U.S. Equities Poised to Outperform in 2012
U.S. stocks are in a good position to perform better than equities in other developed markets in 2012 as the country’s economy builds self-sustaining momentum.
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
A Brief Look Back
In the equity markets, 2011 was marked by significant volatility as investors tried to assess the potential impact of the ongoing eurozone sovereign debt crisis and the uneven worldwide economic recovery from the financial crisis that ended in 2009. The Standard & Poor's 500 Index of U.S. stocks posted a total return of 2.11% for 2011. International markets, weighed down by the European sovereign debt crisis and China's economic slowdown, fared considerably worse, with the MSCI EAFE and MSCI Emerging Markets Indices declining 11.73% and 18.17% in 2011, respectively.
Some Downside Risks Continue, but U.S. Recovery is Gaining Momentum
Many of the downside risks that affected equity markets in 2011 will likely continue to be significant factors throughout 2012. In addition to the problems in Europe, a potential hard landing for the Chinese economy could negatively impact global economic growth. Austerity measures in eurozone countries and restrictive U.S. fiscal policy will likely exert considerable fiscal drag on economic growth around the world. However, we believe that the U.S. economic recovery is gaining momentum and that U.S. stocks offer some compelling buying opportunities. We anticipate that earnings for U.S. companies will continue to be generally strong, with many of these stocks trading at attractive valuation multiples. In particular, smaller-capitalization stocks may increasingly benefit from a strengthening U.S. economic recovery, while larger-cap stocks in general and dividend-paying companies in particular, having outperformed in 2011, are likely to fall out of favor.
More Structural Integration Needed for Eurozone
In Europe, the policy measures that have been proposed to date deal primarily with only the symptoms of the sovereign debt crisis. The underlying economic weakness of the peripheral eurozone countries—and now probably of the core eurozone economies—should continue for some time, which will likely worsen the very symptoms policymakers have been trying to address. Defaults and exits from the monetary union by some peripheral economies such as Greece are no longer out of the question. French sovereign debt spreads spiked up in late 2011 and early 2012, making the downgrade of French and possibly German debt ever more likely (Standard & Poor's downgraded its rating on France's sovereign debt in January 2012 and maintained a negative outlook on the country). All this uncertainty is likely to keep European market volatility elevated and will probably continue to spill over into U.S. markets from time to time.
We believe that a more credible, economic and political structural integration in the eurozone will be required if the monetary union is to remain intact. The eurozone's largely tentative move toward increased fiscal integration and austerity measures will likely create a significant fiscal drag on the region's economy. However, the resulting structural changes should be positive in the long run. Tighter fiscal integration, if achieved, should help open the door for more active involvement by the European Central Bank, which would be extremely helpful for market sentiment toward the eurozone.
Hard Landing for Chinese Economy?
In the fourth quarter of 2011, China unexpectedly cut reserve rates for its banks on the heels of lower inflation numbers and some weaker-than-expected economic data. The move demonstrated China's shift to monetary easing in response to a slowing economy and lower-than-expected inflation. The possibility of a hard landing for the Chinese economy would likely spell trouble for global economic growth and could serve as a further shock to investor confidence sometime in 2012.
U.S. Policymakers Need to Take Action on Debt Levels
Inflation expectations in the United States remain low for the time being, allowing the Federal Reserve (Fed) to maintain its stimulative policy of a near-0% interest rate. Based on the current employment picture, the consensus seems to indicate that wage inflation is not yet a concern, which means that this accommodative policy could remain in place for some time.
Overall, the debt crisis and recession (exacerbated by the fiscal drag) in Europe as well as inaction in Washington are likely to continue to have a dampening effect on U.S. economic growth in the medium term. It remains to be seen what effect the failure of the Congressional "super committee" to deliver solutions for the U.S. fiscal and debt problems might have on the credit rating of the country's debt. We believe that U.S. policymakers need to resolve their differences in favor of the country's needs and address the U.S. debt issue head-on as soon as possible.
U.S. Housing Market Appears to be Bottoming Out
We believe that the U.S. housing market can work through the large number of foreclosures, although the high inventory of homes on the market, including foreclosures, will likely remain something of a drag on housing recovery. Foreclosure activity declined by 34% in 2011 compared to 2010, although much of the drop was attributed to delayed filings caused by documentation and legal issues. In 2012, foreclosure activity is expected to pick up somewhat; however, we don't believe that the impact will be sufficiently strong to send the housing market into a downward spiral.
On the positive side, we anticipate that the U.S. housing market, an important piece of the U.S. economic recovery puzzle, is likely to continue its bottoming-out process in 2012. Housing prices should continue to firm up and likely improve in some regions, starting a long-term upward trend. Based on recent data, it appears that the housing sector is no longer a significant drag on the economy. Housing affordability in the United States is at an all-time high, which, combined with a pick-up in rents, should help provide support for housing prices. The 30-year fixed mortgage rate dipped below 4% in October 2011 for the first time ever, indicating that the Fed's "operation twist," designed to push longer-term Treasury yields down, has been successful. However, while the refinance share of mortgage activity reached a 2011 high in the fourth quarter of last year, financing for new borrowers is still hard to come by as banks' lending standards remain high.
Major Changes at Some Large Banks
In 2012, we anticipate that a large portion of the success of active portfolio managers (relative to their passive benchmarks) will rest on their management of allocations to the financials sector. U.S. bank lending is improving. However, big bank risks in Europe that can impact systematically important U.S. institutions could upset that trend. In fact, a sustained recovery in U.S. financial stocks will likely continue to depend on an orderly resolution of the European sovereign debt crisis.
European financial stocks will also likely be an important proving ground, with further consolidation in the European banking sector likely. In the longer run, banks may shift to less risky strategies and assets, which will likely reduce their returns and hurt their long-term profitability. This trend is also likely to apply to large, globally exposed banks in the United States and other countries outside Europe. In the short term, however, a strong bounce in the sector may leave some active managers behind from a relative return standpoint.
The Bottom Line
We believe that the market impact of a recession in Europe can be offset by economic expansion in the United States and possibly in the emerging markets. We remain constructive on the U.S. economy and equity market going forward, especially given the anticipated continued strength of U.S. corporate earnings and the historically attractive valuation multiples of U.S. equities. Especially relative to assets such as U.S. Treasuries, which have recently reached historically low yield levels, equities appear to offer strong value. As the U.S. economic recovery continues to gain momentum, smaller-cap names are likely to outperform large caps, while high-dividend stocks—the long-term darlings of investors—may underperform.
The downside risks for 2012 are some of the same issues that created significant market volatility in 2011—European recession and a potential hard landing in China. Fiscal drag globally and in the United States will likely be a negative for global economic growth. Geopolitical risks continue to be a concern with oil and gas prices hanging in the balance. As always, a flare-up in political tensions in the Middle East can provide a significant shock to global markets and possibly impact the global economic recovery.
On the other hand, easing moves on a global scale, including emerging markets, should provide some support for global economic growth. The U.S. economy, while not immune to the eurozone's recession, seems to be gathering positive, self-sustaining momentum. We expect these trends to continue well into 2012 with the United States likely outperforming other developed economies.
This commentary represents the opinions of the author as of 2/28/12 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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