Fourth Quarter Market Commentary: Equities Rise as the Economy Shows Marginal Improvements
By Natalie Trunow, Chief Investment Officer, Equities
Calvert Asset Management Company, Inc.
During the fourth quarter of 2009, economic data suggested that the economy continued to recover slowly, as consumers began to emerge from their buyers’ strike and show interest in the deeply-discounted prices to be had in residential real estate and retail offerings. Equity markets responded in kind, with the Russell 1000, the Russell 2000, and the MSCI EAFE IMI Indexes gaining 6.1%, 3.9%, and 1.9%, respectively.
The steady rise in equity markets was reflected in the CBOE Volatility Index (VIX), which dropped to levels not seen since August 2008, just before Lehman Brothers declared bankruptcy. Even the passage of landmark health care legislation by the Senate on December 24th, which could have a major impact on corporate profits over the next few years, failed to strongly impact the market in either direction.
Signs of Economic Recovery
There were a number of positive developments during the quarter. Economic data suggested that the U.S. economy was rising from the bottom of a two-year recession helped by inventory rebuilding and government stimulus.
The Fed’s $300 billion purchase of U.S. Treasury bonds in 2009 supported consumer spending and home buying by helping lower borrowing costs for individuals and corporations alike. During the quarter, U.S. interest rates and the U.S. dollar posted new lows before rebounding later in the quarter.
GDP growth reported during the quarter turned positive for the first time since the second quarter of 2008, owing to the effects of increased consumer spending in response to the cash-for-clunkers program, net exports helped by the extended downtrend in the U.S. dollar, and continued rebuilding of inventories in the manufacturing sector. Manufacturing production advanced 1.1%, with broad-based gains among both durables and nondurables.
Uncertainties Still Exist
During the quarter, improvements in GDP growth did not result in marked improvements in unemployment. What’s more, executives in the service industry, which accounts for almost 90% of the economy, forecasted additional job cuts in 2010.
U.S. consumers remained constrained. Consumer confidence declined after rising to a two year high at the end of the third quarter, signaling that household spending is likely to remain anemic and that American consumers are unlikely to resume their role as the world’s economic engine in the near future. We believe that the U.S. economy will require a stronger consumer rebound than is currently taking place, in order for more robust economic growth to return.
CMBS (commercial mortgage-backed securities) defaults continued to rise as the commercial real estate market continued to deteriorate, further impairing the financial health of lenders. Bank failures reached 115 in 2009 by the end of November, pushing the FDIC, the industry’s insurance fund, into deficit. Capmark, one of the largest U.S. commercial real estate finance companies, filed for bankruptcy during the quarter. In addition, bond rating agency Fitch said that life insurance companies could lose up to $22.6 billion on their commercial real estate holdings over the next two years, with losses intensifying in the next six to twelve months.
U.S. residential real estate had mixed results during the quarter. Government stimulus in the form of low interest rates and a first-time home buyer tax credit helped the residential real estate market. Thirty-year mortgage rates reached a record low 4.71%, supporting residential real estate despite continued stringent credit health requirements and new Federal Housing Authority plans requiring larger down payments in their mortgage guarantee program. At the same time, October data on homebuilding showed an unexpected drop of 11%. The default rate for prime mortgages for the third quarter of 2009 came in at a three-decade high, as unemployment continued to put pressure on homeowners. The delinquency rate for the lowest-risk, prime fixed-rate mortgages rose to 5.8% as the foreclosure inventory rose to 1.95%, the highest since 1972.
Lastly, dramatic downturns in the sovereign creditworthiness of Greece, Spain, and Dubai rattled global financial markets briefly, and the overall strength of the economic recovery in the Euro zone was questioned.
The extreme pessimism in the markets in early 2009 created some of the most attractive investment opportunities on record for long-term investors with domestic, international, and emerging market equities rising from the March 9th bottom by 69%, 79%, and 108%, respectively. We believe that the unprecedented excesses of the multiple bubbles of 2007-2008, particularly the excessive amount of leverage in the economy, are being gradually flushed out of the system and a healthy foundation is emerging from which the economy can recover.
As equity markets bounced back during 2009, however, rapidly-rising stock valuations may have become prematurely extended and earnings expectations somewhat stretched. During the economic downturn, companies aggressively cut costs and slashed inventories, which made for healthier margins, better productivity, and better earnings profiles despite anemic top-line growth. So far, inflation seems to have remained at bay, which also helps support corporate recovery. Going forward, any improvement in the top line should be a big positive for these leaner companies. However, if the top line remains anemic and companies run out of opportunities to slash costs further, earnings comparisons in the coming quarters could be disappointing.
In the financial sector, while the franchise value of large banks was certainly salvaged through government rescue efforts worldwide, the extent to which they are able to leverage their business models will continue to be constrained, with long-term negative implications for earnings in that sector.
While we think that potential challenges to the earnings story could generate some negative surprises and volatility in the equity markets in the first half of 2010, we believe that over the longer term the markets should begin to recover when investors get a firmer confirmation of improvement in economic and earnings data and when the consumer side of the equation improves.
As we look forward, we believe that the 2009 economic data confirmed that the U.S. economic recovery is on track but is likely to be more protracted than the market originally expected, with consumer demand slow to recover and manufacturing providing a larger portion of the economic growth than usual.
Despite many encouraging signs of economic recovery from what is now a two-year long recession, some still place a high probability on a double-dip recession which, if it transpires, is likely to send riskier assets into another tailspin. We do not see this scenario as highly likely, but it is still possible, given the weakness of the consumer and service sectors. At the other end of the spectrum, a V-shaped recovery seems less likely, given the relatively weak consumer demand story. The more likely outcome seems to be a gradual, smile-shaped, slow economic recovery that may prove to be more robust in the long run.
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This commentary represents the opinions of its author as of 2/12/10 and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.