Third Quarter 2011 Equity Market Commentary
The third quarter marked the worst performance by stocks since the 2008 financial crisis as the broad based selloff in global equity markets erased gains from the first half of the year and left all major indices in negative territory year-to-date. Despite another strong earnings season from U.S. companies, investors refocused on the macro picture with the eurozone debt crisis, the downgrade of U.S. government debt by Standard and Poor’s (S&P), and concerns about sluggish global economic growth taking center stage. For the third quarter, the Russell 1000 Index and the Standard & Poor’s 500 Index returned -14.68% and -13.87%, respectively, while the MSCI EAFE Index dropped 18.95% and the MSCI Emerging Markets Index fell 22.46%. Small caps were hit harder than large caps with the Russell 2000 Index declining 21.87%. Growth stocks held up better than value stocks, with the Russell 1000 Growth Index falling 13.14% compared to the Russell 1000 Value Index, which posted a -16.20% return during the quarter.
Investor rotation into the traditionally more defensive sectors continued in the third quarter with utilities, consumer staples, and telecom sectors performing the best; though within the Russell 1000 Index only utilities managed to eke out a positive return for the quarter. The more cyclical materials, financial, and industrials sectors underperformed with financials still the worst performing sector year-to-date.
Positive Earnings Surprise
The U.S. quarterly earnings season was very positive with three-quarters of companies in the S&P 500 Index beating consensus earnings estimates and many companies exceeding revenue forecasts. Google, Apple, and AMD beat estimates by wide margins on both earnings and revenue, contributing to the technology sector’s leading performance in July. Cash-rich U.S. companies also continued to use their cash reserves for mergers and acquisitions. During the quarter, Express Scripts agreed to buy Medco Health for $29.1 billion, which was a significant premium over Medco Health’s stock market value prior to the acquisition announcement. Similarly, Google’s $12.5 billion offer for Motorola Mobility represented a 63% premium over the closing price of Motorola Mobility shares. However, once earnings reports tapered off in August and stopped acting as a positive catalyst for equity markets, investors refocused on the macro picture.Â
S&P Downgrade of U.S. Debt
After months of partisan gridlock in Washington, U.S. political leaders finally reached an agreement and enacted legislation to raise the debt ceiling on August 2â€”—the date on which the U.S. Treasury said that it would have been unable to meet its obligations if a deal on the debt ceiling hadn’t been reached. The deal raised the debt ceiling through 2013 in two phases, with at least $2.4 trillion in spending cuts over 10 years ($900 billion initially). Under the agreement, a special committee of lawmakers was tasked with finding another $1.5 trillion in reductions. A backup package of spending cuts will be automatically triggered if the committee fails to find at least $1.2 trillion in savings.
Despite the last minute agreement, S&P followed through on its threat to cut U.S. debt’s credit rating in light of the political indecision in Washington surrounding a concrete plan for deficit reduction. 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 selloff. It added to market volatility and further depressed investor sentiment while pushing U.S. Treasury yields down as risk aversion in the markets increased. The week of August 7 was one of the most volatile on record for the S&P 500 Index, which plunged 6.7% on Monday, August 8, the first trading day after the announcement of the S&P downgrade, and gyrated up and down in daily increments of more than 4% for most of that week.
Being the first such downgrade in U.S. history, it made investors question the debt 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 in the weeks immediately following the downgrade. U.S. bank stocks also dropped sharply 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. However, in a mid-July letter, Fed Chairman Bernanke cited Fed analysis that claimed U.S. financial companies’ exposure to the eurozone sovereign debt crisis is “manageable.”
Even before the downgrade, investors had been increasingly concerned about problems with European sovereign debt and about a significant slowdown in U.S. economic growthâ€”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 quarter.
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. and even global investors looking for safety there are very few alternatives to the size, liquidity, and depth of the U.S. Treasury market.
