Equity Markets Rally in First Quarter of 2012
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Equities started the year strong as continuously improving U.S. economic data and recent policy steps toward mitigation of the sovereign crisis in Europe provided support for the equity markets worldwide in the first quarter. Global inflation remained tame, and aggressive, accommodative monetary policy by central banks around the globe helped equity markets rally hard off their lows posted last fall, albeit on low volume. For the quarter, the Standard and Poor's 500 (S&P 500), Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 12.59%, 12.90%, 12.44%, 10.98%, and 14.14%, respectively. Growth investment style outperformed value style in each month of the quarter, with the Russell 1000 Growth Index returning 14.69% while the Russell 1000 Value Index returned 11.12%.
Within the Russell 1000 Index, information technology, financials, and consumer discretionary were the top-performing sectors, returning 21.26%, 20.49%, and 16.62%, respectively. The energy, telecommunication services, and utilities sectors lagged, with utilities—the worst performing sector through the first quarter—being the only one in negative territory.
Solid Fourth-Quarter Earnings Season
A good fourth-quarter earnings season, supported by improving leading economic indicators, helped drive improvements in investor sentiment and the equity markets in the first quarter of 2012. Aggregate earnings per share for S&P 500 companies grew 7.7% in the fourth quarter of 2011 compared to the fourth quarter of 2010, but declined 6.6% as compared to the third quarter of 2011. While positive earnings revisions for the S&P 500 were not as good as in prior quarters, the top-line numbers driven by the economic recovery were more encouraging, with 61% of companies beating earnings estimates and 55% beating revenue forecasts. This important improvement in top-line performance is pointing to the sustainability of the positive momentum in the corporate sector.
Positive Economic Data Point to U.S. Recovery Continuing at Slow, Gradual Pace
The U.S. labor market, while still weak, showed very encouraging signs of improvement, with the four-week moving average of initial jobless claims down to 365,000 at the end of the quarter, signaling a longer-term improvement in the labor market. Payroll growth and household employment growth also were very strong during the quarter, which may be a reflection of new small business formation in the U.S. Non-farm payrolls rose more than expected in December and January, which helped push the unemployment rate down to 8.3%, a three-year low for the U.S. economy (at the time of this writing the most recent labor report indicated the unemployment rate had dropped to 8.2%). While this number is likely to remain somewhat volatile and high for some time to come due to the tepid economic growth in this country, the established positive momentum will be key for improving consumer confidence, consumer spending, and the self-sustained economic recovery in the U.S.
The manufacturing sector continued to provide significant support to the U.S. economic recovery. Strong regional manufacturing surveys throughout the quarter led to national manufacturing PMI remaining firmly in expansion territory. A low dollar, thanks to the especially accommodative monetary policy in the U.S., continues to help U.S. exports and support the rebuilding of the domestic manufacturing and industrial base.
However, accelerating recession in Europe and the overall slowdown in the global economy will de-emphasize the contribution of exports to U.S. GDP. Therefore, the continued recovery of the U.S. consumer will be important for a self-sustained U.S. economic recovery. More recently the service sector has been showing signs of improvement. The ISM non-manufacturing index indicated service industries expanded by the most in a year during February â€“ a sign the manufacturing-led recovery in the U.S. may be spreading to other sectors.
In the fourth quarter, personal consumption expenditures increased 2% with retail sales also showing healthy growth. The consumer sector seemed to be performing well despite elevated oil and gasoline prices. Consumer confidence data reported during the quarter indicated the consumer was not as heavily impacted as it could have been had the stock market and the job market not been improving.
While profitability in the U.S. banking sector continued to deteriorate, as demonstrated by a significantly lower than expected earnings report from J.P. Morgan during the quarter, U.S. bank lending continued to improve. An improving consumer balance sheet is now allowing banks to increase lending while adhering to higher lending standards. Moreover, the increase in commercial and industrial borrowing surged to an 18% annual rate in the fourth quarter.
