Equity Markets Post a Strong January
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Recent policy steps toward mitigation of the crisis in Europe, continued positive U.S. economic data, and a good start of the earnings season in the United States provided support for the equity markets worldwide in January. For the month, the Standard and Poor’s 500, Russell 1000, and Russell 2000 Indices returned 4.48%, 4.87%, and 7.07%, respectively. International stocks also had a strong start to 2012 with the MSCI EAFE and MSCI Emerging Markets Indices returning 5.35% and 11.36%, respectively, in January. The growth investment style outperformed the value style with the Russell 1000 Growth Index returning 5.97% while the Russell 1000 Value Index returned 3.78%.
Within the Russell 1000 Index, Materials, Information Technology, and Financials were the top-performing sectors for the month, while the generally more defensive Utilities, Telecoms, and Consumer Staples sectors lagged.
Eurozone Sovereign Debt Crisis Continues
The eurozone continued to be on investors’ minds in January. The Standard and Poor’s (S&P) rating agency downgraded the sovereign debt of France from AAA to AA+ with a negative outlook; however, Fitch Ratings said it did not expect to downgrade France’s AAA rating in 2012. Other European Union downgrades by S&P included Cyprus, Italy, Portugal, and Spain, all losing two levels, while Austria, Malta, Slovakia, and Slovenia were downgraded one level. This was followed by S&P’s downgrade of the European Financial Stability Facility from AAA to AA+ later in the month. Surprisingly for many market observers, equity markets didn’t have a negative reaction to these significant developments, focusing primarily on the earnings season unfolding in the United States instead.
European sovereign debt yields declined gradually throughout January, with 10-year yields on sovereign debt for Spain and Italy easing. Both of those countries had successful debt auctions during the month, signaling the long term repo operation (LTRO) may in fact be helping the eurozone sovereign bond markets by driving down short-end yields. Some have viewed the LTRO as a European version of quantitative easing, especially considering the resulting significant European Central Bank balance sheet expansion.
Despite the positive impact of the LTRO, fears that Portugal won’t be able to access markets for financing increased during January, leading to concern that the country will require a second bailout. Markets were also still concerned that there was no haircut deal between Greece and its private creditors, though reports at the end of the month suggested an agreement was close on a write-down of Greek debt that will see private creditors accepting a coupon of around 3.75% on the new 30-year debt.
With the eurozone’s manufacturing PMI remaining at contraction levels, new industrial orders and retail sales significantly below forecasts, and unemployment at 10.3%, recession in the euro region may accelerate in 2012. Policy measures throughout the region will likely impose a significant fiscal drag in 2012, which would exacerbate the economic downturn and prolong the recession.
Global Inflation Cooling
With global economic challenges keeping inflation in check, policymakers around the globe continued their efforts toward easing monetary policies. In China, this trend is likely to help mitigate the probability of a hard landing for the Chinese economy, fueled by a possible burst of a real-estate bubble there. The Chinese economy continued to decelerate during January as foreign direct investment, one of the major drivers of economic growth in China, fell 12.7% in December from the same period a year ago, the second straight month with a decline. Increasing domestic consumption in the country will be key to offsetting this effect. China’s December retail sales were up an impressive 18.1% on a year-over-year basis.
The global monetary easing cycle continued with Brazil cutting its benchmark interest rate 50 basis points from 11% to 10.5% in January. In the eurozone, core CPI was 1.6% in December on a year-over-year basis, while headline CPI was 2.7%, leaving room for continued policy easing there as well.
Inflation is likely to stay low, which should be positive for the consumer and allow for the continuation of the global monetary easing cycle, which is stimulative to global economic growth.
U.S. Economic Recovery Continues at Slow, Gradual Pace
In the United States, the economic picture continued to improve. The U.S. labor market, while still weak, showed very encouraging signs of improvement during the month with initial jobless claims below the 400,000 level on a four-week moving average basis, which signals a longer-term improvement in the labor market. Non-farm payrolls rose more than expected in December and January, helping push the unemployment rate down to 8.3% as of January—a three-year low reading for the U.S. economy. While this number is likely to remain somewhat volatile and high for some time, the established positive momentum is key for improving consumer confidence, consumer spending, and the self-sustained economic recovery in the United States.
