Equity Markets Continued to Sell Off in May
Stock investors re-priced risk during the month amid worries about sovereign debt.
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Asset Management Company, Inc.
The sharp sell-offs in global equity markets continued throughout the month of May, breaking the steady, extended market ascent that lasted from mid-January through the second half of April. The selling activity caused volatility in May to almost triple from January levels. Most major indices were down significantly for the month with the Standard & Poor’s (S&P) 500, Russell 1000, MSCI EAFE, and MSCI Emerging Markets Indices returning -7.99%, -7.93%, -11.37%, and -8.75%, respectively. As the flight to quality trade intensified, investors fled to the safety of U.S. Treasuries, which gained significantly during the month.
The Energy sector led the underperformance for May, falling by 11% in both the S&P 500 Index and the Russell 1000 Index, driven largely by BP as fallout from its oil spill in the Gulf continues. Industrials, Materials, and Financials all struggled and were down by more than 9%. The best-performing sectors were the most defensive ones, Telecoms and Consumer Staples, but both were still down by about 4%.
Risk Gets Re-Priced
The risk trade was on during the month as investors were taking money off the table after a healthy run-up in equity markets worldwide for the year through the second half of April. A combination of factors--the fact that second-half corporate earnings comparisons are likely to be challenging, impending financial regulation, and the acceleration of the sovereign risk contagion in Europe--are creating global uncertainty for investors, causing re-pricing of risk in both equity and fixed-income assets. Investors are focusing on the risk side of the equation and driving credit default swap (CDS) spreads on European banks to all-time highs, highlighting investor focus on the potential risk of default there.
Economy Still on Track
The U.S. economy appears to be on track and is faring significantly better than its Western European counterparts. Data released during the month confirmed strength in U.S. manufacturing, the health of the U.S. corporate sector, and a resulting increase in M&A activity. U.S. gross domestic product (GDP) growth came in at a healthy 3% annualized rate for the first quarter of 2010, although that was below the consensus estimate of 3.2%.
The four-week moving average of initial unemployment claims rose to 456,500 in the last week of May, indicating continued challenges in the employment market. Nevertheless, consumer sentiment and confidence numbers reported during that week were positive. In addition, U.S. savings rate data reported during the last week of the month showed an increase. This is a positive long-term development as consumers continue to de-lever and rebuild their balance sheets. In the short term, however, this detracts from the spending rate and the rate of overall economic growth.
U.S. home inventories jumped unexpectedly at the end of the month, while the combined percentage of foreclosures and mortgage delinquencies reached 14%. With 10% of all U.S. mortgage payments at least 30 days or more overdue, these data points reaffirm our belief that the U.S. housing market may see a double-dip before a sustainable recovery takes hold.
New Financial Regulations
During the month, the U.S. Senate passed the Financial Overhaul bill, a regulation that some call the most sweeping financial legislation since the Great Depression. The new legislation will substantially change the way banks manage their balance sheets and hedge their positions. It allows litigation against credit agencies and diminishes banks’ ability to charge high credit-card fees. It also creates a consumer financial-protection bureau at the Federal Reserve and provides a new mechanism for dissolving too-big-to-fail entities that present systemic risk as well as an overhaul to derivatives rules. Regulation and consolidation in the European banking sector is also under way.
After a substantial market sell-off that was caused by some erroneous trades, the Securities and Exchange Commission (SEC) proposed new circuit breakers for rapid intra-day single stock moves of over 10%. These trading halts will be introduced on a trial basis for several months and will apply in all markets to companies in the S&P 500 Index.
Sovereign Debt Crisis Intensifies
During the month, the focus on the European Union’s sovereign debt crisis intensified. This crisis--which we called “Subprime, Chapter 2”--is a result of the underlying economic realities in Europe and was not caused by securities markets. Nevertheless, Germany unilaterally banned naked short sales of certain bank and insurance names, as well as some credit default swaps, for investors who don’t have an economic interest in these securities.
Four Spanish banks (with encouragement from regulators) announced plans to combine in order to strengthen their balance sheets. The banking sector worldwide is likely to see more consolidation to deal with the capital deficit. As we commented in the past, the overall profitability picture in the sector is likely to be challenged in the intermediate to long term.
We believe that the European sovereign debt crisis is unlikely to sufficiently hurt the three major European economies of France, Germany, and Italy (which collectively represent two-thirds of the euro-land economy) so severely as to cause an economic recession in the entire region. Investors are worried about specific governments and their ability to roll over their debt in the near future, and are selling off financial shares accordingly. Their worries are not without warrant. At the end of the month, Fitch downgraded Spain’s debt from AAA to AA+ with a stable outlook, further unnerving the markets.
Possible Slowdown in China
In our opinion, a slowdown in China is of more immediate concern than one in Greece. During the month, Chinese officials raised interest rates in an attempt to engineer a soft landing and prevent the bursting of the asset bubbles in that country. As we mentioned in previous reports, these asset bubbles could deflate in a disorderly fashion, pushing the Chinese economy to a hard landing which would certainly impact global growth prospects. Based on these risks, commodities traded off substantially during May along with other risky assets, even gold, causing cross-asset correlations to blow out.
Also in Asia, escalation of provocative political rhetoric between South and North Korea contributed to the negative market sentiment and perception of risk. Overall geopolitical risks, including potential conflict on the Korean Peninsula or in the Middle East, are becoming more probable as the economic health of the developed western economies
deteriorates and their resources and willingness to respond to such crises become stretched.
Correction Should Create Opportunities in Equities
From the March 2009 market low through the April 23, 2010 high, the S&P 500 Index returned 84.21%; for 2010 through April 23, it posted a 9.16% gain. Given these facts, it is not surprising that investors were inclined to lock in their gains in the face of mounting uncertainty in the global landscape. Financial markets have produced a V-shaped recovery through April while the underlying economic recovery has been firmly U-shaped--the two need to reconcile. We view this correction as a healthy development for the equity markets, one that will produce attractive investment opportunities once volatility subsides, with the U.S. market likely to outperform relative to the rest of the world in the short term. We have commented for some time that U.S. equities at the moment may be one of the most attractive asset classes, a point that was clearly demonstrated in the markets this month as U.S. equities outperformed a host of other risky assets.
The sell-off in the equity markets has been relatively orderly so far. We could see a total decline of 20-25% off the April highs if earnings comparisons are heavily challenged in the next two to three months. At that point, smart money is likely to reallocate to equities in a more meaningful way.
We also believe that, with so much turmoil in the markets, investors and regulators are not sufficiently focused on the potential long-term effects of climate change. If not mitigated, we believe that climate change could have a very significant negative impact on global GDP growth, subtracting as much as one-fifth of the potential growth rate for an extended period of time.
This commentary represents the opinions of its author as of 6/11/10 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.
Calvert Asset Management Company, Inc., 4550 Montgomery Avenue, Bethesda, MD 20814