Overall, the U.S. economy seems to be on the path to self-sustained recovery with the index of Leading Economic Indicators (LEI) increasing throughout the quarter. Fourth-quarter GDP was revised up to 3% from the previously reported 2.8% pace, and U.S. GDP growth forecasts are up to 2.3% for 2012. As investor consensus moved further toward sustained economic expansion in the U.S., the selloff in Treasuries accelerated toward the end of the first quarter.
U.S. Housing Market Continues to Stabilize, Removing the Drag on Economy
The U.S. housing market continued to bottom out and showed signs of improvement during the quarter, supported by improvements in consumer data. Data from home builders showed considerable improvement despite the Mortgage Bankers Association Mortgage Applications Index generally declining throughout the quarter as the share of applicants seeking to refinance dropped to an eight-month low. With mortgage rates still at historic lows, confidence among U.S. home builders increased in February to the highest level since June 2007. Housing starts were near a three-year high and sales of existing homes hovered near a two-year high during the quarter, indicating an overall improvement in housing market activity despite continued softness in housing prices.
While the housing market is clearly not out of the woods yet, especially with foreclosed inventories still high and having to be worked through, we believe that the repair and the bottoming-out process have started and are likely to continue as the U.S. economy and U.S. consumer recover. The housing sector, while not providing much growth, is not likely to be the drag on the economy that it has been for many quarters following the burst of the housing bubble.
Accommodative Monetary Policy by the Fed Continues
Despite the visible improvements in the macroeconomic data, in January the U.S. Fed announced extension of its low interest rate policy through the end of 2014, a more dovish stance than markets anticipated, but very much welcomed. The FOMC adopted a formal inflation target of 2% and suggested that balance sheet expansion through a third round of quantitative easing (QE3) is not out of the question should economic conditions deteriorate, though less likely in the near-term. The move appears to reflect the Fed's heightened focus on unemployment, which has become an increasingly important part of the Fed's dual mandate of price stability and maximum employment this election year.
If QE3 is in fact implemented, it will come on top of the unprecedented $2.3 trillion of bond purchases already done by the U.S. Fed in the first two successful rounds of quantitative easing. "Operation Twist," announced in September of last year, has achieved its goal of lowering longer-term borrowing costs by replacing $400 billion of short-term debt in the Fed's portfolio with longer-term Treasuries. The Federal Reserve's Flow of Funds report for 2011 indicated the Fed purchased 61% of total net Treasury issuance last year, compared to minimal amounts before the financial crisis.
However, if the U.S. economy continues on a path to recovery at the current or better pace, QE3 won't be necessary and could possibly be harmful as excess supply of cheap money tends to create speculative bubbles that hurt the economy in the long run. The aggressively accommodative monetary policy is likely to create an environment conducive to imbalances and bubbles in the global economy and markets. With U.S. interest rates and the dollar at historic lows, U.S. dollar-denominated commodities like oil have been rising in price to levels where the demand destruction begins to create negative feedback on both commodity prices and economic growth globally. Interestingly, this negative feedback may be disproportionately higher for the commodity-hungry emerging-market economies than for the U.S. itself. Therefore, it could be that the U.S. will end up "exporting" the recessionary pressures outside its borders to more commodity-intensive economies like China, where data indicated industrial profits fell 5.2% through the first two months of 2012 compared to the same period one year ago. Brazil and Australia, who export heavily to China, also saw GDP growth slow considerably in the fourth quarter of 2011.
Waning Inflation Allows Global Easing Cycle to Continue
With global economic challenges keeping inflation in check, policymakers around the globe continued their efforts toward easing monetary policies. Brazil cut its benchmark interest rate twice during the first quarter of 2012 while the Bank of Japan announced its intention to purchase $127 billion of bonds. On the flip side, the easing cycle is inflating the balance sheets of the world's six biggest central banks, which have more than doubled since 2006 to an unprecedented $13.2 trillion.
Continued low inflation and the global monetary easing cycle supported investors' optimism and forced the risk-aversion trade into submission during the first quarter. The "fear index," or VIX, which measures equity market volatility, was down to 15.5 at the end of March 2012 from the high 40s in October 2011.
Inflation is likely to stay low, which should be positive for the consumer and allow for the continuation of the global monetary easing cycle, which is stimulative to global economic growth.
