U.S. Equities Hold Up Better than International Stocks in November
In November, equity markets were disappointed by the reality of the "one step forward, two steps back" attempts at crisis resolution in Europe during the month. However, the continued trickle of positive economic data in the United States provided some support, leading to the significant outperformance of U.S. equity markets relative to their international brethren. For the month, the Standard & Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -0.22%,
-0.26%, -0.36%, -4.83%, and -6.66%, respectively. Within the Russell 1000 Index, the more defensive Consumer Staples, Energy, and Industrials sectors performed the best while more cyclical sectors of the economy—Financial, Information Technology, and Consumer Discretionary—lagged.
Growth stocks held up slightly better during the month, with the Russell 1000 Growth Index down 0.01% while the Russell 1000 Value Index dropped 0.52% owing primarily to the poor performance of Financial stocks, which were down significantly in sympathy with their European counterparts.
European Debt Crisis
The potential collapse of the eurozone is still very much at the center of investor worries. The region's economic picture, including macroeconomic and fundamental earnings data, is looking increasingly grim with peripheral economies firmly in a recessionary spiral and the entire union likely in a recession already. The eurozone's move toward increased fiscal integration and fiscal austerity measures will likely create a fiscal drag and not help the European Union (EU) economy in the near term, although resulting structural changes should be good in the long run. Tighter fiscal integration, if achieved, will open the door for more active involvement by the European Central Bank (ECB), which should be extremely helpful for market sentiment. The ECB's unexpected 25 basis point interest rate cut at the beginning of November supports this view. ECB President Draghi also hinted at further rate cuts in his first speech early in November, though eurozone inflation remained at its highest rate in three years in October, with core CPI (consumer price index) up 1.6% and headline CPI up 3% year-over-year.
Bond markets are translating the sovereign risk crisis into soaring yields on the sovereign debt of Spain, Italy, and now France (200 basis points above German bunds at one point during the month). With Italian sovereign debt yields blowing through the 7% stress level and reaching 7.5% during November before pulling back, it is quite apparent that if EU policy solutions to the crisis are not forthcoming, markets will force a solution by making borrowing extremely expensive for countries with poor balance sheets, a lack of fiscal discipline, and bleak economic prospects, thereby facilitating political change. This dynamic precipitated the progress toward new, technocratic governments in both Greece and Italy. While this is a welcome development, a more credible, structural integration in the eurozone on both an economic and a political level will be necessary for the monetary union to stay intact. Unfortunately, this outcome seems more and more remote, and markets are reacting accordingly with U.S. Treasuries continuing to benefit from the turmoil in Europe.
The plan to leverage the European Financial Stability Facility (EFSF) continued to hit obstacles and European leaders also failed to agree on a plan to increase funds from the International Monetary Fund (IMF) available to help countries under fiscal pressure. Meanwhile, the ECB and Germany remained reluctant to commit to further purchases of sovereign bonds, with German Chancellor Angela Merkel pushing for closer economic ties among eurozone countries rather than expanding the role of the ECB.
Additionally, European banks need to raise capital as Financial-sector companies globally are still compromised. MF Global filed for bankruptcy protection during the month after suffering significant losses from bad bets on European bonds, which raised concerns about other financial institutions' exposure to European sovereign debt. In the United States, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup had their long-term credit ratings cut from A to A- by Standard & Poor's. JPMorgan Chase was downgraded from A+ to A.
In response to the pressures facing the financial industry, the Fed, the ECB, and the central banks of Canada, Switzerland, Japan, and the United Kingdom made a coordinated move to cut the premium on overnight dollar borrowing from OIS (overnight indexed swap rate) plus 100 basis points to OIS plus 50 basis points. The move sent the Dow Jones Industrial Average to the largest daily gain (as of the end of November) since March 2009. In particular, financial stocks across the globe responded by recovering some of the losses suffered earlier in the month.
U.S. Economy Continues Slow Recovery
Despite the European crisis, the U.S. economy continues to proceed on the path of gradual recovery, with the GDP growth rate likely now improving to at least a 3% annualized pace during the fourth quarter.
The third-quarter corporate earnings season in the United States produced very impressive results. Nearly 70% of companies in the S&P 500 Index beat earnings expectations and 62% beat revenue forecasts. What's different this time is that the top-line growth was 11% year-over-year, an important improvement. In particular, Cisco Systems, an important bellwether of U.S. economic activity, reported very good earnings. Overall earnings guidance for the next quarter for S&P 500 companies is also promising.
Consumer spending is improving with retail sales rising 0.5% in October, exceeding expectations, and driven by the largest gain in electronics purchases in two years. Auto sales and production also look encouraging. Retail sales data were positive with chain-store sales up 5% year-over-year, despite the lack of improvement in real incomes and a 2.4% drop in unit labor costs in the third quarter. The increased spending seems to be coming at the expense of the lower savings rate, however. In September, the U.S. savings rate was 3.6%, the lowest in nearly four years. The consumer had to contend with higher food and energy prices as well as rising rents. At the same time, corporate profitability continues to improve with worker productivity rising 3.1% in the third quarter.
