August Equity Market Commentary
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Global equity markets were strong in August in part due to a better-than-expected corporate earnings season in the U.S. and promises of stabilization in Europe, but equities mainly responded to increasing speculation about possible Federal Reserve (Fed) action regarding QE3, which materialized on September 13, 2012. For the month, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, and MSCI EAFE Indices returned 2.25%, 2.43%, 3.33%, and 2.70%, respectively. Weighed down by China's slowing growth, emerging markets stocks underperformed with the MSCI Emerging Markets Index declining 0.29%. Growth stocks outperformed value names with the Russell 1000 Growth Index up 2.69% while the Russell 1000 Value Index returned 2.17%.
Within the Russell 1000 Index, Information Technology, Consumer Discretionary, and Financials were the top-performing sectors in August, while the more defensive Utilities, Telecommunication Services, and Consumer Staples sectors lagged.
Manufacturing Activity Slows But Gradual Economic Recovery Continues in U.S.
U.S. manufacturing, the driver of the U.S. economic recovery in the past four years, continued to show signs of slowing in August. The Empire State Manufacturing Index unexpectedly declined into contraction territory and, despite improving, the Philly Fed Manufacturing Index indicated manufacturing activity in the mid-Atlantic region shrank for a fourth consecutive month. In line with the weakness in the regional manufacturing surveys, the release of the August ISM National Manufacturing Purchasing Managers Index (PMI) at the time of this writing showed a third straight month with a reading slightly below 50.
Despite U.S. manufacturing data showing signs of softness, figures released by the Commerce Department during the month revealed durable goods orders rising 4.2% in July with orders for motor vehicles and parts increasing 13% as demand for autos remained strong. In another positive sign, factory orders increased 2.8% in July while industrial production rose 0.6%, driven by increased use of utilities as a result of the heat wave across the country during the month.
Consumer confidence data were mixed during the month. The Conference Board's Consumer Confidence Index unexpectedly declined in August, while the final reading of the University of Michigan Survey of Consumer Sentiment showed consumer confidence rising.
Data also continued pointing to cooling inflation with the Consumer Price Index (CPI) flat in July and Core CPI, which excludes the more volatile food and energy components, at 0.1%. Both were below consensus forecast. On a year-over-year basis, CPI was 1.6% with Core CPI at 2.1%, both down from the prior month. However, market participants are anticipating a rise in food prices over the next few months as the impact of the drought in the U.S. takes effect.
Personal incomes rose 0.3% in July from the prior month and real consumer spending increased 0.4%, the largest advance since February, as retail sales (excluding autos and gas) increased 0.9%, exceeding expectations. As a result, the personal savings rate fell marginally to 4.2% in July.
On the jobs front, the four-week moving average of initial jobless claims ticked up to 370,000 at the end of August.
Overall, the U.S. economy seemed to continue on its path of slow self-sustained recovery despite the global economic slowdown. Second-quarter real GDP growth was revised up to 1.7% from the initial estimate of 1.5%, and the index of Leading Economic Indicators (LEI) rose more than anticipated in July.
Housing Data Continues to Improve
The U.S. housing market continued to show signs of recovery in August. Data released during the month indicated sales of new homes increased 3.6% in July from the prior month and were up 26% from the same period one year ago. Pending home sales and housing starts also posted solid gains in July while building permits surged, a sign of future activity.
July inventory of existing homes for sale was down 23.8% on a year-over-year basis with the low availability of homes helping boost prices. The Federal Housing Finance Agency (FHFA) reported a seasonally adjusted 0.7% rise in home prices during June, while the FHFA's House Price Purchase Index rose 1.8% in the second quarter compared to the first quarter. Similarly, the S&P/Case-Shiller 20-City Composite Home Price Index increased more than forecast in June with home prices increasing on a year-over-year basis for the first time since September 2010.
In another positive sign pointing to the continued recovery of the housing sector, Toll Brothers Inc., one of the nation's largest luxury home-builders, reported a 46% increase in third quarter net income during the month. Confidence among home builders reached its highest level since February 2007.
As we have commented for several months now, housing can provide a positive surprise for the U.S. economy and equity markets through the powerful multiplier effect it can have on the economy through the consumer.