Gasoline Prices Rise as Geopolitical Risks Increase
Unfortunately for the global economy and consumers, the rate of increase in oil prices kept pace with the stock market during the quarter. This rising oil price trend, if not reversed, will likely put a damper on global economic growth. There is a natural boost to oil prices as economic activity improves and fuel consumption increases; however, the price increase this time is exacerbated by the geopolitical tensions in the Middle East, where Iran's nuclear ambitions are once again in focus.
Eurozone Sovereign Debt Crisis
In the eurozone, things were quieter during the first quarter but the sovereign debt crisis remained on investors' minds. European sovereign debt yields declined gradually through the first three months of 2012, with 10-year yields on sovereign debt for Spain and Italy easing for the time being. Both of those countries had several successful debt auctions, signaling the LTRO (long term repo operation) may in fact have helped the eurozone sovereign bond markets by driving down short-end yields and reducing the investor perception of the probability of a tail risk event, such as a global financial crisis in the first quarter. Some have viewed the LTRO as a European version of quantitative easing, especially considering the resulting significant European Central Bank (ECB) balance sheet expansion. The second round of the LTRO resulted in loans of 530 billion euros to 800 lenders, with the combined LTRO assets totaling 1 trillion euros.
A deal on the Greek bailout was reached by all involved parties during the quarter with the market participants responding to the Greek optimism favorably, driving up the prices of risk assets. The resulting Greek bond swap continued to move along with more than 80% of private creditors agreeing to participate in the debt swap that reduced the debt face value by about half. With the collective action clauses (CACs) under Greek law forcing holdouts to join the bond swap, the total participation rate was around 96% and reduces Greece's debt burden by 100 billion euros. However, the International Swaps and Derivatives Association (ISDA) determined Greece's use of CACs constituted a credit event, which triggered credit default swap payments totaling $2.89 billion. Even with the bond swap, debt in Greece is becoming an increasingly larger percentage of GDP due to the rate at which Greece's GDP is contracting. This trend will continue to jeopardize the country's credit health.
Despite the positive impact of the LTRO, Europe continued to provide a negative backdrop to investor confidence and was a drag on the global economy. Eurozone GDP contracted 0.3% in the fourth quarter, while the unemployment rate reached a 15-year high of 10.8%. The fiscal drag started to have a pervasive negative impact on economic growth throughout Europe, with core economies coming under stress during the quarter as well. The European Union (EU) forecasted the Dutch economy to contract 0.9% this year, primarily due to the implementation of tough austerity measures. During the eurozone sovereign debt crisis, the Netherlands was considered to be part of the stronger "core" economies, but now the EU projects only Greece, Portugal, and Spain to perform worse. Moreover, both German and French manufacturing PMI declined significantly in March, leading the drop in eurozone aggregate manufacturing PMI to 47.7 in March.
These data confirmed our concerns about the eurozone's economic outlook and the stronger recession in Europe, including the core economies. Meanwhile, concern that Portugal won't be able to access markets for financing and will require a second bailout increased throughout the quarter while widespread protests in Spain at the end of March highlighted the public's opposition to another round of austerity measures.
Investors continue to focus on the symptoms of the EU sovereign debt crisis, such as EU sovereign debt spreads, as well as policy solutions to the crisis. While these are important pieces of the puzzle, we believe that the crisis will not resolve itself until the key underlying drivers and issues—the lack of effective, true fiscal and monetary integration within the union and, more importantly, the significant weakness of the underlying European economies exacerbated by the fiscal drag—are addressed. The latter is likely to make the EU crisis more protracted and severe than investors seem to currently believe. A continued economic recession in the eurozone may reignite the flames of the sovereign debt crisis.
Economic Growth in China Slows
China cut its economic growth target from 8% to 7.5% during the first quarter, signaling the country's need to transition from export-driven to a more sustainable, consumer-driven, economic model. A slower inflation trend allowed the Chinese government to continue to reposition its economic policy from contractionary for most of 2011 to stimulative.
