Equity Markets Retreat in April Despite Strong Earnings Season
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
In the midst of strong negative headwinds from the eurozone, a slowdown in China, and the U.S. policy stalemate—which will likely worsen later in this election year—equity markets were propped up by a string of very strong corporate earnings from U.S. companies, but still finished April in negative territory. For the month, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -0.63%, -0.58%, -1.54%, -1.84%, and -1.17%, respectively. Despite the recent pullback, most global equity markets are still up considerably for the year as of the end of April. Growth stocks held up better than value names in April, with the Russell 1000 Growth Index declining 0.15% versus the Russell 1000 Value Index's drop of 1.02%. Growth stocks have outperformed value stocks in each month of 2012.
Within the Russell 1000 Index, telecommunication services, utilities, and consumer discretionary were the top-performing sectors during the month, while the information technology, financials, and energy sectors lagged. While giving up some leadership in April, information technology and financials remained the top-performing sectors for the year through the end of April. Despite a strong bounce this year, financials gave up some ground due to the re-acceleration of negative investor sentiment toward the European economic and sovereign debt crisis. At the same time, fears of a significant slowdown in China have resulted in the energy, materials, and industrials sectors lagging the market for the year through the end of April.
Healthy U.S. Corporate Profits Kick Off Earnings Season
While earnings estimates for U.S. companies were revised down in the first quarter, the U.S. corporate sector remained strong and provided some upside surprises for investors to kick off earnings season. Markets found support during the month in a string of good corporate earnings reports, with 72% of the companies that reported their earnings in April beating earnings expectations, a record number. Importantly, 70% of companies also beat their revenue estimates, which speaks to the improvements in the top-line numbers.
Manufacturing Continues to Drive Economic Recovery in the United States
In the United States, economic activity continued to show solid improvements, with a healthy manufacturing sector supporting employment and consumer spending. Data released at the time of this writing indicated U.S. ISM Manufacturing PMI increased to 54.8 in April, although the Prices Paid Index remained high at 61. Other data released during the month showed factory orders climbing 1.3% in February with broad-based gains, while inventories also increased. U.S. auto sales remained strong as domestic demand continued to pick up. Retail sales increased 0.8% in March despite rising gasoline prices, with sales of building materials increasing 3%. The Index of Leading Economic Indicators (LEI) increased 0.3% in March, the sixth consecutive month of increases, and U.S. gross domestic product (GDP) grew 2.2% in the first quarter with personal consumption rising 2.9% and inflation slowing. Commodity prices, especially food and energy, have softened.
On the weaker side, the decline in the Empire State Manufacturing Index in April indicated manufacturing in the New York region expanded at the slowest pace in five months. The Philadelphia Federal Reserve Bank (Fed) General Economic Index reported a similar drop in manufacturing activity.
U.S. labor market improvements seemed to slow down somewhat, with the four-week moving average of initial jobless claims now up to 382,000, while continuing claims ticked up during the month. This data followed the previous month's disappointing payroll numbers. However, we believe that this may be a short-term development because the longer-term trend in employment data is still positive.
While still high, gasoline prices in the United States softened somewhat toward the end of April, helping improve consumer confidence. The University of Michigan Consumer Confidence Index increased from 76.2 to 76.4. U.S. energy production is healthy, especially in natural gas.
Overall U.S. economic data reported during April, while somewhat less robust, were still generally positive.
Housing Market is Less of a Drag on the Economy and is Bottoming Out
The U.S. housing market continued to bottom out and show signs of improvement even though longer-term home price data were still negative. Housing affordability in the United States remained at historically high levels, with mortgage rates dipping back below 4% during the month and a considerable foreclosed home inventory still on the market. The S&P/Case-Shiller 20-City Composite Index of home prices increased 0.15% in February from the prior month, while down 3.5% on a year-over-year basis.
While housing prices are still in the process of bottoming out, housing activity has now been on the mend for several months. Housing starts activity seems to have been pulled forward into the earlier part of the year due to unseasonably good weather, causing housing starts to fall 5.8% in March, while existing home sales also declined. However, building permits were up in March and homes under construction increased for the seventh consecutive month. Pending sales of U.S. homes rose 4.1% in March from the prior month and increased 10.8% on a year-over-year basis, both exceeding expectations, and February's sales were revised up significantly.
QE3 Unlikely but Not Off the Table
With economic data strong and employment data continuing to improve, a U.S. QE3 is becoming less justifiable. Although the release of the most recent Federal Open Market Committee (FOMC) minutes during the month showed that the Fed is prepared to act with further policy stimulus should economic conditions deteriorate, keeping the door for QE3 open, it seems unlikely at this time. The minutes also confirmed the Fed's commitment to maintain a low interest rate environment until 2014.
Fed Chairman Ben Bernanke's speech during the month also focused on financial reform, citing the need for banks to hold more capital, which would be part of Basel III (an international regulatory framework for banks). While a solid move toward fortification of the balance sheets of U.S. banks, the trend will continue to spell trouble for long-term profitability in the sector.
