Market View, Equities
U.S. equities retreat while emerging markets continue to rebound
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Equity markets retreated in July ...
U.S. equity markets retreated in July after a sharp pull-back at the end of the month offset earlier gains spurred by strong corporate earnings in the U.S. and mostly positive macroeconomic data. Domestic small-cap equities continued to be pressured and suffered a steep sell-off; however, emerging markets stocks performed well, providing mixed signals on investor's risk appetite, while sluggish economic growth in Europe weighed on international developed equity markets. For the month, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -1.38%, -1.62%, -6.05%, -1.97%, and 1.93%, respectively.
From an investment style perspective, growth stocks held up better than value, but value remains firmly ahead year-to-date. Looking at sector performance, the more defensive Telecommunication Services sector was the top performer, followed by IT and Health Care, while the Utilities, Industrials, and Energy sectors lagged. Despite their poor performance in July, Utilities and Energy remain two of the top performing sectors on a year-to-date basis, with Health Care in the lead.
With increases in rates looming in the next 9-18 months, it is understandable that performance of small-cap stocks has been less than stellar recently. However, as investors get more clarity on timing, magnitude, and the clip of interest rate increases from the Fed, we believe small-cap stocks can outperform large-caps as their earnings have been showing better growth and their business models are more leveraged to U.S. economic recovery.
...as the S&P 500 posted its worst weekly return in more than two years to close out the month...
A lot of media attention has focused on the S&P 500 posting its worst weekly return in more than two years to close out the month of July (week ended August 1st); however, if not for a 2% drop on the final day of the month triggered in part by fears that the Fed may raise interest rates earlier than anticipated by market consensus, large-cap equities still would have finished July in positive territory. Even after the worst weekly return since June 2012, the S&P 500 is still up more than 5% for the year and more than 15% over the trailing one year period. It seems investors have become so accustomed to rising markets that the slightest pull-back becomes cause for concern with imminent calls that a market correction is needed.
Typically though, this sentiment fails to address why a correction has to occur. From a valuation perspective, equities are not overly expensive, albeit they're not cheap, and there have been plenty of times throughout history where the S&P 500 has gone longer, and experienced greater gains, without a 10% or even 5% sell-off. At this point, a "sideways" market is consistent with the notion that additional risk premium is likely being priced in given geopolitical events and the eventual normalization of monetary policy by the Fed. As we have commented in the past, this should result in a pick-up in volatility from the current historically low levels. However, we believe this negative impact can be offset by acceleration in corporate earnings and economic growth, which can provide further support to the equity markets and possibly allow for broader multiple expansion.
...despite strong U.S. corporate earnings and an improving labor market.
With roughly 80% of companies in the S&P 500 having reported, nearly 70% beat earnings expectations and 65% beat revenues expectations. Importantly, both top- and bottom-line growth accelerated with reported earnings up 8.5% and reported sales up 4.6% compared to the same period one year ago. Small-caps fared even better with reported earnings up nearly 15% and top-line growth of 9%. Other macroeconomic data released during the month were also positive. The four week moving average of initial jobless claims fell below 300,000 for the first time since April 2006, and despite adding fewer jobs than forecast, July's employment report indicated monthly payroll gains exceeded 200,000 for a sixth consecutive month. The unemployment rate ticked up to 6.2% due to an increase in labor force participation rate which is actually a sign that the labor market is healing and more people have decided to re-enter the workforce, implying greater confidence in the ability to find a job. In the short-term, this may keep a lid on wage growth and inflation, but if this trend continues over the long-term it should be a positive driver of economic growth.
U.S. macroeconomic data were mostly positive...
Regional Manufacturing PMIs were strong throughout the month and the ISM Manufacturing Index rose to 57.3, the highest level since April 2011. Second quarter GDP exceeded forecasts, growing 4% as the economy rebounded from the first quarter pull-back. Consumer confidence was mixed, however, as the Consumer Board measure soared to the highest level since October 2007, though the University of Michigan Index of Consumer Sentiment edged down in July. Some of these positive macroeconomic data should continue to be reflected in consumer confidence over time.
The U.S. housing market activity has been somewhat softer recently. It appears that individual investors are hesitant to invest at prices that have been significantly bid up by the institutional buyers over the past six years. We do think that despite the recent softness, the U.S. housing market can continue to recover as year-over-year numbers remain robust and foreclosure activity is at post-financial crisis lows.
With inflation remaining well below the Fed's 2% target, as measured by the personal consumption expenditure price index (PCE), there is more leeway for the Fed to maintain accommodative policy but there was no change to the tapering process and we expect the Fed to continue managing expectations regarding interest rate hikes to minimize volatility in the markets. That said, as the prospect of tightening draws closer we expect market volatility to increase, even if modestly.
..but geopolitical turmoil and sluggish economic growth in Europe weighed on markets.
Despite these positive macroeconomic developments in the U.S., geopolitical turmoil continued to linger with intensified fighting in Gaza, Ukraine, and Iraq, and a ramp up of sanctions against Russia in response to their continued role in the Ukrainian conflict. Combined with Argentina's default and the sudden collapse of Portugal's largest listed bank, Banco Espirito Santo, it was not surprising to see investors take some profit off the table.
Meanwhile, economic growth in the eurozone remained tepid and market participants are beginning to recognize that European economic recovery may take longer to materialize than consensus had indicated, a view we have been touting for some time now. Emerging markets, on the other hand, continued to rebound, benefiting from signs of improving growth in China. China's GDP accelerated for the first time in three quarters while the Chinese Manufacturing PMI continued to rise and now sits firmly in expansion territory as the Chinese economy has benefited from its "mini stimulus" policies trickling down to the local level. We are not convinced, however, that China's economy is out of the woods yet and that the latest round of stimulus will succeed at orchestrating a soft landing for the Chinese economy.
With macroeconomic data continuing to be positive, the next couple of quarters could show a pick-up in economic activity, increases in GDP growth, and further positive news on the earnings front. Unfortunately, equity markets seem to have priced some of these positives in, and may be overly reliant on continued stimulative support from the central banks. In the U.S., this sentiment is likely to change in the next 6-9 months with the end of quantitative easing by the U.S. Federal Reserve. Additional risk premium is likely to be priced into the market with the potential for increased market volatility which could present attractive buying opportunities. We believe this negative impact can be offset by acceleration in corporate earnings and economic growth which will provide further support to the equity markets. However, the net impact is likely to be mild, so we don't expect significant further appreciation in the U.S. equity market in that time frame.
Having said that, the contrast in economic conditions between the U.S. and both Europe and China (and other emerging markets) should continue to draw more investment to the United States in the near-term, and Fed tapering will most likely add to this effect, both in equities and in other asset classes. We expect the dollar to continue strengthening slowly, which may provide another reason for foreign investors to favor U.S. securities over investments available in their domestic markets. This also supports our outlook for continued low inflation in the near-term. Overall, we believe global economic growth will continue to move ahead slowly, with the U.S. markets in the strongest position.
This commentary represents the opinions of the author as of 8/6/14 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. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.