October 2012 Equity Market Review
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
The global macroeconomic backdrop continued to negatively impact equity markets in October. With the excitement of the QE3 announcement wearing off and uncertainties about the U.S. earnings season, the presidential election, and the impending fiscal cliff setting in, investors took profits in equities during the month.
For the month of October, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -1.85%, -1.69%, -2.17%, 0.84%, and -0.60%, respectively. Value stocks held up better than growth stocks during the month with the Russell 1000 Value Index declining 0.49% compared to the Russell 1000 Growth Index's drop of 2.92%. Value stocks now lead growth stocks year-to-date for the first time this year.
Within the Russell 1000 Index, Financials, Utilities, and Industrials were the top-performing sectors with Financials and Utilities the only sectors in positive territory for the month. Information Technology, Telecommunication Services, and Energy sectors lagged.
The U.S. Corporate Earnings Season Mixed So Far
As we anticipated, the ongoing U.S. earnings season has proved to be less than stellar and unable to provide a sufficient boost to the market that would help sustain the magnitude of the momentum created by the announcement of QE3 by the U.S. Federal Reserve in September. Large U.S. companies continued to face headwinds in their profits linked to the eurozone and some of the largest emerging-market economies, like China and Brazil.
Through the end of October, 64% of companies in the S&P 500 had reported third-quarter earnings with 66% beating expectations. That said, reported earnings were down 1.2% on a year-over-year basis and top-line numbers were weaker than expected with just 37% of companies beating consensus estimates and revenues down 2.3% from the same period one year ago. If top-line growth continues to be a challenge going forward, earnings will likely stay under pressure in the fourth quarter.
Gradual Economic Recovery in U.S. Continues
Data released during the month indicated improvements in the employment picture with continuing jobless claims trending down, a positive sign for future improvement in unemployment statistics. As of the time of this writing, the release of the October jobs report showed more workers added to payrolls than anticipated, though the unemployment rate ticked up to 7.9% due to more people entering the labor force, a byproduct of improving conditions.
After posting softer numbers for the previous three quarters, the U.S. manufacturing sector started to show signs of improvement. The U.S. ISM Manufacturing Index unexpectedly increased in October as manufacturing activity expanded for a second consecutive month. However, uncertainty surrounding the impending fiscal cliff and the global economic slowdown continued to impact exports, causing few market participants to expect further acceleration of manufacturing activity in the coming months.
Vehicle sales remained strong as interest rates on new-car loans fell to the lowest on record with QE3 appearing to be having the intended effect of pushing down interest rates. Residential construction posted solid gains, but this was more than offset by declines in commercial and government construction projects. With inflation staying low, the U.S. service sector recovery helped real GDP increase at a 2% annualized rate in the third quarter on a quarter-over-quarter basis, exceeding expectations.
Strong signs of recovery in the U.S. housing market, the slowly improving employment picture, and good performance in the equity markets year-to-date seemed to be making a positive impact on American consumers. Consumer confidence reached its highest level in five years while consumer spending has also been increasing, giving us confidence that U.S. equity markets can continue to perform well in the long-run.
In the short-term, however, we are likely to see some softness and volatility in the equity markets as the fiscal cliff in the United States continues to loom. Despite reports surfacing during the month that bipartisan discussions were ongoing, a credible solution supported by both political parties does not appear to be forthcoming quite yet, and some market participants commented that risks resulting from the fiscal cliff were not yet reflected in market prices.
Data Shows Improvements in U.S. Housing Market
The U.S. housing market has now been recovering, however mildly, for several months. As we commented for the past several months, we believe that the U.S. housing market can provide a significant positive catalyst for U.S. economic growth and help offset some of the softness in the manufacturing sector. Our contention from last year that the U.S. housing sector had started to recover is now supported by multiple data points. Confidence among home builders rose to its highest level since June 2006 while housing starts reached a four-year high in September. Sales of new and existing homes continued to increase while the inventory of homes for sale has been tightening, both of which have helped to push home prices higher.
Mortgage rates dropped to new record lows, helped by QE3. At the same time, mortgage credit standards remained tight with banks fearful of taking on riskier loans because they could be forced to take back non-performing loans by Fannie Mae and Freddie Mac.
Eurozone Recession Drags On
The eurozone continued to provide a negative backdrop for equity markets with core European economies impacted by the region's economic troubles. Eurozone Manufacturing PMI fell deeper into contraction territory in October and the Composite PMI reached its lowest level since June 2009, confirming our suspicion that things in Europe will likely get worse before they get better—though the market consensus seems to be quite a bit more optimistic than that.
There were some improvements on the sovereign debt side. Yields on government debt of peripheral eurozone countries, including Spain, Italy, Portugal, Ireland, and Greece, continued to drop during the month as the European Central Bank's pledge to buy the sovereign debt of countries under severe fiscal stress has helped restore some investor confidence in the eurozone bond market. While this is a welcome sign, questions surrounding a Spanish bailout request (required in order to activate the ECB bond-buying program) remained unresolved and the ability of the European Stability Mechanism (ESM) to lend directly to Spanish banks has been called into question.
Meanwhile, Greece continued to wait for a decision from international creditors on whether the next tranche of aid will be released and whether the country will be provided an extension to meet deficit targets. Although recent reports suggested that international creditors were planning to disburse bailout funds to Greece, the timing was still unclear and political turmoil within Greece's coalition government could derail voting on the latest international austerity program.
China's Economy Stabilizing but Hard Landing Still Possible
Data released during the month seemed to suggest China's economy may be stabilizing; however, it is not out of the woods yet and with the global economic slowdown still in place, a hard landing for the Chinese economy remains a possibility. If this scenario materializes, global economic growth will be negatively impacted.
Bank lending has been picking up with some of the recently enacted easing measures flowing through the Chinese economy, while inflation remained tame, leaving room for further policy easing if warranted. China's HSBC Manufacturing PMI rose to an eight-month high in October, although it was still in contraction territory. The official Chinese Manufacturing PMI moved into expansion territory for the first time since July. However, foreign direct investment (FDI) continued to decline. China's third-quarter real GDP increased 7.4% on a year-over-year basis, the slowest rate of expansion for the Chinese economy since the first quarter of 2009.
The current weakness in the equity markets is consistent with our outlook over the past several weeks, and we continue to see potential softness and volatility in the equity markets in the upcoming weeks given the uncertainties arising from problems in Europe, the impending fiscal cliff in the United States, and the less-than-stellar results in this corporate earnings season. With the United States presidential election behind us, we believe that a more sustained equity market improvement is possible after policy solutions related to the fiscal cliff are clear. We see the eurozone's problems continuing to drag on and negatively impacting global economic growth. This would particularly affect larger-cap stocks in the developed markets, including the United States, as well as stocks in China and other emerging-market economies.
This commentary represents the opinions of the author as of 11/14/12 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