Eurozone Sovereign Debt Crisis Weighs on Equity Markets
The uncertainties surrounding the European sovereign debt crisis and bank contagion continued throughout the quarter and was part of the reason for negative investor sentiment, as investors worried that the crisis could push that region’s economy into double-dip recession territory (with many peripheral economies already in a contraction mode). The Organization of Economic Cooperation and Development (OECD) slashed growth forecasts for several European countries and is now forecasting that the weighted average GDP of the three largest eurozone economies will fall by 0.4% in the fourth quarter of this year. 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. Overall, the risk of contagion in Europe is still elevated with Spain and other peripheral European countries very much in the danger zone and facing tough choices in restructuring their economies.
During the quarter, Germany’s highest court ruled that German participation in European Union (EU) bailouts was legal, but would require the parliament’s approval going forward. The German parliament also voted to approve the July 21 EU Debt Summit decision to expand the size of the European Financial Stability Fund’s (EFSF) lending capacity to 440 billion euros ($596 billion), which would allow Greece to receive its much needed next tranche of bailout funds. The parliaments of several other EU countries also voted in October to approve the expanded EFSF.. However, the Greek government’s announcement that it will miss its deficit target this year renewed concerns that funds could be withheld, leading to a possible default by Greece. The credit spread on Greek sovereign debt increased significantly throughout the quarter, and at one point implied a 96% probability of default.
European bank stocks continued to be among those most adversely impacted by the eurozone debt crisis as the STOXX 600 Europe Banks Index approached the lows of the 2008 financial crisis before rebounding at the end of the quarter. European banks are facing short-term funding problems. In addition to longer-term funding stress, the falloff in investment in European banks by U.S. money market funds is a short-term stressor. Leading central banks (those of the EU, U.S., England, Japan and Switzerland) responded by agreeing to a coordinated effort to provide European banks with easy access to liquidity, a move similar to policies implemented during the 2008 financial crisis. Further consolidation in the European banking sector is likely to follow and, in the longer run, banks may shift to less risky strategies and assets, which will reduce returns and hurt their long-term profitability. This trend is likely to apply to U.S. and other globally exposed banks.
However, we believe that the U.S. Financial sector may have seen the worst of the selloff and, while still exposed to further deterioration in the eurozone and long-term negative impacts on earnings from new regulatory regimes, may experience a medium-term bounce in the remaining months of 2011.
Economic Recovery Slows in the U.S.
Worries about anemic global economic growth intensified during the quarter with the U.S. Gross Domestic Product (GDP) average annual growth rate revised down for the first half of the year to less than 1%. The data were particularly worrisome to investors because of the measure to cut more than $2.1 trillion from the federal budget enacted in August. The impact of the debt ceiling deal on GDP growth was expected to be negative and was expected to amount to as much as a 1% hit and negatively impact unemployment. In a similar dynamic, recent gains in private employment were offset to a large degree by job losses at the federal, state, and local government levels. The most recent release of employment figures in early September showed that the unemployment rate remained at 9.1% in August despite the consensus estimate of 68,000 jobs added. Additionally, payrolls fell in 30 U.S. states in August, according to data released by the Department of Labor. Jobs data is likely to be a lagging indicator of economic activity and may not improve until other indicators are more firmly in positive territory.
Weak employment numbers will continue to depress consumer confidence and spending for some time. We believe, however, that this setback in job creation may be driven in part by the crisis of confidence on the part of U.S. businesses. Other concerns include the ability of the U.S. political process to effect positive economic change, as well as the supply chain disruptions in Japan earlier in the year (which is likely to recover somewhat by the end of the year). Payroll tax breaks for U.S. companies should play some role in job creation later this year as well.
President Obama gave his much anticipated jobs speech to Congress early in September, calling for the passage of a $447 billion jobs act. His proposal included extending unemployment insurance benefits through 2012, aid to state and local governments (including cash for hiring teachers), an infrastructure/transportation project spending bank, and a temporary cut in payroll taxes for employers and employees. However, there was no mention of a corporate tax repatriation holiday despite the preceding speculation. Some economists estimate the proposed jobs plan could add one to two percentage points to real GDP growth in the U.S. and create more than one million jobs. This is in stark contrast to the previously proposed status quo fiscal policy, which economists estimated would actually be a net drag on the economy.
