Will the Strong Performance of Equity Markets in 2010 Continue?
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Asset Management Company, Inc.
For the calendar 2010, 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 a 2.9% year-over-year rate, corporate earnings beat estimates, and consumers resumed spending. Most equity markets ended the year in positive territory. Higher-beta small caps and emerging markets outperformed other indices during the year, returning 26.9% and 19.2%, respectively, while developed 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 the year, while Utilities and Health Care lagged the most.
Concerns around high levels of U.S. and European sovereign debt, continued weak consumer sentiment, and the sustainability of the economic recovery, as well as financial regulation, challenging unemployment, and fears of a double-dip recession, fueled uncertainty and drove global market volatility in the first half of the year, re-pricing risk in both equity and fixed-income assets.
In the second half of the year, investors were optimistic 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 second round of quantitative easing (QE2).
Stubborn Unemployment and the Weak But Recovering Consumer
Throughout 2010, the unemployment rate was high but relatively stable, ranging from 9.4% to 9.9%, and ended the year at its lowest level—9.4%—in December. Impacted by high unemployment and coupled with the double dip in the housing market, U.S consumers continued to be constrained, focusing on rebuilding their balance sheets by taking out less debt, spending less, and saving more. Towards the end of the year, we started to see a recovery in consumer sentiment. There were steady improvements in year-over-year retail sales figures during the year and 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 fourth 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.
In 2010, strength in U.S. manufacturing and the health of the U.S. corporate sector were the leading sources of growth in the U.S, which fared significantly better than its Western European counterparts. Corporate earnings for the year were strong as U.S. corporations hoarded cash and contained costs, a trend that boosted profits but negatively impacted the jobless rate. Some strong companies that came out of the recession even stronger used their cash coffers for mergers and acquisitions, taking advantage of some of the attractively priced and distressed asset sales that became available during the year. As a result, we saw a significant pick-up in M&A activity worldwide in 2010.
Double Dip in Housing
In the third quarter of 2010, the housing market entered a double dip, a situation that was exacerbated by the already high inventory of foreclosed homes as well as protracted resolution of the foreclosure process caused by the loan documentation scandal that came to a head in the third quarter. Lower mortgage credit availability—despite lower mortgage rates—also continued to dampen 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. We believe that the market may start to bottom out in the first half of 2011—particularly the commercial real estate segment of the market, where recent activity is showing signs of renewed vitality. In the long run, if prices accelerate at a 3% annual rate, it will take about 10 years to reach the previous peak for housing prices.
Government Efforts for Economic Stimulus
The Obama Administration looked for ways to stimulate the economy and improve the employment picture. The controversial and historic health care reform bill was passed early in the year, but is now imperiled by Republicans who made repeal of this bill a centerpiece of the House and Senate races and now stand as a majority in the House of Representatives. A $180 billion bill providing business tax breaks and infrastructure investment was also approved to boost spending and job growth. These long-term investments could produce positive long-term effects in the economy in the years to come. While these measures should help stimulate employment in the long run, budget deficit levels are at unprecedented highs and will need to be addressed soon.
The U.S. Federal Reserve’s (Fed) $600 billion bond purchase plan fueled purchases of risky assets, including global equities and commodities, in the second half of the year. In reaction to the news, international markets rallied to a two-year high, and oil and gold continued to go up in unison while the U.S. dollar advanced 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 was mixed. Some expect QE2, which was widely expected, 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 new Congress elected in November made the reduction of the U.S. deficit a top priority. The White House’s Deficit Reduction Committee released its recommendations in November, which included cuts in 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. President Obama announced a two-year freeze on the salaries of federal employees as part of budget reduction measures.
Financial Sector Continues to be Under Scrutiny
The Financial sector continued to be under close scrutiny during the year, with new regulations and upheaval. In May, after a substantial market sell-off that included 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 were introduced on a trial basis for several months and were applied in broader exchanges to companies in the S&P 500 Index in the second half of the year.
