Fourth Quarter 2010 Market Commentary: A Vigorous Finish to the Year for Equity Markets
For the fourth quarter of 2010, the Standard & Poor’s 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Market Indices returned 10.8%, 11.2%, 16.3%, 6.7%, and 7.4%, respectively. For the calendar year, despite significant market gyrations throughout the year, the Dow Jones Industrial Average and the Standard & Poor’s 500 Index rose 14.1% and 15.1%, respectively, as the U.S. economy avoided a double-dip recession by growing at an estimated 2.8% annualized rate, corporate earnings beat estimates, and consumers resumed spending. Most equity markets ended up in positive territory for the year. Higher-beta small caps and emerging markets outperformed other indices during the year, returning 26.9% and 19.2%, respectively. International markets lagged the U.S. with the MSCI EAFE Index returning 8.2%.
Within the Russell 1000 Index, the Energy, Materials, and Consumer Discretionary sectors were the top performers for both the fourth quarter and the year, while Utilities and Health Care lagged the most in both periods.
At the end of the quarter, the S&P 500 Index was trading at 16.7 times reported profit, a relatively rich valuation given the uncertainties still in the global economic system. Advances in the stock market, continued gradual improvement in the economic environment, an expected boost in economic stimulus with the introduction of a second round of quantitative easing (QE2), and incremental improvement in incomes despite high unemployment in the U.S. were spurring improvements in consumer confidence and market sentiment at the end of the year. U.S. consumer confidence ended the year at a six-month high as consumers filled some of the pent-up demand that accumulated over the prior two years of recession. Consumer spending, as reported by the Commerce Department, picked up faster than forecast during the quarter, prompting businesses to order additional equipment to meet demand. The next step is likely to be investment in human capital and increased hiring which should help reduce the unemployment rate.
The U.S. labor market may be taking a turn for the better as the economy accelerates into 2011. Holiday temporary jobs were on the rise from last year, indicating retailers expected year-over-year improvements in sales this holiday season. Indeed, “Black Friday” sales were up over 9% year-over-year. It is fair to say that, while total holiday temporary hiring was up 10% to 30% over 2009, it was still 10% to 20% lower than in 2007. Some of the largest U.S. states—California, New York, Texas, and Florida—reported improving employment figures, which should help the economic recovery as well as help improve states’ income and budget deficit problems.
At the end of quarter, claims for jobless benefits dropped to the lowest level in two years, while applications for unemployment assistance decreased by 34,000 to 388,000 in the week ending December 25, breaking under the 400,000 level for the first time since July 2008, according to Labor Department figures. Other data showed businesses expanded at the end of the fourth quarter at the fastest pace in two decades. December employment data released in January showed that the year ended with an unemployment rate of 9.4%, down from 9.8% earlier in the year.
Investors were optimistic during the quarter about the two-year extension of Bush-era income-tax cuts, a reduction in the payroll tax in 2011, and the Federal Reserve’s plan to buy an additional $600 billion of Treasury securities under the newly announced QE2 program, while shrugging off the highly publicized insider-trading scandal engulfing corporate insiders in the Technology sector and their hedge fund clients.
Foreclosure Debacle has Broad Impact
The real estate market remained in negative territory throughout the quarter, although it too may start to bottom out in the first half of 2011—especially the commercial real estate segment of the market, where recent activity is showing signs of renewed vitality. The residential real estate market remains in a double-dip state with housing prices depressed by a high inventory of foreclosed homes. Lower mortgage credit availability—despite lower mortgage rates—is still dampening home prices while recession and unemployment have spurred a decline in borrowers’ credit scores. The U.S. homeownership rate has reached a 10-year low.
The double-dip in the housing market has now been protracted by the pause in foreclosure filings caused by lenders’ reviews of documentation practices and pending litigation. This likely will continue to dampen consumer confidence and spending even if the unemployment rate subsides. JPMorgan Chase, Wells Fargo, Bank of America, and other banks are likely to suffer from the cost of litigation and delays in the foreclosure process. Such delays will stall the clearing of housing inventories, further dampening the already weak housing market and negatively impacting the balance sheets of U.S. banks.
Banks’ earnings will also take a hit if legal actions lead to mortgage principal reductions and if investors in mortgage-backed securities are able to put these bonds back to the banks. Investors in mortgage-backed securities are demanding refunds from banks on loans based on faulty data about the property or borrower. By some estimates, the total cost of potential mortgage buybacks to the industry is in the $50 billion to $100 billion range. During the quarter, JPMorgan announced that it is creating a $2.3 billion reserve for potential litigation and other expenses, while Bank of America faces demands for almost $13 billion of refunds from mortgage investors. The majority of claims are related to prime mortgages. The resolution process, however, may be drawn out, which should allow the banks to regain their footing in order to address the issue.
Renewed Concern over Eurozone Debt Crisis
The eurozone continued to suffer during the quarter, weighed down by struggling smaller economies within the complex. Concerns about Irish sovereign debt were high in November until the European Union and International Monetary Fund hammered out a rescue package for Ireland. Irish sovereign debt was downgraded five levels to Aa2 by Standard and Poor’s. The fear of contagion continued through the quarter as concerns around debt levels in Portugal and Spain remained high. As a result, sovereign debt around the region continued to trade at historically high spreads.
