Third-Quarter Market Commentary: Equity Markets Climb as Economy Shows Signs of Improvement
By Natalie Trunow, Chief Investment Officer, Equities
Calvert Asset Management Company, Inc.
During the third quarter, economic data continued to confirm that the pace of economic deterioration has slowed, even as some sectors of the economy continued to generate mixed results. Second-quarter U.S. gross domestic product (GDP) declined only 0.7%—an improvement from the first quarter’s 6.4% drop—indicating that the 20-plus month recession may have reached its bottom and that government spending has finally begun to have a positive impact. The pace of economic recovery and expansion, however, could be more gradual than the dramatic recovery in global stock prices and valuations might suggest.
During the quarter, quickly-swelling stock valuations reached pre-crisis highs despite the still-vulnerable state of the global economy. With continued weakness in the global financial system, high unemployment, and the unsteady commercial and residential real-estate markets, highly optimistic valuations and earnings estimates for 2010 and 2011 left little margin for error in global equity markets. It is clear that corporate earnings are subdued because of the recession, making valuations seem deceptively high. However, the pace and strength of the recovery will determine the pace of earnings recovery and the related valuations.
During the second and third quarters, economic data confirmed that the larger banks that presented systemic risk to the global economy had been stabilized by the unprecedented, coordinated efforts of governments across the globe. However, non-performing loans and potential new write-offs continue to threaten the survival of many medium- and smaller-sized banks.
Employment remained weak, with the U.S. unemployment rate rising to 9.7% by quarter-end, steadily approaching our expected 10% to 11% forecast for the end of the year. While payroll reports during the early months of the third quarter showed better-than-expected results, data from September disappointed.
In the face of economic uncertainty, consumers have continued to deleverage their balance sheets, and the personal savings rate continued to rise. Decreased spending combined with the falling U.S. dollar resulted in a drop in imports, which, in turn, contributed to an increase in overall net exports, driving up GDP during the quarter. The very popular “cash for clunkers” program also had a positive effect during the quarter, although the program may have “borrowed” from future demand. The Treasury Department’s efforts to keep long yields and mortgage rates down, the new tax credits for first-time home buyers, and an abundance of distressed, attractively priced properties helped improve overall demand for housing. During the quarter, the S&P/Case-Shiller Index data indicated that a bottoming out of single-family home prices may have started in the second quarter. However, recent data on sales of existing homes in the third quarter showed an unexpected decline. The commercial real-estate market continued to deteriorate, with the trend likely to continue in the near term.
The third quarter saw double-digit returns for the world’s equity markets. U.S. large-cap stocks, as measured by the Russell 1000 Index, rose 16.07%, bringing that index’s year-to-date return to 21.08%. Mid-cap stocks were the best performers overall, with the Russell Mid-Cap Index gaining 20.62% for the third quarter and 32.63% for the year. Value stocks bounced back during the quarter, outperforming growth stocks across the full range of market capitalizations. Small-cap value stocks were the best performers for the quarter but still lagged their small growth counterparts by almost 13 percentage points for the year.
International equities posted double-digit gains for the third quarter as well. The MSCI EAFE IMI Index gained 19.82% in the third quarter, with local-currency average market returns of 15.10% boosted by the weak performance of the U.S. dollar. Emerging markets produced another strong quarter, but one that was more in line with developed market returns than was the case during the second quarter of 2009, as the MSCI Emerging Market IMI Index rose 21.30% for the third quarter. Both developed and emerging markets were driven higher by the strong performance of European equity markets, while Asian markets, particularly in Japan, lagged.
At the end of the quarter, markets reacted negatively to mixed economic news, signaling a potential correction off the recent highs. The strong rally since the market’s low of March 9, 2009 has left observers wondering whether rapidly-rising stock valuations have become prematurely rich and earnings expectations somewhat stretched. While we are cautious about the performance of the market in the short term, we continue to expect a slower, but more robust and sustained, “smile-shaped” economic recovery in the long run.
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