triggered and what effect the failure of the super committee to deliver solutions might have on the U.S. credit rating. U.S. policymakers need to resolve their differences in favor of the country's needs and address the U.S. debt issue head-on as soon as possible. At the end of December, Republicans finally agreed to a payroll tax break extension, albeit for two months instead of the entire year.
Supply chain disruptions, particularly in the technology and auto industries, stemming from the floods in Thailand, are likely to have a similar impact on the global economy as the natural disasters in Japan did earlier this year, with both production and demand pushed out a quarter or two. This means that the floods probably dampened the economic activity in the fourth quarter of this year but will likely have a positive effect in the first and second quarters of 2012.
Housing Market to Continue Bottoming Out in 2012
The U.S. housing market, an important piece of the puzzle in U.S. economic recovery, is likely to continue its bottoming-out process into 2012 with prices continuing to firm and likely to improve in some regions. This should start a long-term upward trend, which means housing will no longer be a drag on the economy.
Housing affordability in the U.S. is at an all-time high which, combined with a pick-up in rents, should help provide support for housing pricing. The 30-year fixed mortgage rate dipped below 4% in October for the first time ever, indicating that the Federal Reserve's "operation twist," designed to push longer-term Treasury yields down, is having the desired effect. Mortgage rates are at all-time lows; however, while the refinance share of mortgage activity reached a 2011 high during the quarter, financing for new borrowers is still hard to come by as banks' lending standards remain high. High inventories of foreclosed homes also continue to dampen the housing market improvements.
Multi-family housing is already exhibiting robust recovery while housing starts and building permits both increased throughout the quarter, exceeding expectations. Pending and existing home sales rose more than forecast. This increase in housing activity—as measured by the S&P/Case-Shiller Composite Index (a broad measure of U.S. housing values of 20 cities), which fell more than forecast in October—while not pushing prices up at this point, willÂ likely continue to help form a bottom in housing prices.
Global Inflation Slows but Risk of China "Hard Landing" Persists
The slow pace of global economic growth is having a dampening effect on global inflation, allowing for global easing of monetary policies by central banks which, in turn, should help stimulate economic growth. A global easing cycle continued with Sweden, Russia, Denmark, and Norway easing their monetary policy during the quarter. On the other hand, the silver lining in rising inflation numbers had been the additional pricing power that corporations can translate into earnings.
China unexpectedly cut reserve rates for its banks on the heels of lower inflation numbers and lower-than-expected PMI data, which suggests the possibility of a hard landing for the Chinese economy. The move demonstrated China's shift to monetary easing in the face of a slowing economy and lower-than-expected inflation. Both China's and India's GDP growth numbers are decelerating with the risks of hard landings increasing. This, combined with the potential risk of a significant negative event in Europe, could serve as a further shock to investor confidence sometime in 2012.
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. We believe that a recession in Europe can be offset by economic expansion in the United States. 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 U.S. equities valuation multiples.
U.S. bank lending is improving. However, big bank risks in Europe that could impact systematically important U.S. institutions could upset that trend. We continue to believe that it may take a significant negative event in Europe such as a failure or nationalization of a major bank(s) for investors to wrap their arms around the magnitude of the potential resulting "domino effect" on the U.S.'s systemically important institutions before a sustained recovery in U.S. financial stocks can take root. At that point, significant portfolio underweights in the financial sector, while beneficial over the past several quarters, will likely separate the "haves" from the "have nots" in investment manager alpha land.
In Europe, proposed policy measures appear designed to deal mainly with crisis symptoms. However, the underlying economic weakness of the peripheral eurozone countries—and now probably of the core eurozone economies—should continue for some time, which will likely worsen the very symptoms policymakers are trying to address, i.e. sovereign debt issues. Additionally, Italy is so large and so indebted that it is too big to bail out, especially given the continued lack of agreement on the specifics of EFSF enhancements. Defaults and union exits by some EU peripheral economies such as Greece are no longer out of the question and are being openly debated. French sovereign spreads are spiking up, making the downgrade of French and possibly German debt ever more likely. This uncertainty is likely to keep European market volatility elevated with continued spillover into U.S. markets.
We believe that some of the stronger-than-expected economic data in the United States is a bounce-back from the shocks to the system that occurred earlier in 2011 with the supply chain disruptions caused by the environmental disasters in Japan (it is worth noting that Japan's real GDP bounced back 6% in the third quarter) and with the political brinksmanship in Washington causing the downgrade of U.S. government debt.
Similarly, the subsequent supply chain disruption caused by floods in Thailand may mean somewhat slower growth earlier in 2012 but is likely to have a positive multiplier effect later on as activity is restored and pent-up demand met. Overall, the debt crisis and recession (exacerbated by the fiscal drag from austerity measures) in Europe as well as inaction in Washington are likely to continue to dampen U.S. growth in the medium term.
The downside risks for 2012 are some of the same issues we discussed over the past several months—European recession and a potential hard landing in China. Fiscal drag globally and in the U.S. will be a negative for global economic growth. Easing moves in several countries, especially within emerging markets, should provide some support for global economic growth. The U.S. economy, while not immune to the eurozone's recession, seems to be gathering positive, self-sustained momentum. We expect these trends to continue well into 2012 with the U.S. likely outperforming other developed economies.
This commentary represents the opinions of the author as of 1/20/12 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