July 2012 Equity Market Commentary
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Despite the continued economic and sovereign debt crisis in the eurozone and a material slowdown in the emerging markets, equity investors globally were mildly optimistic in July as U.S. corporate earnings reports came in better than expected and the continued global monetary easing cycle provided support for equity markets worldwide. For the month, the Standard and Poor’s (S&P) 500, Russell 1000, MSCI EAFE, and MSCI Emerging Markets Indices returned 1.39%, 1.19%, 1.15%, and 2.02%, respectively. Small-cap stocks underperformed their large cap counterparts as the Russell 2000 Index declined 1.38%, and growth stocks outperformed value names with the Russell 1000 Growth Index returning 1.34% while the Russell 1000 Value Index returned 1.03%.
Within the Russell 1000 Index, the more defensive telecommunication services, energy, and consumer staples sectors were the top performers in July while the more cyclical materials, consumer discretionary, and financials sectors lagged. Information technology stocks also lagged after some disappointing earnings reports, especially within the internet industry.
U.S. Corporate Earnings Better than Expected, but Top-Line Growth Slows
Performance in the equity markets in July was driven to a large extent by U.S. corporate earnings announcements, as well as some negative earnings pre-announcements. At the time of this writing, 85% of S&P 500 companies had reported earnings, with 67% beating earnings estimates. The top line results, however, were less than stellar, with 43% of companies topping revenue forecasts and reported revenues declining 0.3% on a year-over-year basis. Smaller-cap companies have been outperforming their large-cap counterparts so far this earnings season in terms of positive earnings and revenue surprises, which may help these stocks’ prices outperform in the next few months. U.S. large-cap, multi-national companies with large exposures to Europe and emerging markets are the most vulnerable to a significant slowdown in global economic growth.
A softer earnings season for U.S. companies is likely to result in more realistic earnings expectations going forward, paving the way for better stock market performance later in the year and possibly into 2013.
Gradual U.S. Economic Recovery Continues with Fed Prepared to Act
U.S. economic data continued to show signs of softness, although the overall trajectory is still positive. Data released early in the month indicated U.S. payrolls increased moderately in June, but below a rate that could assure more robust economic growth in the United States. Private payrolls came in at 84,000 jobs versus expectations of 106,000, indicating that U.S. private businesses have been in “wait-and-see” mode again this summer before any policy resolutions are passed and before they can have more visibility into 2013. With public sector employment continuing to contract, the unemployment rate held steady at 8.2% in June. At the time of this writing, the release of July payrolls by the Labor Department showed a better than expected 164,000 jobs added, with strong private sector growth, though June’s gains were revised down. The unemployment rate ticked up to 8.3% due to the household employment survey indicating a loss in jobs.
At the same time, average hourly earnings numbers were reported above consensus in June and the average workweek increased to 34.5 hours, reversing a decline in May—a positive sign. The average workweek remained unchanged in July. Additionally, after some volatility in initial jobless claims during the month, the four-week moving average of claims was down to 368,000 at the end of July. Continuing claims also fell more than forecast during the month, indicating the overall unemployment environment may continue on a very slow path to recovery.
The U.S. consumer continued to be negatively impacted by high unemployment. Despite personal incomes rising 0.5% in June, retail sales declined 0.5% and consumer spending was unchanged from the prior month as U.S. consumers increased their savings rate to 4.4%, the highest since June 2011. Inflation remained tame, which helped consumer confidence and kept the global easing cycle on track.
Meanwhile, the U.S. manufacturing sector continued to show signs of slowing. At the time of this writing, the release of the July ISM Manufacturing Purchasing Managers Index (PMI) indicated a second consecutive month of contraction with a reading below the 50 threshold, despite rising slightly to 49.8 from 49.7 in June. However, other data released during the month showed construction spending, factory orders, industrial production, and business inventories all increasing more than forecast, while vehicle sales also remained strong.
U.S. real GDP expanded at a 1.5% annualized rate in the second quarter compared to the 1.4% consensus forecast, while first-quarter GDP growth was revised up from 1.9% to 2%, which provided support for the equity markets. The GDP numbers were negatively impacted by a decrease in government spending of 1.4%, while the private sector posted a respectable 2.2% growth rate, a promising development. Personal consumption also increased more than forecast in the second quarter, rising 1.5% The Index of U.S. Leading Economic Indicators (LEI) fell 0.3% in June, and has now declined two of the last three months.
On the policy front, the stance of the Federal Reserve (Fed) remained that it is ready to act should economic conditions in the U.S. deteriorate and warrant further action. At the same time, the U.S. government reported a $60 billion increase in the budget deficit in June with the looming budget debate likely to accelerate in the coming months.
