Calvert  News & Commentary

Focus on Equities: Improving Consumer Balance Sheet Health is Key to Market Recovery

This year equity markets have done exceptionally well (as they largely have since 2009), but is this trend sustainable?


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As 2013 sprints to a close, equity markets have done exceptionally well this year. Many indices are now registering all-time highs, despite mixed economic signals and concerns over the Fed's "tapering" of long-term asset purchases and exit from quantitative easing. The S&P 500 Index, as of December 1, 2013, has risen over 26.5% year-to-date, delivering nearly 30%, including dividends. Were we to have closed 2013 at November, January to November performance alone would place 2013 close to the top 10% of calendar-year returns since 1950.

Comparative Equity Index Performance Jan-Nov 2013

Source: Bloomberg (S&P 500), Russell Investments (Russell 1000 & 2000); MSCI (EAFE & EM)

An important driver of economic activity, and by extension Fed policy, is the improving health of the consumer balance sheet…

While much market commentary has focused on what is happening at the Federal Reserve, we think that an important driver of economic activity, and by extension Fed policy, is the improving health of the consumer balance sheet. In the wake of the 2008 financial crisis, the U.S. consumer has been more financially prudent and consumer balance sheet quality has improved as a result. This gives consumers readier access to consumer loans and mortgages and enables activities that are key to the continued recovery of the housing and automotive industries, among others.

As the overall economic recovery stabilized, improvements in employment, housing, and the equity markets have all helped to strengthen the consumer balance sheet. As a result, U.S. consumer confidence and spending have recovered considerably from post-financial-crisis lows and are now contributing to GDP growth. Not only have U.S. consumers become less risk averse as their financial health improved, they now have more assets available to invest in risky assets.

Total Assets and Structure of Consumer Non-Profits Balance Sheet, 1990-2012

Consumer and non-profit balance sheets recovering since 2008:
Fewer liabilities, more net worth

Source: Federal Reserve Flow of Funds Data (Dec. 6, 2013)

The process of improving investor confidence tends to feed on itself organically, and is likely still in its early stages…

The process of improving investor confidence tends to feed on itself organically and is likely still in its early stages. Initially, some investors who feel more secure in their financial situation put additional money to work, pushing up prices by driving up demand where little had existed before. In turn, positive price action convinces more investors to follow suit: some seeing upward momentum as a sign that the worst risks have passed, while others grow concerned about missing out on gains, thereby providing support for Wall Street.

This healthier consumer helps Main Street too, through increased consumption, creating a positive feedback loop driving corporate earnings and GDP growth. These dynamics reinforce positive momentum for equities, producing an environment that supports earnings multiple expansion. In 2013, earnings multiple expansion has been a major component of market returns, in addition to earnings growth.

Consumer an Non-Profit Liabilities and Credit as a % of Total Assets, 1990-2012

Consumers have significantly deleveraged their balance sheets since the peak of the financial crisis, although one can argue that further deleveraging toward historical averages may be healthy.
Source: Federal Reserve Flow of Funds Data (Dec 6, 2013)

Equity mutual fund flows strengthened significantly in 2013 for the first time since the financial crisis… We believe there is likely more to come in 2014.

Equities benefitted this year from reduced consumer (and institutional) risk aversion. Given the bitter taste of bond losses this year, as well as the likely continued headwinds in fixed-income, investors have favored equities at the expense of fixed-income, and, most other asset classes when deploying capital.

Gains in housing prices have dampened recently as a result of the expected negative impact of tapering on mortgage rates. Seasonal winter doldrums can also be expected to have a temporary negative impact in the near future. Therefore, the pace of balance sheet reconstruction may slow somewhat over the next quarter or two, but the general positive trend remains.

Case-Shiller Composite Index, Jan 2000-Sep 2013

Real estate prices recovering from post-crisis low (Jan 1, 2012)
Source: Federal Reserve Economic Data (FRED), St. Louis Federal Reserve

Improvements in the strength of the U.S. consumer and housing sectors will influence the timing of Fed tapering decisions…

The consumer is a major driver of the U.S. economy and a critical indicator of its health. With the Fed's mandate strongly linked to GDP growth and employment figures, continuing improvements in the strength of U.S. consumer and housing sectors will influence the pace and timing of Fed tapering decisions, even if indirectly.

The Fed announced on December 18 2013 that it will start tapering its purchases of long-term assets in January 2014, ending speculation on when tapering might begin. We continue to believe that the Fed will be extremely careful about managing expectations about future taper activities – both timing and magnitude – by careful telegraphing of its position for the duration of the tapering process. At the same time, the Fed will be very sensitive to the volatility that tapering activities are likely to have on interest rates and other key market metrics. Changing volatility and interest rate expectations can easily drive mortgage rates higher, negatively impacting housing activity and weakening a major component of the U.S. economic recovery.

Observations on ESG factors

Our September note mentioned that sectors that typically score low on ESG factors, e.g. energy, materials and industrials, may experience a snap-back as the economic recovery gains strength, potentially hurting SRI investors. We believe that the economic recovery can accelerate significantly next year, making this outcome more likely. So far, though, that snap-back has not happened, although the industrials sector has been performing in-line with the rest of the market.

Sector ETF Returns vs S&P 500 Total Return: 9/30/13 - 11/30/13

Recently, the higher returning sectors have tended to be the higher-scoring ESG sectors…
Source: iShares ETF total returns from Yahoo. S&P 500 Total Returns from Standard and Poor's.

In some industries, like automotives, we see tension between the long-term impact of ESG factors and short-term market factors. Generally, younger consumer generations are noticeably less interested in buying cars than their parents and grandparents were, creating an overall drag on long-term auto sector demand, that should cut into long-term auto revenues and, by extension, equity performance for the group.

At the same time, auto companies stand to benefit from some shorter-term cyclical factors tied to the general economic recovery. Pent-up demand left over from the depths of the recession is now being released, as employment and income improvements enable consumers to replace aging fleets, and attend to purchases that had been put off when things were tighter. The healthier consumer balance sheet further assists this process because there are a larger number of credit-worthy consumers able to finance auto purchases. All of these stand to promote short-term profits in the auto sector, even though the long-term demand story is less sanguine.

This commentary represents the opinions of the author as of 12/20/13 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. Calvert may have acted upon this research prior to or immediately following publication. In addition, 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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