Second-Quarter 2012 Equity Market Commentary
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Despite a good corporate earnings season, 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—kept investors on edge during the second quarter and were a drag on equity markets globally. Apparent progress on the policy front in Europe helped drive a relief rally in June, but all major global equity indices still finished the second quarter in negative territory. For the quarter, the Standard and Poor’s 500 (S&P 500), Russell 1000, and Russell 2000 Indices returned -2.75%, -3.12%, and -3.47%, respectively, while international stocks fared even worse, with the MSCI EAFE and MSCI Emerging Markets Indices returning -6.85% and -8.77%, respectively. Value stocks held up better than growth names with the Russell 1000 Value Index returning -2.20%, while the Russell 1000 Growth Index returned -4.02%, though growth stocks still remain firmly in the lead year to date.
Within the Russell 1000 Index, the more defensive telecommunication services, utilities, and consumer staples were the top performing sectors in the second quarter while the financials, energy, and information technology sectors lagged. Despite a strong bounce this year, financials gave up some ground due to the reacceleration 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-to-date through the end of June.
Corporate Earnings Provide Lift to U.S. Equity Markets
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 during earnings season. Markets found support in a string of good corporate earnings reports, with 69% of companies in the S&P 500 beating earnings expectations. Importantly, 67% of companies also beat their revenue estimates, which speaks to the improvements in the top-line numbers and overall improvement in the strength of the U.S. economy.
Manufacturing Continues to Drive Gradual Economic Recovery in the U.S.
While the overall economic picture in the U.S. continued to be positive, some economic indicators have begun to be impacted by the economic recession in Europe and a slowdown in the emerging markets. The manufacturing sector continued to provide a boost to employment and the U.S. economy during the second quarter, although some manufacturing activity data showed signs of slowdown late in the quarter and actually shrank for the first time in nearly three years in June, likely driven by near-term uncertainty about U.S. policy outcomes as well as the tumultuous global economic landscape.
Business inventories continued to increase and vehicle sales also remained strong as domestic demand continued to pick up. However, the pull-forward of economic activity due to unseasonably warm weather earlier in the year had an effect of dampening some economic data in the second quarter, including hiring and consumer spending. The unemployment rate edged back up to 8.2% as U.S. labor market improvements seemed to slow down somewhat, although public sector jobs accounted for a large portion of the losses. The four-week moving average of initial jobless claims was up to 387,000 at the end of June. The total number of job openings, while dropping in the most recent data release, remained high, indicating firms may be reluctant to hire new employees due to global and domestic economic and political uncertainty in the near term. As a result, recent net job growth figures were driven more by the drop in layoffs than a pickup in hiring, a phenomenon observed last year as well. We believe that hiring is likely to resume once pending policy measures clear political hurdles and companies have better visibility for the next several quarters. The longer-term trend in employment data remained positive.
Personal incomes and consumer spending continued to increase modestly with data pointing to a slow gradual economic recovery in the United States, though investors seemed to focus more on the worse-than-expected employment numbers reported during the quarter rather than the increases in consumer spending and incomes. With fewer jobs being created than expected and sluggish income growth in the United States, we expect the recovery in the consumer sector to continue to be slow. That said, the U.S. consumer also continued to show signs of recovery during the second quarter. Consumer credit has been increasing and growth in unused credit lines at U.S. banks with more than $20 billion in assets, a potential gauge for future increases in business lending, increased 17% year over year in the fourth quarter of 2011.
Commodity prices, especially food and energy, have softened, driven by the global economic slowdown and the slowdown in China in particular. Gasoline prices also softened throughout the quarter, providing another source of support for the U.S. consumer. Consumer confidence, as measured by the University of Michigan Consumer Sentiment Index, rose to 79.3 in May, the highest level since October 2007, before pulling back in June, and confidence among U.S. small businesses rose to a 14-month high in April. At the same time, the U.S. service sector continued to show signs of recovery, a particularly encouraging development as the services sector represents a larger portion of the economy than does manufacturing, which has been the main driver behind economic recovery in the U.S. so far.