U.S. Housing Market Continues to Pick Up
With mortgage rates at record lows, the housing market continued to recover during the month and may provide a significant positive surprise for U.S. investors. Housing is a significant driver of consumer wealth and confidence, and any incremental pickup in activity and the health of this market cannot be underestimated.
Confidence among U.S. homebuilders increased in July to the highest level since early 2007, while housing starts increased a more-than-forecast 6.9% in June from the prior month with strong growth in both single- and multi-family homes. Building permits, while declining by 3.7% from the prior month, have been trending upward since early 2011 and sales of both new and existing homes were up on a year-over-year basis. The number of foreclosed homes for sale has now fallen considerably, and is providing support for home prices. The Federal Housing Finance Agency’s monthly House Price Index increased more than forecast in May, rising 0.8% from the prior month, with gains across all regions. The Standard & Poor’s/Case-Shiller 20-City Home Price Index also increased a seasonally adjusted 0.9% in May from the prior month with every city showing price increases, and the composite index declined on a year-over-year basis by the smallest amount in almost two years.
Eurozone Sovereign Debt Crisis Continues
As expected, the details from last month’s European Union Leaders Summit on how Spain’s banks will directly access bailout funds have not been finalized, and there is still considerable disagreement over how this will work. Meanwhile, Germany’s Supreme Court has yet to issue a final ruling on the constitutionality of the European Stability Mechanism, which could prove to be yet another obstacle in implementing the solutions agreed on, in principle, at the Summit.
With the Spanish economy continuing to fall into deep recession, the yield on 10-year Spanish debt surged to 7.6% toward the end of the month after Spain’s regional governments announced they would seek bailouts from the central government; however, the yield fell back below 7% as the European Central Bank (ECB) signaled it would intervene to preserve the euro and may return to buying government bonds. Still, credit default swaps on Spanish debt were implying around a 40% chance that the country will default in the next five years.
Meanwhile, this month’s data continued to confirm the eurozone, including its core economies, is slipping further into recession with the PMI in the region dropping further into contraction territory in July. The impact of the eurozone sovereign debt crisis is clearly spreading to core economies, as German and French manufacturing PMIs were actually a drag on the eurozone aggregate figure after declining to 43.3 and 43.6, respectively. The unemployment rate in the eurozone ticked up to a new record high of 11.2% in June, driven by labor cuts in Spain and Italy, while industrial production and construction output in the eurozone were down considerably on a year-over-year basis.
The U.K. economy contracted by significantly more than forecast in the second quarter, with GDP shrinking 0.7% on a quarter-over-quarter basis and decreasing 0.8% on a year-over-year basis. The double-dip recession in the U.K. is likely to further ignite the debate over the merits of fiscal austerity and growth-boosting policies.
Inflation continued to fall, which is a positive for further monetary easing but a negative as deflation has now become a serious threat. The ECB cut interest rates 25 basis points to 0.75%, citing weak economic growth and heightened uncertainty. The Bank of England (BOE) also launched another round of quantitative easing which will increase its asset purchase program by Â£50 billion ($77.6 billion), or 3% of GDP, in a measure to stimulate economic growth.
Cooling Inflation in China Leaves Room for Further Monetary Easing
Inflation continued to cool in China with the Consumer Price Index (CPI) coming in at 2.2% in June, down from 3% the prior month and slightly below expectations. Deflation could be a threat. At the same time, China continued to slow during the month with the Chinese economy in contraction territory. Foreign direct investment (FDI) in China was down 6.9% in June on a year-over-year basis, a larger drop than forecast, and Chinese real GDP increased 7.6% in the second quarter, the slowest pace in more than three years, making a hard economic landing more probable. Industrial profits were down 2.2% year to date through July.
In response to lower-than-expected manufacturing data, the People's Bank of China (PBOC) lowered benchmark rates for the second time in a month. The one-year deposit rate was cut by 25 basis points. The PBOC also cut lending rates and boosted the discount banks can offer on loans.
Our medium- and longer-term forecast remains the same, calling for choppy equity markets for the next few months with significant downside risk, but turning positive once policy measures due later this year are enacted, the U.S. presidential elections are behind us, and better visibility into 2013 helps improve investor confidence.
The sovereign debt crisis in Europe and the economic slowdown in the emerging markets may have a bigger impact on the earnings of large-cap U.S. companies, causing them to lose their recent performance edge relative to their small-cap counterparts.
We believe that the U.S. economy can continue to grow despite external growth shocks once the fiscal cliff and the policy issues in the U.S. are resolved. As global economic growth continues to slow, the U.S. remains one of the few areas of positive growth and enviable corporate health.
This commentary represents the opinions of the author as of 8/10/12 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.