Equity Markets Continue to Advance in the First Quarter on Earnings Optimism
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Asset Management Company, Inc.
Equity markets generally continued to climb in the first quarter of 2011, rising sharply over the first two months of the quarter and then suffering a slump in early March triggered by the political turmoil in North Africa and the Middle East as well as the tragedy in Japan. Equities staged an impressive rebound over the last two weeks of the quarter, finishing another quarter of good returns for equity investors. The Russell 1000 and Standard & Poor’s 500 Indices returned 6.24% and 5.92%, respectively, for the first quarter, while the MSCI EAFE Index was up 3.45% and the MSCI Emerging Markets Index rose 2.10%. Small-cap names outperformed large-cap names in the U.S., with the Russell 2000 Index outperforming the Russell 1000 Index by 1.7%. Value stocks slightly outperformed their growth counterparts, with the Russell 1000 Value Index returning 6.46% versus 6.03% for the Russell 1000 Growth index for the quarter.
Sectors across the board finished the first quarter in positive territory. Within the Russell 1000 Index, Energy was by far the best-performing sector, returning 16.77% over the quarter largely due to the continued rise in oil prices spurred by geopolitical instability in the oil-producing countries of the Middle East and North Africa. The Industrials sector was another top performer, advancing 8.89% for the period. Most of the rest of the economic sectors underperformed, with Consumer Staples and Financials lagging the most for the quarter by returning 2.99% and 3.48%, respectively.
This sector dynamic continues to dampen the performance of portfolios that apply environmental, social, and governance (ESG) criteria, which are most restrictive in the Energy, Materials and Industrials sectors. While sector leadership trends tend to be cyclical and revert in the medium-to long-term, some argue that we are in the midst of a mega-trend in commodities fueled by economic growth in emerging markets and an increase in world population. If this is true—and we believe this to be a very likely scenario, especially given the potential contributing impacts of climate change—this sector-driven headwind may continue to present an uphill battle for some time to come. Having said that, we believe that in the short term investor enthusiasm about the Energy sector may be momentum driven and that the immediate positive sector dynamics are largely priced in. As such, we may see a reversal in sector leadership away from Energy.
Geopolitical Tensions Push Up Price of Oil
As crude oil hit 20-month highs during the quarter, oil price increases are threatening global economic growth prospects. Both Goldman Sachs Group and Bank of America Merrill Lynch raised their oil-price forecasts during the quarter. Some market observers use a $130 to $140 oil price range as a threshold level where the price of oil may have a significant negative impact on global economic growth. As we commented in the past, emerging markets are most vulnerable to such sudden spikes in commodity prices, while developed market economies, especially the U.S., are somewhat more immune.
U.S. and NATO bombing of Libyan military targets at the end of March provided investors with greater confidence about a positive resolution to the political conflict in that country and Libya’s ability to resume normal oil production. It is unclear, however, how the multiple political conflicts in the region (now also including Syria) will impact oil production and supply in the next several months.
In response to the continued political tensions, investors have also increased purchases of safer assets like gold, silver, and U.S. Treasuries, pushing prices of these assets up significantly. The price of silver set several new 30-year highs during the quarter and doubled in the 12 months through the end of the quarter.
Inflation Becoming a Concern Worldwide
Inflation is becoming more of a focus for investors worldwide as food and energy prices increase globally, causing concerns about global economic growth, especially in emerging economies. One of the elements impacting prices is extreme weather conditions around the world, from extreme heat in Russia to floods in Australia to severe snowstorms in Europe and North America over the past several quarters. Whether this is caused by El Nino or ongoing climate change is yet unclear, but if this is a longer-term trend, emerging-market economies will be most severely affected since they rely more on commodity inputs for their fast economic growth. Emerging-market stocks underperformed their developed-market counterparts for each month of the first quarter.
China is continuing to fight inflation with a series of measures including interest-rate increases, currency appreciation, and hikes in bank reserve requirements—the country ordered its banks to increase their reserves three times during the first quarter. Growth in China is slowing down, with recent export numbers down considerably. A less orderly downturn in China’s economic growth will likely spell trouble for global economic growth. India is also battling inflation and raised its interest rates during the quarter, further tightening the country’s monetary policy.