The previously reported first quarter GDP annual growth rate of 2.2% was revised down to 1.9%, but overall, U.S. economic data reported during the quarter, while somewhat less robust, were still generally positive.
Housing Market on the Mend and Could Provide a Positive Surprise for Investors
On the housing front, most data continued to point to an improving environment in the residential housing market with historically low mortgage rates and low home prices supporting housing activity. While housing prices are still in the process of bottoming out, housing activity has now been on the mend for several months. Though some activity seems to have been pulled forward into the earlier part of the year due to unseasonably good weather, given the significant size of the U.S. housing market and its impact on consumer wealth, confidence, and, indirectly, spending, any good news is doubly good for the U.S. economy as it leverages the positive impact on consumers, which represent two-thirds of the U.S. economy.
Confidence among homebuilders reached a five-year high during the quarter while new and existing home sales exhibited strong growth. Sales of new homes surged in May, rising 7.6% from the prior month to a 369,000 annual rate—a two-year high. As a result, inventory of new homes declined to 4.7 months of supply, the lowest since 2005. Meanwhile, the national mortgage delinquency rate dropped to a seasonally adjusted 7.4% in the first quarter of 2012, the lowest level since 2008, though the percentage of mortgages in foreclosure remained little changed from the prior quarter at 4.4%.
A low dollar has also been contributing to improvement in U.S. housing activity. According to data released by the National Association of Realtors during the quarter, international buyers accounted for 9% of total spending on residential real estate in the U.S. over the trailing 12-month period ending in March of this year. This represented a 24% year-over-year increase in sales to international buyers, who have been taking advantage of the weak dollar and historically low U.S. home prices.
Low Inflation Leaves Room for Accommodative Monetary Policy by Fed
The Federal Open Market Committee (FOMC) minutes released throughout the quarter suggested there was little change to the Fed’s stance. Officials reiterated they were prepared to step in with an accommodative policy should economic conditions deteriorate, but did not believe further action was yet warranted. This so-called “Bernanke put” has provided support for U.S. equity markets so far this year with investors believing the Fed will provide future liquidity injections in the event the economy falters. The minutes also confirmed the Fed’s commitment to maintain a low interest rate environment until 2014.
That said, statements from the Fed towards the end of the quarter communicated an increased concern about downside risks to the U.S. economy stemming from the European crisis. While the Fed still seemed to expect a continuation of a slow, gradual recovery in the overall U.S. economy and labor market, low inflation in the U.S. and globally has left room for further accommodative monetary policy.
The FOMC announced an extension of “Operation Twist” through the end of the year, whereby the Fed will continue purchasing Treasuries with longer maturities while selling short-term securities in an effort to further reduce long-term interest rates.
Outside of the U.S. the global easing cycle continued with the Reserve Bank of Australia cutting its benchmark interest rate by 25 basis points and the Bank of England announcing a $150 billion liquidity program. Russia, India, and Brazil also cut rates during the quarter.
Banks Continue to Face Regulatory Scrutiny
J.P. Morgan acknowledged trading losses stemming from inadequate risk management at the firm and the market moving against its derivative positions linked to corporate debt. These losses, which were initially estimated at $2 billion, are now estimated to potentially go as high as $9 billion. This headline is likely to intensify the debate over the Volcker rule, which limits banks’ ability to trade with their own capital and is set to take effect in late July pending agreement on the final details. Despite this being a significant setback for the banking industry, we believe that the U.S. banking system is generally in much better shape than its European counterparts. Having said that, the Volcker rule and increased regulatory scrutiny of the banking industry will likely continue to make the industry less profitable from a historical standpoint for some time to come. Additionally, the alleged LIBOR rate manipulation by global banks (investigations into the actions of several banks and financial institutions including Citigroup, ICAP, UBS, RBS, Barclays, and Deutsche Bank are ongoing) could become a widespread scandal and play out similarly to the Salomon Brothers treasury scandal, further crippling the banking sector and possibly intensifying the regulation surrounding it.