Congress also passed new financial regulation during the second quarter, enacting major changes in the oversight of the Financial sector, especially involving complex financial products. While the banks may still be permitted to be involved in derivatives, proprietary trading, hedge funds, and private equity, the degree of such involvement will likely be drastically reduced. Overall, the new regulations seem to be more lenient towards banks than investors had anticipated.
JPMorgan Chase, Wells Fargo, Bank of America, and other banks are likely to bear heavy costs from litigation and delays arising from the fallout around lenders’ foreclosure documentation practices, negatively impacting banks’ balance sheets. 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 property and borrower data. By some estimates, the total cost to the industry of potential mortgage buy-backs is in the $50 billion to $100 billion range.
BP Oil Spill in the Gulf
The devastating oil spill in the Gulf of Mexico and attempts at containing it plagued the region, its people, BP, and the U.S. federal government during the year. BP’s credit rating was cut by six levels from AA to BBB by Fitch on potential liabilities related to the oil spill in the Gulf of Mexico. The company established a $20 billion escrow account to handle spill-related claims and was at risk of losing U.S. leases and contracts as a result of the spill as lawmakers were debating future penalties.
European Sovereign Debt Crisis
Budgetary irregularities in Greece sparked a fiscal and sovereign debt crisis in Europe. Persistent, large budget deficits and weak economies in Italy, Spain, Portugal, and Ireland widened the problem. Worries about the European budgetary and sovereign debt crisis weighed on the eurozone throughout the year. During the first half of the year, Greece’s debt was downgraded to junk status by Moody’s and Standard & Poor’s. Concerns about Irish sovereign debt were high late in the year 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. Fears of contagion spread as concern around the debt levels of Spain, Portugal, and Italy remained high. As a result, sovereign debt around the region continued to trade at historically high spreads. Several countries in the European Union implemented strict austerity programs, slashing budgets and leading to civil unrest. These politically unpopular but fundamentally necessary steps will likely lead to much slower economic growth in the eurozone in the next two to three years.
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.
Earlier in the year, the European Union performed stress tests on European financial institutions, similar to the ones done on U.S. financial institutions in 2009. As a result, the Basel Committee on Banking Supervision established a new set of rules to toughen banks’ capital and liquidity requirements in September. Investors were worried about European governments’ ability to roll over their debt in the near future, and sold off financial shares accordingly. Their worries were not without warrant.
Possible Slowdown in China and Emerging Asia
Throughout the year, China’s economic growth data were indicating that the Chinese government was having some success in engineering a soft landing and getting the economic growth rate down from the 11% to 13% range of the past several years to a more manageable 8% to 10% level. Chinese officials raised interest rates during the year in an attempt to engineer a soft landing and prevent the bursting of the asset bubbles in that country. Needless to say, a hard landing for an overheated Chinese economy would have strong negative implications for global economic growth.
In June, ahead of the G-20 summit, the Chinese government announced that it would allow greater flexibility in the value of its currency, triggering the biggest appreciation in the yuan in half a decade. This was a positive development for both the U.S., in its ability to rebalance its trade deficit with China, as well as for China, in bringing more purchasing power to its citizens, particularly in light of creeping inflation. With labor unrest in factories leading to 20% to 30% wage increases, China must manage the growth of its economy in a way that minimizes social unrest.
However, the appreciation of the yuan was not very significant. 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, was hamstringing the country’s efforts to suppress inflation. At the end of 2010, China reported that inflation rose to 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 fourth quarter, fueling concerns that the country’s economic growth may slow, negatively impacting the global economic recovery.
Also in Asia, political tensions between South and North Korea worried investors in the second half of the year.
Market participants are anticipating better-than-forecast economic growth in the U.S. with some estimates now showing 3.5% gross domestic product (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 pull-back 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 later in 2010 continues, negative flows from the emerging markets asset class 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 4/1/11 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.