Austerity measures in response to historically high budget deficits and the sovereign debt crisis have thrown some of the eurozone economies into stagnation. During the quarter, we saw civil unrest in the U.K. in reaction to austerity measures there. News about weak gross domestic product (GDP) and high unemployment from Greece made it clear that there is no short-term resolution to these problems.
The U.S. got a taste of the austerity-measure debate when the Deficit Reduction Committee released its recommendations in November, which included cutting defense spending and non-defense federal payrolls, raising the retirement age for Social Security, eliminating most income-tax deductions (including the home mortgage deduction), and taxing capital gains and dividends at the same rate as income. These proposals were met with almost universal condemnation across the political spectrum. During the quarter, President Obama announced a two-year freeze on the salaries of federal employees.
Reactions to QE2
The U.S. Federal Reserve’s (Fed’s) $600 billion bond purchase plan announced early in the quarter renewed investor enthusiasm, fueling purchases of risky assets including global equities and commodities. International markets rallied to a two-year high in reaction to the news, and oil and gold rallied in unison while the U.S. dollar rallied off its lows on optimism about economic recovery in the U.S.
Despite the initial positive market reaction, investor sentiment toward the Fed’s moves has been mixed. Some expect the widely predicted and largely priced-in QE2 by the Fed to be successful in stimulating U.S. economic growth. Other investors perceived the measure as unnecessary, given recent positive incremental economic news from both industrial production figures and consumer spending. The G-20 meeting in South Korea saw some rancor over the Fed’s QE2 plans, which some foreign governments saw as more intended to further weaken the U.S. dollar than boost domestic economic activity.
China and Emerging Economies
China’s continued policy of a weaker yuan in support of the country’s export sector, which comprises two-thirds of the country’s economy, is hamstringing the country’s efforts to suppress inflation. At the end of 2010, China reported that inflation was 5.2%, a 28-month high. The country’s policies aimed at keeping the yuan cheap were a hot topic at the G-20 meeting, with the U.S. intensifying the call for the Chinese to allow their currency to appreciate. In an effort to temper inflation, China’s central bank raised its reserve requirements for the country’s commercial banks and raised its interest rates by 0.25% during the quarter, fueling concerns that the country’s economic growth may slow, negatively impacting the global economic recovery.
We remain cautious with respect to potential fallout from recent confrontations between North and South Korea and the escalation of geopolitical tensions in that region. While the calmer environment of recent weeks is a welcome sign, negative developments earlier in the fourth quarter considerably impacted asset and currency prices in Asia and have the ability to further disrupt markets.
Market participants are anticipating better-than-forecast economic growth in the U.S. with some estimates now showing 3.5% GDP growth in 2011. We continue to be optimistic about improving prospects for the economic recovery in the U.S. and are pleased to see the U.S. consumer showing the signs of recovery we were hoping for in 2010. This is a welcome change that can considerably improve prospects for higher revenue numbers in the corporate sector, allowing U.S. firms to maintain high levels of profitability even if they start hiring new workers, which should help reduce unemployment. Having said that, given the historically high absolute unemployment levels today, it may take quite a while.
We also believe that automatic addition of the newly announced QE2 to the U.S. budget deficit may be premature. It is possible, given the positive developments in the economy, that the Fed may decide not to proceed with the program as originally conceived or to utilize a much smaller amount for asset purchases. If this happens, U.S. debt securities, which seem to have priced in the positive impacts of QE2, are likely to be negatively impacted.
Our outlook for equity markets continues to be positive long-term, although current valuations may prove optimistic and cause a sell-off in the short term. If the earnings picture continues to be positive and top-line numbers show improvement, valuations should come back to more attractive levels, especially if we see some pullback in the market after a considerable run-up in 2010. It is also likely that once the earnings season subsides, equity markets may be vulnerable to negative news or further deterioration in geopolitical tensions and could see a sell-off.
We still think, however, that an upside surprise in GDP growth in 2011 is possible in light of the current 3.2% consensus expectation. GDP growth could accelerate above 3.7% in 2011 given the better consumer confidence numbers and now stronger top-line growth in the corporate sector of the economy. This may cause the Fed to increase interest rates sooner than expected, potentially in the second half of 2011. We are also concerned that inflation expectations may be negatively impacted by higher food and energy prices, also increasing the probability that the Fed will raise benchmark interest rates sooner than expected. If the move comes sooner than markets anticipate, it could precipitate a sell-off in Treasuries and dampen economic growth in 2012. We also believe that under this scenario growth equities are likely to underperform their value counterparts.
We expect M&A activity to continue and be strong in 2011 and 2012, a trend that should continue to further benefit small- and medium-capitalization stocks.
If the relative underperformance of emerging-markets stocks continues, negative fund flows may exacerbate the downward trend, especially given the relatively low liquidity in emerging markets. Prompt reallocation of assets in investment portfolios, especially generic international and global portfolios with large exposures to emerging markets, could further exacerbate the underperformance of the emerging markets asset class in 2011.
As of 2/28/2011, accounts managed by Calvert Asset Management Company, Inc. held securities issued by the following companies: JPMorgan Chase, Wells Fargo, and Bank of America. Calvert may or may not still invest in, and is not recommending any action on, companies listed.
This commentary represents the opinions of its author as of 3/30/11 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. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Asset Management Company, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
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Effective 4/30/2011, Calvert Asset Management Company, Inc. will be renamed Calvert Investment Management, Inc., Calvert Distributors, Inc. will be renamed Calvert Investment Distributors, Inc., and Calvert Group, Ltd. will be renamed Calvert Investments, Inc.