During the quarter, Fed Chairman Ben Bernanke also gave a speech focusing on financial reform. He cited 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 continued regulatory scrutiny also will continue to spell trouble for long-term profitability in the sector.
Meanwhile, Moody’s downgraded the credit ratings of 15 global banks during the quarter, including several of the largest U.S. banks. Morgan Stanley, Goldman Sachs, J.P. Morgan, and Citigroup were all downgraded two notches, while Bank of America was cut one notch.
Recession Deepens Across Europe as Eurozone Sovereign Debt Crisis Intensifies
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 austerity measures that have been implemented in Europe are likely to result in a more severe economic downturn, which will exacerbate the sovereign debt crisis through bond vigilante actions as well as potential further sovereign debt and European bank downgrades by credit rating agencies. Core European economies also continued to show signs of weakness, indicating they are not immune to the crisis engulfing the region.
German and French manufacturing PMI remained firmly in contraction territory while German bond spreads relative to U.S. Treasuries stayed wide during the quarter. Weak unemployment data in Germany mirrored the overall worsening unemployment picture in the region as the underlying economic fundamentals in the region continued to deteriorate. Eurozone manufacturing PMI sank further into contraction territory and the June reading of the Eurozone Index of Economic Confidence was the lowest since October 2009. Meanwhile, deflation in Europe is not out of the question, which could be a significant problem.
Political Turmoil in Eurozone
As if things couldn’t get worse in the eurozone, during the second quarter 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, roiling the markets once more with political turmoil. Meanwhile, French and Greek voters made it clear they wanted some relief from austerity measures by supporting “pro-growth” political parties. French voters elected Socialist Party candidate Francois Hollande as president, choosing a leader who vowed to incorporate growth-boosting measures across the eurozone and scale back the austerity measures built into the region’s Fiscal Compact.
Greek voters also overwhelmingly rejected the two main parties in the outgoing coalition, instead casting votes for more extreme far-left and far-right parties, an outcome that led to a political stalemate with the country’s political parties unable to form a coalition government. Elections in mid-June were framed as a referendum on Greece’s status in the eurozone. The New Democracy party emerged victorious in the much-anticipated elections and was able to form a coalition government. The election results were followed by a global sigh of relief hoping Greece would adhere to the international bailout agreement, although the outcome does not change the underlying problems affecting the Greek economy and the eurozone as a whole.
Spain Requests Bailout for Banks
The banking crisis accelerated in Spain during the quarter with the country’s financial system badly in need of a capital injection. Spain hoped its banks would be allowed to tap European Stability Mechanism (ESM) funds directly without additional austerity measures rather than having to seek a full bailout similar to those accepted by Greece, Portugal, and Ireland.
As pressure mounted on the country’s financial institutions, the yield on 10-year Spanish sovereign debt continued to increase, breaking through the 7% barrier before receding at the end of the quarter. The Spanish government had to nationalize Bankia, Spain’s fourth-largest bank, as Moody’s downgraded the credit ratings of 16 Spanish banks. Since Spain is simply “too big to fail” and too interconnected, it is hard to imagine the rest of the eurozone not experiencing significant aftershocks from any serious trouble that may be brewing in Spain. Furthermore, as evidenced by investor actions last year, the ability of bond vigilantes to significantly increase sovereign debt spreads for countries in economic trouble could further intensify the sovereign- debt crisis.
Eurozone officials agreed to a €100 billion bailout for Spanish banks. However, despite opposition from the IMF, the debt still went through the government, which will increase Spain’s debt load. Not surprisingly, both Moody’s and Fitch credit agencies downgraded Spain’s credit rating by three notches while investors responded to the country’s “admission” of the problems in its banking sector by pushing yields up even higher on Spanish sovereign debt. Concern also continued to mount that bailouts of eurozone countries that subordinate private government bond holders to official creditors were having the adverse effect of scaring away investors from the sovereign bond market, which could further accelerate and exacerbate the sovereign debt crisis and the likelihood of contagion.