Eurozone Sovereign Debt Crisis Likely to Reignite
As we anticipated, markets seem to have overestimated the efficacy of the policy action in Europe and underestimated the possibility of a more severe economic recession in the eurozone. Considerable fiscal drag and draconian austerity measures that have been implemented in Europe are likely to result in a more severe economic downturn, which could exacerbate the sovereign debt crisis through bond vigilante actions as well as potential further sovereign debt and European bank downgrades by credit rating agencies. This could be a source of considerable volatility in the markets.
Both the Services and Manufacturing PMI in the eurozone dropped more than anticipated in April with Manufacturing PMI falling to 46 from 47.7 the prior month and Services PMI declining to 47.9 from 49.2. Moreover, core European economies may not be able to avoid a recession, which may end up being worse than markets anticipate. New data released this month seemed to support that view. Specifically, Germany's Manufacturing PMI fell to 46.3 in April from 48.4 the prior month, despite expectations for a slight increase.
Eurozone PPI increased more than expected in February, rising 0.6% from the prior month and 3.6% on a year-over-year basis. These inflationary concerns prompted European Central Bank (ECB) President Mario Draghi to keep the benchmark interest rate unchanged at 1%. As a result, more emphasis continues to be placed on fiscal policy, which is a more painful and protracted solution in a recessionary environment the eurozone is experiencing. This is likely to continue to dampen investor confidence and reignite concerns about the European sovereign debt crisis, making the positive impact of the long term refinancing operation (LTRO) program short-lived. Investors reacted by driving the yields on 10-year Spanish and Italian debt up throughout April. S&P downgraded Spain's credit rating two notches from A to BBB+ during the month.
If things couldn't get worse in the eurozone, markets focused on increased political turmoil in April as the Dutch government collapsed after it failed to reach agreement on a budget that would bring its deficit in line with European Union (EU) limits. Meanwhile, at the time of this writing, French voters have elected Socialist Party candidate Francois Hollande as president, choosing a leader who has vowed to scale back Europe's austerity policies. Similarly, Greek voters overwhelming rejected the two main parties in the outgoing collation government, instead casting votes for more extreme far-left and far-right parties. This outcome will likely make it more difficult for Greece to implement austerity measures the country previously agreed to in exchange for bailouts from the EU, International Monetary Fund (IMF), and ECB.
It became more apparent during the month that a deficit target of 3% of GDP by 2013 will not be attainable for many eurozone countries. Italy slashed its growth forecasts for 2012 and 2013 during the month, while the country announced that it would miss its deficit targets. The United Kingdom reported a 0.2% drop in GDP for the first quarter of 2012, the second consecutive quarter of contraction, indicating a double-dip recession for the U.K. economy. Despite Germany's insistence that fiscal discipline is the best medicine for eurozone economies, the backlash against austerity measures led ECB President Mario Draghi to announce that a "growth compact" was needed to restore competitiveness in Europe. In light of the backlash, German Chancellor Angela Merkel also supported the idea of focusing on ways to spur economic growth in the region. At the same time, Deutsche Bundesbank urged that the ECB not be called on to solve the structural problems of eurozone sovereigns by further loosening monetary policy and warned that banks may become addicted to central bank funds.
The world's financial leaders announced a plan to commit $400 billion or more to boost the IMF's war chest to prepare for a potential worsening of Europe's debt crisis.
In the face of a global economic slowdown, the global stimulative monetary easing cycle continued, with Russia, India, and Brazil cutting rates in April. However, monetary policy cannot fix the fundamental structural problems in Europe, so the crisis there may flare up again.
In China, economic data seemed to indicate that a hard landing remained a possibility. While industrial production and retail sales numbers were good, real GDP in China expanded 8.1% in the first quarter of 2012, the slowest pace since the first quarter of 2009, and below the consensus forecast of 8.4%. Real estate in particular appeared to be a drag on the economy, with residential property sales down 15.5% year-over-year in the first quarter â€“ a sign the housing bubble in China may be bursting. China's Manufacturing and Services PMI both showed declines in March, and the preliminary reading of China's HSBC Purchasing Managers Index for April indicated a sixth consecutive month of contraction for China's manufacturing, increasing the likelihood of further monetary policy easing.
On the positive side, China's consumer price index was up 3.6% in March on a year-over-year basis compared to 3.2% in February, but still below 4%. Oil and gas prices are stabilizing in response to weak global economic data and a continued slowdown in China.
Despite the resilient economic environment in the United States, the expiration of the Bush tax breaks and the payroll tax holiday along with debt ceiling negotiations expected later this year will likely be a significant negative for the economy. Despite positive corporate earnings and continued gradual economic recovery in the United States, these looming developments in the political landscape will most certainly have a negative impact on U.S. GDP growth and are likely to be a source of volatility for the markets in the second half of the year.
In addition, the equity market's great start to the year is likely to be susceptible to temporary setbacks, especially from the renewed focus on the economic crisis in Europe and a slow-down in China.
Overall, we believe that the more likely scenario for the rest of the year is for heightened volatility in the equity markets going into the presidential election and for a more positive tone thereafter.
This commentary represents the opinions of the author as of 5/9/12 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.