The European Central Bank announced that it might raise the benchmark rate from a record low of 1% as soon as in April to counteract inflationary pressures. The ECB did in fact raise the benchmark lending rate to 1.25% in early April.
In the U.S., despite the increases in the prices of many commodities (wheat, corn, energy, etc.) over the past several quarters, the Federal Reserve (Fed) continues to focus on core inflation, a statistic that does not account for price changes in the volatile components of the consumer price index, i.e. food and energy. So far, core inflation in the U.S. has remained stable and low, allowing the Fed to maintain its stimulative policy of a near-zero percent interest rate. Inflation expectations in the U.S. remain low for the time being and the consensus seems to indicate that, based on the current employment picture, wage inflation is not yet a concern, which means that the accommodating interest-rate policy could remain in place for some time. We believe, however, that continued positive GDP growth data and improving employment and housing figures may prompt the Fed to raise rates sooner rather than later, possibly ahead of the consensus first half of 2012 time frame.
Renewed Concern over Eurozone Debt Crisis
The European sovereign debt crisis continues to be an issue with Portugal likely needing a rescue this year. The Fitch ratings service cut the country’s credit rating in March. Moreover, the cost to insure against sovereign default in Europe hit record highs during the quarter as the eurozone struggles to assure investors of the viability of the proposed long-term solutions to the debt crisis.
The European Union summit was convened in Brussels early in February to review a potential increase in funds earmarked for bailouts and a reduction in interest rates on rescue loans, along with a discussion of broader economic policy coordination among member states. There remains, however, a strong sentiment among investors that some of the eurozone’s member nations are likely to leave the union in the next several years and default on their sovereign debt despite the austerity measures put in place by many of these nations, including Ireland, Spain, Greece, and Portugal.
Tragedy in Japan Unsettles Investors
In March, Japan’s natural disaster—exacerbated by its impact on the country’s nuclear reactors—sent a ripple effect through global financial markets, with nuclear energy related names (Entergy, Exelon), Japanese insurance, luxury goods (Coach, Nike), and PC and communications equipment names suffering the most.
The insurance and reinsurance industries were facing record catastrophic losses from the immediate outcomes of the earthquake and tsunami in Japan. Other industries were impacted due to just-in-time manufacturing and low inventories in the PC supply chain. Due to Japan’s significant role as a supplier into global manufacturing, disruptions in the country’s manufacturing production negatively impacted PC and communication equipment companies around the globe.
On the other hand, clean-energy stocks attracted investors’ attention as a result of the nuclear crisis in Japan and the impending scrutiny and regulation for the nuclear energy industry. Names like Solarworld, Norway’s Renewable Energy, and Gamesa, Spain’s largest wind-turbine maker, rallied at the end of March.
Housing Market Remains Under Stress
The residential real estate market continues to be under stress with potentially 20% more homes going into foreclosure this year. An estimated three million homes have been repossessed by banks in the past three years. Some expect the total number to reach six million by 2013.
U.S. home prices, having fallen 31% from their peak, are reaching pre-bubble levels owing to some degree to the glut of foreclosed home inventory being pushed back into the first quarter by litigation and inquiries surrounding the mortgage documentation debacle. With consumer confidence rising, unemployment inching down, and mortgage rates increasing from historical lows, the bottom in housing prices is likely to occur this year as home buyers look for attractive deals. The combination of historically low home prices and mortgage rates is already starting to positively impact home sales.
Financials Sector Faces Increased Scrutiny
The Financials sector continues to be held under the regulatory microscope. During January, as part of the Dodd-Frank financial services reform, the U.S. Securities and Exchange Commission recommended that a uniform fiduciary standard be applied to brokers who provide personalized investment advice in the same way that it applies to registered investment advisers. Currently, broker-dealers are held to a less stringent suitability standard while registered investment advisers are held to the higher fiduciary duty standard with clients’ best interests held as a priority. If passed, this regulation could significantly impact the retail industry’s product offering and business model, with potentially negative implications for profitability.
During the quarter, Financials were negatively impacted by the Massachusetts State Supreme Judicial Court’s decision on some foreclosures, deeming them invalid because Wells Fargo and U.S. Bancorp didn’t have sufficient documentation to prove the ownership of the mortgages.