Temporary Relief Due to Some Progress on the Policy Front
It became more apparent during the quarter 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 quarter while the country announced that it would miss its deficit targets. Despite Germany’s insistence that fiscal discipline is the best medicine for eurozone economies, the backlash against austerity measures led European Central Bank (ECB) President Mario Draghi to announce that a “growth compact” was needed to restore competitiveness in Europe.
Discussions continued throughout much of the quarter on how growth policies might be enacted in the eurozone, but little was put forth in terms of concrete proposals. After much nervous anticipation, market participants responded to the glimmer of hope coming from the European leaders’ two-day summit held at the end of the June with what looks like a short-term relief rally. Viewed by many as the region’s last chance to come up with concrete measures to combat the eurozone sovereign debt crisis, there were some important breakthroughs, with Germany appearing more flexible on many of the proposed solutions.
There was broad agreement to create a single bank supervisory body for the eurozone which would eventually allow bailout funds to recapitalize banks directly rather than first being channeled through the government, a move that would reduce Spain’s debt burden once implemented. The leaders also announced that Spain’s bailout loans would not receive preferential treatment over private creditors. Additionally, talks focused on more immediate steps to address the rising borrowing costs of Spain and Italy with further details expected to be finalized in the coming weeks. The 10-year yields on Spanish and Italian government debt responded favorably by declining at the end of the month. We believe that these steps, while important and heading in the right — just that, steps toward, but not a resolution of the crisis. This will be a long process that will continue to challenge countries, politicians, and markets in the short to medium term.
Growth in China Slows and the Risk of a Hard Landing Increases
The Chinese economy continued to show signs of slower growth during the quarter with the most recent reading for the HSBC China Manufacturing PMI indicating further contraction in June, the eighth consecutive month below 50. Since Europe is a large trading partner for many emerging market economies, especially China, the negative spillover effect on those economies from the European sovereign debt crisis and economic recession should not be underestimated.
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-indicating the housing bubble in China may be bursting. Data also indicated industrial production in China was growing at a declining pace while new Yuan loans and M2 money supply also increased less than anticipated. Also worrisome, a New York Times article published at the end of the quarter claimed China deliberately misstated economic data to understate the true economic slowdown and its impact on the Chinese economy. It is therefore possible that the “hard landing” scenario is already in play and may take investors by surprise.
The Chinese government has responded with easing measures as the People’s Bank of China cut its benchmark one-year bank lending rate by 25 basis points to 6.31%, signaling a shift to an accommodative monetary policy. The move was received positively by investors and helped ignite a rally in global equity indices. An accelerated slowdown will also increase the likelihood of further monetary policy easing.
Nevertheless, a hard landing in China—a more probable outcome than ever before—would have a significant negative impact on the global economy and investor sentiment. Commodities markets will likely be hit hardest.
We believe that the relief rally following the EU Leaders Summit at the end of the quarter, while a welcome sign, may be short-lived, as eurozone policymakers’ promises are yet to be backed up by timely actions, and a whole range of upcoming policy decisions in the U.S. won’t be resolved until later this year. Once we have more visibility into the “fiscal cliff” scenarios, however, market participants may feel better about investing in risky assets for the long term.
In the U.S., we believe that the housing sector can provide a positive surprise and support for the consumer and the economy overall, and that many market observers are not yet anticipating this scenario. If true, this should help investors gain the confidence in U.S. equities that we have all been waiting for.
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. The Supreme Court upheld President Obama’s healthcare law, the “Affordable Care Act.” Despite the decision, healthcare is likely to remain a hot topic during election season and may make it more difficult for a budget deal to be reached prior to the “fiscal cliff.” Despite healthy 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.
We remain quite positive on the long-term (three- to five-year) prospects for U.S. equities and view potential near-term volatility as a buying opportunity given the relative attractiveness of current equity valuations and the health of U.S. corporate earnings.
Overall, while a global economic slowdown is likely having a marginally negative impact on the U.S. economy, particularly on the U.S. large capitalization companies, the U.S. is still likely to be able to stay on its path of slow economic expansion.
This commentary represents the opinions of the author as of 7/12/12 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.
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