Volatility Rattles Equity Markets in August
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
August was an eventful month with significant volatility in equity and commodity markets globally. We saw one of the most volatile weeks on record for the Standard & Poor’s (S&P) 500 Index, which plunged 6.7% on Monday, August 8, the first trading day after the announcement of the downgrade of U.S. government debt by S&P. The S&P 500 Index gyrated up and down in daily increments of more than 4% for most of that week. Equity markets saw some recovery at the end of August, but all major equity indices globally finished in negative territory for the fourth consecutive month.
For the month of August, the S&P 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -5.43%, -5.76%, -8.70%, -9.02%, and -8.90%, respectively. Despite the broad-based sell-off in equity markets, the more defensive sectors managed to end the month with positive returns. In the Russell 1000 Index, Consumer Staples and Utilities were up 0.47% and 1.81%, respectively, while the Energy, Financial, and Materials sectors were all down more than 7% for the month. Utilities and Consumer Staples have now moved into the leadership position for the year to date, highlighting market rotation towards more defensive sectors.
Growth stocks continued to hold up better than value names in August, with the Russell 1000 Growth Index returning -5.28% compared to the Russell 1000 Value Index, which returned -6.24%. For 2011 through the end of August, the Russell 1000 Growth Index was up 0.18%, while the Russell Value Index was down 3.99%.
S&P Downgrade of U.S. Government Debt
As we expected, the S&P downgrade of U.S. government debt from AAA to AA+ on August 5 presented an additional blow to investor confidence and contributed to a global equity market sell-off. It added to market volatility and further depressed investor sentiment while pushing U.S. Treasury yields down, as risk aversion in the markets increased. Being the first such downgrade in U.S. history, it made investors question the ratings of countries like France (currently an S&P AAA rated country), which in turn put into question balance sheets and even the solvency of French banks, the share prices of which were decimated during the month. U.S. bank stocks followed suit on fears that counterparty risk related to European banks may take U.S. banks down as well, engulfing the global financial system and assuring a double-dip recession in the United States. We do not believe that this scenario is likely;
however, the Financial sector continues to be under pressure and was still by far the worst-performing sector for 2011 through the end of August. While we still have concerns about banks in particular, at the time of the writing of this piece in early September, the Financial sector may have sold off to levels that may be close to a short-term bottom.
When it downgraded U.S. government debt following the debt ceiling agreement, S&P stated that it was “pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.” One of the unintended consequences of the move by S&P could be that austerity measures are implemented in the U.S. sooner rather than later, increasing the risk of a double-dip recession, which in turn would further dampen the U.S. credit outlook.
There's no question that S&P's action helped turn investor sentiment more negative (stocks in particular had begun to turn sharply downward in late July and early August), but it probably received more attention in the media for triggering the sell-off than it truly deserved. Even before the downgrade, investors had been increasingly concerned about problems with European sovereign debt and about a significant slowdown in U.S. economic growth—or, more ominously, a double-dip recession in the United States. We believe that these were the true underlying causes of the equity market volatility during the month of August.
The fixed-income markets seemed to shrug off the S&P downgrade, which many bond traders and analysts likely anticipated (although the timing of the downgrade surprised many). At no point did the market for Treasuries, government-guaranteed agency securities, or short-term financing show signs of strain amid the recent turmoil. Although Treasuries may not be the true “risk-free” asset that they were once considered to be, for U.S. investors looking for minimal credit risk there are very few alternatives. Even for international investors, there is no other asset class that has anything approaching the size, liquidity, and depth of the U.S. Treasury market.
Macro Picture Replaces Earnings Season as Driver for Equities
The earnings season in the U.S. was very positive with three-quarters of companies in the S&P 500 Index beating analysts’ consensus earnings estimates, and many companies exceeding revenue forecasts. Once earnings reports tapered off in August and stopped acting as a positive catalyst for equity markets, investors refocused on the macro picture. Mutual fund outflows were at record levels during the month.
The European sovereign debt crisis and bank contagion were part of the reason for negative investor sentiment as uncertainties about the European Union debt crisis continued throughout August and threatened to pull that region’s economy into double-dip recession territory with many peripheral economies already in a contraction mode. European stocks hit a two-year low before rebounding. France, Spain, Italy, and Belgium were among several nations that banned short sales in response to market turmoil. However, if Germany and France avoid a severe double-dip scenario, the impact of the European crisis on the U.S. economy could be muted.
Worries about anemic economic global growth intensified during the month with U.S. gross domestic product (GDP) growth numbers revised down for the first half of the year to an approximate 1% average annual growth rate. The data were particularly worrisome because of the measure to cut more than $2.1 trillion from the federal budget enacted earlier in the month. The impact of the debt ceiling deal on GDP growth is expected to be negative and could amount to as much as a 1% hit.
Philadelphia Fed manufacturing survey numbers released during the month were disastrous, but it is important to note that they were compiled after the unproductive debt ceiling negotiations and after the U.S. government debt downgrade by S&P was announced. They reflected the severe shock to U.S. business confidence triggered as a result of those events. It is reasonable to assume that the uncertainty prevented business leaders from aggressively implementing expansion and hiring plans. The manufacturing survey results fueled the fears of a double-dip recession in the U.S. and dealt a blow to already-shaky investor confidence, resulting in continued heightened volatility in the equity markets. JPMorgan Chase and Citigroup revised their economic growth forecasts for the U.S. economy to lower, albeit still positive, levels.