However, at the end of the quarter Financials benefited from the Fed’s clearing of some of the 19 systemically important U.S. banks to increase dividends, buy back shares, or repay the government. Financial stocks rallied after the announcement as companies like JPMorgan Chase, Wells Fargo, and many other banks announced dividend increases and share repurchases, events that investors see as positive catalysts for stock prices.
Positive Market Sentiment
Despite the many risk pockets in the global market environment, recent positive market sentiment seems to be driven primarily by continued health in earnings reports and better- than-expected sales guidance from U.S. companies this earnings season. Fourth-quarter GDP growth numbers being revised upward from 2.8% to 3.1% also helped. Driven by healthy corporate balance sheets and impressive cash war chests accumulated by many corporations, M&A activity continues to be quite strong, benefiting small- and medium-capitalization stocks.
U.S. manufacturing data showed better-than-expected expansion towards the end of the first quarter. The ISM index rose to 69, the highest reading in seven years. This sustained expansion in the private sector, spurred partially by the availability of low-cost credit, is helping generate job growth. If we see further substantial improvements in the jobless rate in the next few months, coupled with healthy GDP growth numbers, the Fed is likely to abandon its low interest-rate policy earlier than the market-anticipated first half of 2012.
Data from the service industry during the first quarter was also encouraging with faster-than-forecast growth reported during January. Consumer spending continued to improve with fourth-quarter holiday purchases showing a rise of 5.5% off the depressed lows of 2009, the best performance since 2005.
The manufacturing-led recovery in the U.S. is now being complemented by improvements in consumer spending, while inventory re-stocking is slowing down. The combination of healthy manufacturing and consumer sectors of the economy will be the key to a sustained, robust economic recovery and continued earnings growth for U.S. companies. Leaner inventories, while contributing less to economic growth in the short term, may contribute to higher growth for 2011.
New regulations that extend the Bush-era tax breaks, reduce payroll taxes, and allow firms to depreciate all of their capital expenditures in 2011 may boost spending and business investment throughout 2011. These policies are expected to continue to boost hiring in the private sector and to help decrease jobless claims.
Consumer confidence is improving, rising to its highest level in eight months during the first quarter. In February, consumers’ outlook on employment and the overall economy turned positive for the first time in seven years. This improvement, supported by more optimistic job prospects and rising equity markets, has driven increases in consumer spending over the past several months and is likely to continue to boost consumer sentiment. We believe that this trend, if it continues, will be the primary driver behind potentially better-than-expected economic growth this year.
By some estimates, another 10% to 20% increase in the price of oil may start to impede U.S. and global GDP growth. High gasoline prices are already negatively impacting consumer confidence, but not enough to offset the improving employment picture and advances in the stock market. We continue to see the potential for further geopolitical crises and commodity and inflation spikes as negative catalysts for equity markets. However, consistent with our expectation for a slow, gradual economic recovery, we believe that equity markets and the global economy can successfully navigate through temporary setbacks.
If the relative underperformance of emerging-market stocks that occurred in the first quarter continues, negative fund flows may exacerbate that downward trend, especially given the relatively low liquidity in emerging markets. Investor reallocation of assets— especially in generic international and global portfolios with large exposures to emerging markets—toward developed markets could further exacerbate the underperformance of the emerging markets asset class.
Given the strong run-up in equity prices in the last several months and current valuations, it is likely that once the earnings season subsides, equity markets will 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 3.1% consensus expectation. GDP growth could accelerate above 3.5% in 2011 given the better consumer confidence numbers and now stronger top-line growth in the corporate sector of the economy. If the impending interest rate hike by the Fed comes sooner than the markets anticipate (before the first half of 2012), 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 to be strong in 2011, a trend that should continue to benefit small- and medium-capitalization stocks.
As of 3/31/2011, accounts managed by Calvert Asset Management Company, Inc. held securities issued by the following companies: Goldman Sachs, Bank of America, Exelon, Nike, Gamesa, JPMorgan Chase, Wells Fargo, and U.S. Bancorp. 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 4/26/11 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.