Nevertheless, the Chinese economy continued to decelerate during the quarter as foreign direct investment (FDI), one of the major drivers of economic growth in China, has declined on a year-over-year basis for four consecutive months. Increasing domestic consumption in the country will be key to offsetting this effect. In a slower growing economy, a system with no healthcare insurance or retirement system and a populace with a very high savings rate to provide for these services, it is unclear whether consumer spending will be able to fully compensate for the growth lost in FDI and exports. China's HSBC Flash Manufacturing PMI fell to 48.1 in March, indicating a further slowdown while retail sales in China also increased less than expected on a year-to-date basis.
A potential sharp slowdown or, more importantly, a hard landing in China, fueled by a possible burst of a real estate bubble there, will certainly create strong ripple effects throughout the global economy, especially other emerging market economies that supply into China, like Brazil and Australia. As for the U.S., this indirect impact may be less damaging than a domestic recession.
Silver Lining in Reduction in the U.S. Workforce
Despite the recent drop in the unemployment rate to a three-year low of 8.3%, concerns about weak labor force participation, and the slow rate of U.S. labor market improvement in general, seem to now be more in the forefront of Fed policy. The U.S. Fed has expressed a view that the unemployment rate may not improve further in 2012. While it is true that this severe and prolonged recession in the labor market may have caused some workers to give up on their search and prompted others to settle for part-time opportunities, we believe that there may be a silver lining to the medium-term reduction in the U.S. workforce. While contractionary in the short term, there may be positive long-term benefits from the trend as many of the significantly impacted areas are linked to the parts of the U.S. economy that were artificially inflated as a result of the real estate and credit bubbles. This adjustment is healthy for the U.S. economy in the long run. In addition, there are significant demographic trends impacting the size of the workforce which may be difficult to quantify. Specifically, with baby boomers entering retirement age, a higher retirement rate may be a part of what we are observing in the workforce participation data.
No QE3 May Be a Good Thing
As the U.S. economy continues to improve, justifications for QE3 weaken. Paradoxically, this is disappointing to the investors who seem to prefer a sure and quick (however short-lived) policy-driven shot in the arm to an organic, self-sustained, but more painful long-term economic recovery. We clearly prefer the latter. This will in turn boost expectations for higher interest rates. At these levels, we may see some consolidation in the equity markets in the short to medium-term before any further upside.
Despite subdued recovery in the consumer sector and tepid income growth, the self-sustained recovery in the U.S., while slow, will likely create a positive feedback loop through the high multiplier effect stemming primarily from the manufacturing and industrial segments of the economy.
Political Stalemate in Washington Likely to Continue to Be a Drag
As 2012 marches on towards the presidential election, the key policy event to watch is what could be the most important predictor of GDP growth for 2013 â€“ the fiscal drag from the expiration of both the Bush tax breaks and the extension of the payroll tax cut through January 1, 2013, with possible negative impact on economic growth by as much as 4%. If a bipartisan solution to the issue is not found in time this would effectively raise taxes while government spending is cut.
Volatility is Here to Stay
Overall, the European sovereign debt crisis continues to evolve, although so long as it continues to resolve itself in a somewhat orderly fashion, we believe that it is unlikely to derail a U.S. economic recovery.
If a U.S. economic recovery proves robust enough to withstand the negative headwinds from Europe and China in 2012, U.S. equities may significantly outperform Treasuries, given the relative valuation of the two asset classes. Highly bid-up, dividend-yielding securities may also underperform as investor risk aversion subsides. However, if more investors refocus on the underlying economic fundamentals in Europe, the risk aversion trade may return for some time during the year. In this environment, despite stronger economic data in the U.S., one thing is most certain; equity market volatility is likely to be here to stay for most of 2012.
With such strong returns in the equity markets so early in the year, we would not be surprised to see a temporary pullback in equities, especially if some of the negatives in the global economic picture come into focus. From an absolute return standpoint, gains in equity markets achieved through the end of the first quarter of 2012 are attractive enough that, given the lingering negative backdrop from Europe and rising oil prices, some investors may choose to take profits and wait for new positive catalysts, like the upcoming earnings season, before reentering the "risk-on" trade.
This commentary represents the opinions of the author as of 4/13/2012 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.
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