Institute for Supply Management (ISM) manufacturing numbers, while still in expansionary territory, decreased to a two-year low, indicating that the engine of the economic recovery was slowing. Having said that, the ISM report provided a pleasant surprise as consensus expectations for the data were considerably lower. This, combined with anemic consumer spending and the likely slowdown of government spending, reignited investors’ worries about the possibility of a double-dip recession. The release of June consumer spending data indicated that consumer spending and business investment in the first half of the year were slow but positive, providing support for the tepid economic expansion.
Employment report numbers for July were released during August and came in better than the consensus estimates. The data showed that U.S. employers added 117,000 workers in July. The unemployment rate inched back down to 9.1%, owing primarily to larger numbers of discouraged workers leaving the labor force. The unemployment rate remained unchanged with the release of August employment numbers in early September, showing that payrolls were actually flat despite the consensus estimate of 68,000 jobs added.
During August, President Barack Obama called for a temporary payroll tax relief measure to boost employment and advocated further extension of unemployment benefits in advance of his September 8 jobs speech to Congress. On the negative side, the economy was hurt by drops in government spending, especially at state and local levels where the budget gap prompted considerable payroll reductions.
Crude oil declined on the lower economic growth outlook – a welcome sign as potentially lower gasoline prices would help soften inflation concerns and improve consumer confidence. Gold also hit an all-time high during the month amid investors’ flight to safety.
The northeast region of the U.S. experienced a medium-strength earthquake in late August followed by Hurricane Irene at the end of the month. Though the hurricane did not appear to cause significant damage to refineries along the U.S. east coast, disruption as the storm approached may still temporarily push the cost of fuel up.
The Fed and QE3
Equity markets fluctuated nervously during the days leading up to Fed Chairman Ben Bernanke’s speech on August 26 at the Fed’s annual symposium in Jackson Hole, Wyoming. In his speech, Bernanke assured investors that the central bank has the capacity to stimulate the U.S. economy, which has been having a soft patch, but reiterated his view that the economy is in a recovery mode and should pick up steam later in the year. He also reiterated his encouragement for Congress to come up with a credible plan for reducing the U.S. budget deficit over the longer term, but doing it gradually so as to not hurt soft economic growth in the short term. The fact, however, that a second day has been added to the next meeting of the Federal Open Market Committee in September indicates that the Fed is preparing for a more lengthy discussion of economic conditions should it need to act on any further signs of deterioration in the U.S. economic recovery.
Equity markets reacted positively to Bernanke’s message that the U.S. economy may recover on its own and doesn’t need additional stimulus, with IT and Materials names bouncing the most.
While the idea of a third round of quantitative easing1 (QE3) hasn't had a lot of support until now, if markets decline and accelerated austerity measures threaten to tip the U.S. economy into double-dip recession territory, additional stimulus may be forthcoming.
While we recognize that the risks to the downside are now heightened and that our cautiously optimistic stance is now in the contrarian camp, we still place a higher probability on a slow recovery than on the double-dip scenario at this point, and we believe that decreasing equity valuations in the short run can present attractive investment opportunities for long-term investors. Last year, the S&P 500 Index hit a low in August on double-dip concerns and rallied 20% from those levels through the end of 2010 following the announcement of QE2 by the Fed. There are still both fundamental and policy catalysts that can produce a similar outcome in 2011.
In the equity market, it seems that fundamental U.S. economic data, coupled with strong corporate earnings and balance sheet health, should provide some support for the market going forward. Wal-Mart and Target, both of which are bellwethers for the mass-market retail industry, reported healthy quarterly earnings and provided strong outlook statements in August, which was an encouraging sign.
Though macroeconomic data is mixed, there are enough positive data points (corporate earnings, payrolls, retail sales data beating expectations, etc.) to suggest that the (slow) economic recovery in the U.S. is still underway. It is clear that we do not yet have a financial system crisis, an earnings crisis, or an economic crisis, but that we do have a crisis of confidence in the U.S. that could make a double-dip recession a self-fulfilling prophecy. Consumer sentiment is now at a multi-decade low, although that number is likely to improve as macro risks subside.
While we may see further volatility in the equity markets, this may be the time when buying the dips could produce the potential for greater returns for those who step in to buy in a time of uncertainty. Equity valuations in terms of the forward price/earnings ratio (PE) on the S&P 500 Index reached the same levels during the sell-off in early August as in the depths of the financial crisis in 2008, with the Bloomberg consensus 12-month forward PE dropping to 10.13 during August.
Market participants were visibly frustrated by the partisan stalemate in the U.S. debt ceiling negotiations. However, we believe that S&P's downgrade of U.S. government debt could have one very positive effect: it could help convince our political leaders to work together to address the fiscal problems that have built up in the United States over time. In the short run, the markets have signaled their confidence in U.S. Treasury securities by continuing to aggressively buy U.S. Treasuries. However, in the longer term, if markets start to believe that the credit quality of the U.S. government has entered a long-term, secular slide, the cost of borrowing in the U.S. could increase. The United States has the ability to avoid this type of long-term decline if our political leadership is willing to prevent it.
1. Quantitative easing involves the Federal Reserve buying bonds on the open market and essentially paying for them by adding funds to the banking system.
This commentary represents the opinions of the author as of 9/9/11 and may change based on market and other conditions. These 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 Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
Accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
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