Housing Market Shows Signs of Bottoming Out
The housing market, one of the stronger headwinds to economic growth, seems to be stabilizing, which should provide a considerable boost to consumer confidence. Helped by historically low mortgage rates and home prices, the U.S. housing market is showing some signs of bottoming out and firming up. Data released during the quarter indicate that existing home sales increased unexpectedly, jumping 7.7% in Augustâ€“a five-month high. The continued trend of rising rent prices is also positive for the housing market.
Other economic data for the U.S. was mixed during the quarter, though a greater number of positive data points reinforced our view that a slow, painful recovery is more likely than a contraction/double-dip. The “Beige Book” release early in September indicated the economy continued to expand at a slow pace with some regions showing weakening activity while consumer spending increased marginally, with the biggest boost coming from the auto sector.
On a positive note, the Institute of Supply Management’s index of non-manufacturing businesses increased to 53.3 in August from 52.7 in July, while the U.S. trade balance improved to -$44.8 billion in July from -$51.6 billion in June, shrinking by 13.2%. More importantly, U.S. industrial production increased 0.2% in August, which seems to suggest that manufacturing is still able to support the economic recovery. Additionally, the Chicago PMI and ISM Manufacturing PMI were both better than expected in September and remained in expansionary territory.
However, the U.S. Small Business Confidence Index fell to a 13-month low in September, declining for the sixth consecutive month, and the U.S. Personal Income report was not optimistic, showing a 0.1% decline in August, the first drop in nearly two years.
Core CPI increased more than expected in August, with the continued uptick in inflation numbers making significant further easing by the Fed less likely.
Crude oil declined on the lower economic growth outlookâ€“a welcome sign as potentially lower gasoline prices would help soften inflation concerns and improve consumer confidence. Consumer confidence rose to 57.8 in September, up from August when it recorded its lowest level since November 2008.
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 is in the midst of 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 called on Congress once again to put forward 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.
This was followed by the Fed's well-timed September 21st announcement of “Operation Twist,” its plan to sell $400 billion in short-term Treasuries while purchasing the same amount of longer-term Treasuries. This could provide a much needed boost to investment and re-financing in the U.S by reducing long-term interest rates, although it was accompanied by alarming statements about U.S. economic weakness, which further unsettled markets.
China's Growth Momentum Slows, But a Stall Not Likely
In China, the release of August consumer price index data indicated that inflation eased somewhat to 6.2% year-over-year, down from 6.5% in July and in line with expectations. Despite the decrease, the threat of inflation still looms in emerging market economies and may make it difficult for China and other emerging market countries to implement more accommodative monetary policy in the near-term.
Industrial production numbers in China were also positive, increasing 13.5% year-over-year for August. Manufacturing data was slightly contractionary but not at hard landing levels. Still, Fitch Ratings warned during the quarter that it could downgrade the credit rating for both China and Japan in the next few years because of debt loads and concerns about financial stability.
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. 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 good support for the market going forward. Walmart and Target, both bellwethers for the mass-market retail industry, reported healthy quarterly earnings and provided strong outlook statements in August, which was an encouraging sign.
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. Combined with marginally positive U.S. economic data and attractive equity valuations (the 12-month forward PE for the S&P 500 was at 10.61 after the close on September 30th), as well as signs that China’s growth momentum has not stalled, we continue to believe that the market can see a healthy recovery in the next couple of months. We remain cautiously optimistic on U.S. economic growth, albeit less so on European growth.
We believe that the U.S. earnings season which started on October 11th is likely to provide positive earnings surprises and serve as a positive catalyst for the U.S. and possibly global equity markets, especially given current valuation levels.
This commentary represents the opinions of the author as of 10/26/11 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.
Calvert Investment Management, Inc., 4550 Montgomery Avenue, Bethesda, MD 20814