The U.S. corporate earnings season is now in full swing with many companies beating Wall Street estimates not only on earnings but also on revenues, a trend we would like to see continue. As of January 31, 58% of S&P 500 companies that reported beat earnings expectations and 53% beat revenue expectations.
Personal consumption expenditures increased 2% in the fourth quarter, while fourth- quarter retail sales also showed healthy growth. Consumer confidence improved during the month and the manufacturing sector continued to post good results. Strong regional manufacturing surveys throughout January were followed by the national manufacturing PMI increasing to 54.1 from a revised 53.1 in December. U.S. gross domestic product (GDP) grew at a 2.8% annualized rate in the fourth quarter, the fastest pace of economic growth since the second quarter of 2010. Additionally, the index of U.S. leading economic indicators increased 0.4% in December, the third consecutive monthly increase. The U.S. consumer should continue to benefit from low inflation.
While profitability in the U.S. banking sector continued to deteriorate as demonstrated by a significantly lower-than-expected earnings report from JPMorgan Chase during the month, U.S. bank lending continued to improve, resulting in a combined increase in revolving and non-revolving consumer credit by $20.4 billion dollars in November, a 9.9% annual increase. An improving consumer balance sheet is now allowing banks to increase lending while adhering to higher lending standards. Moreover, commercial and industrial borrowing surged 18% year-over-year in the fourth quarter.
The health of the U.S. government balance sheet, meanwhile, continued to deteriorate as the United States’ rising debt returned to the forefront of political discussion with the Senate allowing the White House to increase the debt limit by $1.2 trillion during the month.
The Federal Open Market Committee (FOMC) statement released at the end of January indicated the Federal Reserve (Fed) is not satisfied with the pace of recovery and intends to keep interest rates low until the end of 2014, a more dovish stance than markets anticipated. The FOMC adopted a formal inflation target of 2% and suggested that balance sheet expansion is not out of the question, with the Fed prepared to take further accommodative action if economic conditions deteriorate. Output growth and inflation forecasts were also revised down modestly.
Accelerating recession in Europe and the overall slowdown in the global economy will de-emphasize the contribution of exports to U.S. GDP. The U.S. trade deficit increased a more-than-expected 10.4% in November from the prior month to $47.8 billion. Exports from the U.S. fell to a four-month low, reflecting the impact of slower global economic growth. Therefore, the continued recovery of the U.S. consumer will be important for a self-sustained U.S. economic recovery.
U.S. Housing Market Still Bottoming Out
The U.S. housing market is continuing to bottom out and showing signs of improvement. In January, the National Association of Home Builders confidence index rose to the highest level since 2007, while existing home purchases rose 1.7% in 2011 compared to the prior year. Mortgage applications, as measured by the Mortgage Bankers Association Index, also increased throughout the month.
The Federal Housing Finance Agency’s home price index increased 1% in November from the prior month, but was down 1.8% from the same period one year ago. While the housing market is clearly not out of the woods yet, especially with foreclosed inventories still high and having to be worked through, we believe that the repair and the bottoming-out process have started and are likely to continue as the U.S. economy and U.S. consumers recover.
If U.S. economic recovery proves robust enough to withstand the negative headwinds from Europe and China in 2012, U.S. equities may significantly outperform Treasuries given the relative valuation of the two asset classes. Highly bid-up dividend-yielding securities may also underperform as investor risk aversion subsides.
As the U.S. economy continues to improve, justifications for QE3 weaken. Paradoxically, this is disappointing to those investors who seem to prefer a sure and quick (however short-lived) policy-driven shot in the arm to an organic, self-sustained—but more painful—long-term economic recovery. We clearly prefer the latter.
Overall, the European sovereign debt crisis continues to evolve, although so long as it continues to resolve itself in an orderly fashion, we believe that it is unlikely to derail a U.S. economic recovery.
This commentary represents the opinions of the author as of 2/8/12 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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