A weaker dollar continued to support the manufacturing sector and exports. The financial sector is also healthier in the United States than the rest of the developed world and lending is improving, despite concerns about the impact of the eurozone debt crisis. The housing market, meanwhile, continued to show signs of bottoming out, but not robust improvement. U.S. consumers are continuing to improve their balance sheets with mortgage delinquencies falling to 7.99% in the third quarter of 2011.
The unemployment rate, while still very elevated, ticked down from 9.1% in September to 9% in October and dropped to 8.6%, the lowest it's been since March 2009, as of November. The four-week moving average of initial jobless claims also fell throughout November and continuing claims dropped more than forecast. Data released by the Labor Department during the month indicated that job openings in the United States increased by 225,000 in September to 3.35 million, the highest level in more than three years and a 7.2% increase from the prior month. We believe that these marginal improvements in the employment picture helped drive continued improvement in consumer confidence.
U.S. inflation data remains tame; the CPI fell 0.1% in October while core CPI rose 0.1%. The U.S. producer price index declined 0.3% in October from the prior month as food and energy prices stabilized.
The congressional "super committee" (the Joint Select Committee on Deficit Reduction) was not able to come up with a sufficient agreement by November 23, which disappointed the market. It remains to be seen whether the previously agreed-on automatic spending cuts will be triggered and what effect the failure of the super-committee to deliver solutions to the U.S. fiscal and debt problems might have on the U.S. credit rating. While the U.S. corporate sector and consumers are on the path to recovery, the U.S. government balance sheet is dangerously ill. U.S. policymakers need to resolve their differences in favor of the country's needs and address the U.S. debt issue head-on as soon as possible. Additionally, the U.S. Senate voted against the extension of the payroll tax breaks. Continued failure to extend the payroll tax breaks into next year will likely be a drag on the economy.
Both China's and India's GDP growth numbers are decelerating. China's economy, while still expanding, is at risk of a "hard landing," which would be a significant shock to the global economy.
During the month, China unexpectedly cut reserve rates for its banks on the heels of lower inflation numbers and lower-than-expected PMI data, which suggests the possibility of a hard landing for the Chinese economy. The move demonstrated China's shift to monetary easing in the face of a slowing economy and lower-than-expected inflation. A slowdown in food price increases and in overall inflation globally will be conducive to global central bank policies of easing money supply.
We continue to believe that the upside potential for U.S. equity markets remains high, especially given current valuations vis-Ã -vis earnings and macro fundamentals. The U.S. economy remains resilient to external shocks although it is quite apparent that troubles in Europe will dampen U.S. economic and earnings growth. While investors continue to watch the developments out of Europe, we believe that the sovereign debt and developing economic crisis in the region are unlikely to push the U.S. economy into recession at this stage.
We believe that some of the stronger-than-expected economic data in the United States is a bounce-back from the shocks to the system that occurred earlier in 2011 with the supply chain disruptions caused by the environmental disasters in Japan (Japan's real GDP bounced back 6% in the third quarter) and with the political brinksmanship in Washington causing the downgrade of U.S. government debt. This and the subsequent supply chain disruption caused by floods in Thailand may mean somewhat slower growth earlier in 2012 but are likely to have a positive multiplier effect going forward as activity is restored and pent-up demand met. Overall, the debt crisis and recession (exacerbated by fiscal drag) in Europe as well as inaction in Washington are likely to continue to have a dampening effect on U.S. growth in the medium term.
It may take a significant risk event in Europe such as nationalization of a major bank (or banks) for investors to get comfort that there is no subsequent "domino effect" on U.S. banks and conclude that U.S. banks are safe to invest in. As it is, banks' financial statements are too opaque for investors to decipher the real risk exposures to the European debt crisis. In the meantime, the U.S. banking sector is continuing to get punished along with its European counterparts.
In Europe, proposed policy measures are dealing primarily with the symptoms of the crisis. However, the underlying economic weakness of the peripheral eurozone countries and now probably of the core eurozone economies should continue for some time, which will likely worsen the symptoms policymakers are trying to address, i.e. sovereign debt issues. Additionally, Italy is so large and so indebted that it is too big to bail out, especially given the continued lack of agreement on the specifics of EFSF enhancements. Defaults and union exits by some EU peripheral economies such as Greece are no longer out of the question and are being openly debated. French sovereign spreads are spiking up, making the downgrade of French and possibly German debt ever more likely. This uncertainty is likely to keep European market volatility elevated with continued spillover into U.S. markets.
As the earnings season in the United States winds down, additional positive economic news will be needed to support further improvements in the U.S. equity market. Holiday season consumer spending and potentially some of the end-of-year budget spending by corporations may be catalysts that help produce positive economic news.
We believe that, despite the challenging global macro environment at the moment, U.S. equities still look quite attractive and can present extremely attractive investment opportunities for long-term investors.
This commentary represents the opinions of the author as of 12/12/11 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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