Calvert  News & Commentary

June Equity Market Commentary: Stock Markets Fall Amid Focus on Global Risks

7/14/2011

Untitled Document

By Natalie Trunow, Chief Investment Officer, Equities, Calvert Asset Management Company, Inc.

Natalie Trunow, Head of Equities Natalie Trunow,
CIO, Equities

For the month of June, all major equity indices globally were down. The Standard & Poor’s 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -1.67%, -1.75%, -2.31%, -1.23%, and -1.50%, respectively. While the selloff was broad-based and all of the major economic sectors were down, generally the defensive sectors held up the best. In the Russell 1000 Index, Consumer Discretionary, Materials, and Utilities outperformed the rest of the market, while the Financials, Consumer Staples, and IT sectors lagged. Financials continue to be the worst-performing sector year-to-date, while Health Care names have now overtaken Energy stocks in the leadership position for the year with a 14.15% return for the year through the end of June. Growth stocks held up slightly better than value names in June, with the Russell 1000 Growth Index returning -1.43% while the Russell 1000 Value Index returned -2.05% for the month.

Most equity indices are still up for the year, and we don’t see this correction developing into a major one this year. Despite the more recent negative sentiment in the market that stemmed from refocusing on risks globally and particularly in Europe, we believe that—absent major new shocks to the system—the second half of this year has the potential for upside surprises in both earnings and GDP growth.

Eurozone Debt Crisis and Global Risks

Equity market sentiment continues to be generally negative despite some recovery at the end of the month coinciding with the Greek parliament’s approval of austerity measures. Concerns about global economic growth prospects related to potential contagion in Europe that could be caused by sovereign debt default are impacting investor sentiment. The Greek crisis is now 21 months old with the E.U. continuing to “push the can down the road” and buying time in hopes that the crisis dissolves without a default spiral and major repercussions for the global financial system.

The extent of the potential contagion will determine how much of an impact it will have on the global economy. Specifically, if multiple peripheral states default, or especially if Spain defaults, the impact on global economic growth could be significantly negative. We don’t see a high probability of the U.S. going into recession due to a sovereign debt default by Greece; however, this possibility seemed to be driving the market sentiment in June.

China continues to be a potential source of risk which seems to be largely overlooked by investors. Credit and asset bubbles that may be developing in that country could result in a hard landing for the second-largest economy and have a pronounced negative impact on global economic growth.

Soft Patch in U.S. Economic Recovery

Economic data reported during the month confirmed that the economic recovery is continuing to be slow and gradual with the unemployment rate still high—backing up to 9.1% in May and 9.2% in June—and payroll numbers below expectations.

While this soft patch in the economic recovery is having a negative impact on the equity markets, we believe that it is a temporary one. The recent retrenchment is appropriate given the risks in the system and should create better valuations and entry opportunities for long-term-oriented equity investors. Negative ramifications from supply-chain disruptions caused by the events in Japan, extreme weather in parts of the U.S., job cutting at the municipal level, and the expiration of QE2 are having a short-term negative impact on economic growth and employment.

Pending home sales jumped significantly in May, increasing by 8.2% month-to-month and 13.4% year-over-year, beating economic forecasts by a wide margin. As a forward- looking indicator, this suggests that home sales may rise in the coming months and is a sign that the residential real estate market may be rebounding from its prolonged slump.

Moreover, the U.S. manufacturing sector continues to be strong. Factories, particularly auto parts and computer manufacturers, are likely to rebound in the second half of this year from the impact of the disasters in Japan. These extreme events, as well as increased costs of raw materials, were in part responsible for the slower growth in the U.S. in the first quarter.

U.S. Bank Regulation

U.S. banks continue to suffer from increased regulation—with rules on swipe-fee revenue introduced at the end of June—and stringent capital requirements necessary to de-lever and detoxify banks’ balance sheets.

In particular, U.S. banks are still balancing the need to meet higher capital requirements with the demand for lending from smaller businesses vital to economic growth. Such lending is seeing a pick-up recently, which should help offset the impact of the end of QE2. Some are recommending that U.S. banks improve their disclosure of sovereign-debt exposure. This would be helpful to investors and regulators and would improve risk controls in the banking sector.

Bank of America agreed to pay $8.5 billion as part of a settlement with a group of investors over claims that mortgage-backed securities sold by its Countrywide unit were not properly managed. While alleviating some of the uncertainty around mortgage-related concerns, the deal raises expectations for what future settlements may look like and is a reminder that banks are still facing challenges from the financial crisis. These issues have been weighing on the sector’s year-to-date financial performance.

Outlook

Despite the summer doldrums in equity markets and investor pessimism, we do not subscribe to the double-dip recession sentiment that has become more prevalent in the past weeks. QE2 rolled off at the end of June which, if bank loans continue to grow, should have less of an impact on the markets. Moreover, the portion of demand not met due to the catastrophic events in Japan should not be a permanent loss in global GDP but rather a deferral into the third and fourth quarters once the supply chain disruptions are repaired, creating a significant possibility for an upside surprise in the second half of the year.

As demand recovers, we may see positive earnings surprises from U.S. companies, beating more pessimistic consensus estimates. Fuel prices are also retreating somewhat, which should help consumer spending. The pullback in oil prices to a four-month low during June—after the International Energy Agency said crude will be released from strategic reserves—should help global economic recovery and mitigate inflation concerns.

We believe that the U.S. economy can withstand a mild shock from a European default crisis provided it doesn’t engulf U.S. banks. We also believe that the current softening in the economic data is temporary. If a political agreement is reached in July for deficit reduction and an increase in the debt ceiling in the U.S., equity markets are likely to react positively.




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