Calvert News & Commentary

Second Quarter Market Commentary: Investor Optimism Triggers Rally


Untitled Document

By Natalie Trunow, Senior Vice President, Head of Equities
Calvert Asset Management Company, Inc.

Natalie Trunow, Head of Equities

The second quarter of 2009 saw a substantial rebound in the equity markets, bringing returns of major indexes for the calendar year through June 30, 2009 into positive territory. Investors’ optimistic outlook for an impending economic recovery fueled the rebound, which started in early March. The rally continued until mid-June, at which point mixed economic news and downbeat earnings projections brought expectations for an early recovery more in line with reality. The vigorous rally left its mark on equity markets--the Standard & Poor’s 500 Index (S&P 500) returned 15.93% for quarter and the Russell 1000 Index gained 16.50%.

Rally Fueled by Perceived “Green Shoots”

Eighteen months into the recession, equity markets reacted to the signs of perceived “green shoots” in the economy. While the economic picture in the United States remained weak during the quarter, reports of a slower rate of economic deterioration were the little encouragement battered investors needed to trigger a rally early in the quarter. Eager for signs of stabilization and recovery, investors interpreted marginal improvements in the leading economic indicators, slowing declines in real estate prices, and better-than-expected reports on job losses as the “green shoots” of recovery.

This optimistic market sentiment triggered a sharp run-up in equity markets around the globe that began on March 9 and continued through June 12 with higher-risk, high-beta assets posting some of the highest gains. During this time period, the S&P 500, Russell 1000 Index, Russell 2000 Index, MSCI EAFE Index, and MSCI Emerging Markets Index rose 40.8%, 41.6%, 54.2%, 50.5%, and 64.4%, respectively. The beaten down Financials and Consumer Discretionary sectors were up 49.1% and 33.6%, respectively. Commodity-related securities also rallied through the quarter on expectations of economic recovery.

Markets Bounce Back

For the calendar quarter, the Russell 2000 Index gained 20.7% and the Russell Midcap Index gained 20.8%. Growth and value stocks performed about the same, except in small-caps, where the higher-beta Russell 2000 Growth Index returned 23.4% and the Russell 2000 Value Index gained 18.0%. Within the Russell 1000 Index, the Financials sector led performance for the quarter with a return of 31.84%. The Telecommunication Services and regulation-impacted Health Care sectors lagged, returning 3.89% and 9.67%, respectively.

Geographically, international equity markets outperformed the U.S. during the quarter, with the MSCI EAFE Index gaining 25.4% in U.S. dollar terms. The MSCI Emerging Markets Index rose 34.7%, with the previously battered markets in Hungary, India, and Turkey returning 69.6%, 59.8%, and 56.6%, respectively.

Table of Market Benchmarks

Economic Activity Remains Weak, But the Pace of Deterioration Slowed

Early in the second quarter, the Commerce Department released its advance estimate of the first quarter’s gross domestic product (GDP) growth, which showed a significantly worse-than- anticipated 6.1% decline. Subsequent reports revised real GDP growth for the first quarter to -5.5%. Over the past two quarters, the U.S. economy has contracted at an annual rate of 5.9%, which is the worst two-quarter performance for the U.S. economy in fifty years.

Early in the quarter, the unemployment picture appeared to improve somewhat, as May’s unemployment report was better than expected and the economy lost jobs at a rate that was slower than in April. Although new temporary jobs accounted for a large part of the difference between expectations and the reported numbers, markets reacted strongly to this report. However, the jobs picture deteriorated later in the quarter—the June report, which was released just after the close of the quarter, saw the U.S. unemployment rate rise to 9.5%, the highest level since August 1983.

Real Estate Still Mixed, Autos Troubled

News was mixed on the real estate front. In April, home price deterioration slowed as home sales stabilized, which sent real-estate development stocks up 62% for the month. Housing price declines appeared less severe, as the U.S. Treasury’s efforts to depress mortgage rates through purchases of Treasury securities and agency paper saw some success. In June, however, mortgage delinquencies continued to rise and, with foreclosure rates at recent highs, building activity continued to slump as builders were unable to compete with the low prices of foreclosed properties.

Troubles in the automotive sector intensified as Chrysler and General Motors filed for bankruptcy. Chrysler was eventually sold to Fiat and General Motors received a total of $50 billion in funding commitments from the government. Bondholders and car dealers chafed at the terms of the bankruptcy filings, but both moved forward.

Conditions Improve for Banks

Financial stocks were the most dynamic sector in the second quarter. Financials in the Russell 1000 Index were up more than 30% during the quarter, and Financials in the MSCI EAFE Index rose more than 40%. During the quarter, the Financial Accounting Standards Board (FASB) changed its mark-to-market accounting rules to allow banks to mark their distressed assets to internal models rather than to fair value. That change, along with better-than-expected earnings data, boosted shares of financial companies that had been weighed down by steep losses on mortgage-backed securities in their portfolios. The FASB’s rule changes, which lessened the threat of nationalization of U.S. banks, will also limit transparency for investors and may result in banks being more reluctant to sell their distressed assets into the Treasury Department’s Public-Private Investment Program at market-clearing prices.

Credit market participants expressed more confidence in the soundness of banks with Treasury-Eurodollar (TED) spreads narrowing and the London Interbank Offered Rate (LIBOR) continuing to fall, reaching pre-crisis, long-term lows. This was a welcome sign which indicated normalization in bank-to-bank and short-term lending—an important step in opening up credit markets.
Even in the midst of improving credit markets, the Treasury Department warned that banks had reported “significant declines” in commercial and industrial lending and in consumer loans, including credit card debt. During the course of their “stress tests” designed to assess the funding needed by the nation’s 19 largest banks in the event of further economic deterioration, Federal banking agencies increasingly focused on the quality of bank loans, and the wide variations in underwriting standards, in determining the health of the banks under review.

In May, the government announced the results of the stress tests. The results indicated that 10 of these banks will need to raise a total of $74.6 billion in new assets. The government also estimated that some 1,000 additional banks would likely fail in the next two to three years. However, given that no major institutions were cited as having severe immediate problems, investors greeted these government announcements with a sigh of relief.

In June, Standard & Poor’s cut its ratings for 18 banks, signaling that banks were not out of the woods yet. At the same time, the Treasury Department made an effort to decrease its involvement in the banking industry by granting financial institutions permission to buy back the government’s shares and to propose fair market values for the warrants held by the government.

Investment Outlook 

Over the past few months, companies have been aggressively cutting costs and slashing inventories, which should make for healthier margins and better productivity once economic recovery takes hold. While top-line revenues have come in below expectations, second-quarter reported earnings were better than expected due to aggressive cost cutting. Going forward, any improvement in the top line should be a big positive for leaner companies. However, if the top line remains anemic and companies run out of opportunities to slash costs further, earnings comparisons in the coming quarter or two could be disappointing.

In the third quarter, we foresee that conflicting economic data will continue to generate volatility in the equity markets. In the longer term, however, the markets should begin to recover when investors get a firmer confirmation of improvement in economic and earnings data. So far, inflation seems to remain at bay, which should help support corporate recovery.

With the steep stock-market rally in the second quarter, markets seemed to be forecasting a sharper, v-shaped recovery. However, judging by fundamentals, this rise came too far, too soon, and we were due for the pause in the rally experienced in June. Overall, we are still placing a higher probability on a slower-paced recovery with high potential for renewed volatility in markets.

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