Fed Remains Prepared to Act
Federal Reserve Chairman Ben Bernanke gave his highly anticipated annual speech at the central bank's annual symposium in Jackson Hole, Wyoming on August 31 and reiterated that the Fed was prepared to act as warranted by economic conditions. He noted that additional asset purchases were an option and expressed concern over the lack of improvement in the job market, although the release of minutes from the Federal Open Market Committee's (FOMC) August 1 meeting revealed there was still some dissent among FOMC members around the prospect of further asset purchases. However, as of the time of this writing, the Federal Reserve had announced a third round of quantitative easing with only one of the twelve FOMC members voting against the measure.
Eurozone Recession Worsens
In the eurozone, data released during the month confirmed the region is in recession. Eurozone GDP contracted at a seasonally annualized rate of 0.2% in the second quarter on a quarter-over-quarter basis and shrank 0.4% on a year-over-year basis. Eurozone industrial production declined 0.6% in June from the prior month and was down 2.1% on a year-over-year basis. Consumer confidence in the eurozone was at its lowest level since early 2009 and the unemployment rate held at 11.3%.
Most importantly, the core economies in the European Union (EU) seemed to be in a recession. Manufacturing PMI for Germany and France remained deep in contraction territory and Germany's closely watched IFO Business Climate Index declined more than forecast in August. Although core European economies have been feeling the impact of the region's sovereign debt crisis, German and French second-quarter GDP figures came in slightly better than expected during the month with German GDP expanding at a quarter-over-quarter seasonally -adjusted annualized rate of 0.3% and 1% on a year-over-year basis. French GDP was essentially unchanged and Netherlands GDP also surprised to the upside.
On the other hand, the Greek economy contracted 6.2% on a year-over-year basis as bankers in Greece reported that 20% of domestic loans were non-performing (more than 90 days overdue). Data released during the month also continued pointing to the mounting pressures on Spain's financial system. Unable to secure private financing, Spanish banks borrowed a record amount from the European Central Bank (ECB) in July.
Despite the relative calm in the eurozone during August, pressure on the region is expected to increase over the next month as creditors will report on progress made by Greece as part of the country's bailout agreement, which will influence the decision on whether the next major tranche of aid will be released. The yield on 10-year Spanish debt continued to hover near the crisis level of 7%, and despite Spanish government officials calling for ECB intervention in the form of open-ended bond purchases to push down borrowing costs, Germany remains staunchly opposed. However, at the time of this writing, ECB President Mario Draghi had announced that the ECB intended to launch an unlimited bond-buying program aimed at lowering short-end yields of sovereign debt issued by countries under severe fiscal stress. Importantly, under this plan ECB purchases would not receive senior status relative to other creditors. Although details of the program will need to be finalized, this represents a promising step in addressing the region's sovereign debt crisis.
Possibility of Hard Landing in China
China also continued to weaken, driven to a large degree by weakening exports. While inflation remained tame, the economic slowdown in China has been quite severe, and, as we have commented in the past, a hard landing in China is not out of the question and could significantly impact global growth.
Foreign direct investment (FDI) in China was down 8.7% in July compared to the same period one year ago, a much steeper decline than forecast, as investors may be losing confidence in China's growth story. This comes on the heels of data released by China's central bank during the month showing that China's banks were net sellers of 3.8 billion yuan ($597 million) in foreign exchange in July, further highlighting the outflow of capital from the country.
Moreover, China's HSBC Manufacturing PMI and the official Manufacturing PMI reported by the country's National Bureau of Statistics were both in contraction territory in August. Statements by Chinese officials during the month confirmed they would increase fiscal and monetary policy easing to stabilize economic growth in the second half of the year. This was followed by similar statements from the People's Bank of China (PBOC) indicating a shift towards stimulative policy.
The global economic slowdown is de-emphasizing the role of manufacturing in the economy, highlighting the importance of a continued rebound in consumer spending. Our forecast is that continued recovery in the housing sector can help improve consumer confidence, which in turn can support consumer spending at levels sufficient for continued economic recovery in the U.S.
It is clear that the eurozone troubles are not anywhere near being resolved, although market participants seem satisfied with the promised policy response for the time being. We view the current state of calmness regarding Europe as temporary, with concerns likely to flare up again and cause market volatility in the near future.
At this stage, the probability of disappointment for the markets is quite high given the recent run- up seemingly based largely on speculation about expected stimulative action from the Federal Reserve. We wouldn't be surprised if the markets have a correction now that QE3 has been announced.
This commentary represents the opinions of the author as of 9/19/12 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.