2011 Equity Market Commentary
The year 2011 was marked by significant volatility in equity markets. Equity markets generally climbed in the first quarter of 2011 despite the continued sovereign debt crisis in Europe, political turmoil in North Africa and the Middle East, and the tragedy in Japan. An impressive corporate earnings season in the U.S. got the second quarter off to a strong start as well, but equity markets retreated in May and June over concerns about global economic growth prospects related to potential contagion resulting from the sovereign debt crisis in Europe, the end of the QE2 program, and political ambiguity surrounding the raising of the U.S. debt ceiling that resulted in a downgrade of U.S. government debt. 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. However, a strong rebound in the fourth quarter left the Standard and Poor’s (S&P) 500 and Russell 1000 Indices up 2.11% and 1.50% for the year, respectively.
Small-capitalization stocks did not fare as well, with the Russell 2000 Index ending the year down 4.18%. International markets, weighed down by the European sovereign debt crisis and the economic slowdown in China, fared even worse, with the MSCI EAFE and MSCI Emerging Markets Indices declining 11.73% and 18.17% in 2011, respectively. The growth investment style outperformed the value style for the year, with the Russell 1000 Growth Index up 2.64% while the Russell 1000 Value Index returned 0.39%.
While 2011 began with Energy and Industrials as the top-performing sectors, the short- term investor enthusiasm about the Energy sector was momentum driven, and we saw investor rotation into the traditionally more defensive sectors as the year progressed. For the year, the top-performing sectors within the Russell 1000 Index were Utilities, Consumer Staples, and Health Care, returning 19.08%, 14.06%, and 11.44%, respectively. Financials was by far the worst-performing sector for the year, down 14.82%. Materials and Industrials also lagged, returning -9.06% and -1.52% for the calendar year, respectively.
Sovereign Debt Crisis in Europe Weighs on Equity Markets Throughout the Year
Concerns about global economic growth prospects related to contagion in Europe caused by the sovereign debt crisis in that region impacted market sentiment throughout the year. Investors increasingly worried about the potential collapse of the eurozone and its likely disastrous consequences for the global financial system. The region’s economic picture, including macroeconomic and fundamental earnings data, was looking increasingly grim towards the end of the year with peripheral economies firmly in a recessionary spiral and the entire union likely in a recession as retail purchasing managers index (PMI) and consumer spending data showed significant declines despite slower inflation.
Investors remained unconvinced that the eurozone’s problems could be solved through the policy measures presented through most of the year and bond markets translated the sovereign risk crisis into soaring yields on the sovereign debt of Portugal, Spain, Greece, Italy, and France. Yields on French government debt reached 200 basis points above German bunds at one point. With Italian sovereign debt yields blowing through the 7% stress level and reaching 7.5% in November before pulling back, it was quite apparent that if credible European Union (EU) policy solutions to the crisis were not forthcoming, markets were going to 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 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 seemed more and more remote as the year progressed, and markets reacted accordingly, with U.S. Treasuries continuing to benefit from the turmoil in Europe.
After some political maneuvering, the parliaments of the EU countries 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, which, at the time, allowed Greece to receive its much-needed next tranche of bailout funds. However, the plan to leverage the EFSF continued to hit obstacles during the year while the European Central Bank (ECB) and Germany remained reluctant to commit to an expanded role for the ECB in capping sovereign debt yields with bond purchases. German Chancellor Angela Merkel instead continued to push for closer economic ties among eurozone countries. The eurozone’s move toward increased fiscal integration and fiscal austerity measures will likely create a fiscal drag on the region’s economy and hurt the EU economy in the near term, although resulting structural changes should be positive in the long run. Tighter fiscal integration, if achieved, will help open the door for more active involvement by the ECB, which should be extremely helpful for market sentiment. ECB President Mario Draghi, who replaced France’s Jean-Claude Trichet, cut interest rates by 25 basis points in November and by 25 basis points again in December to 100 basis points, supporting this view.
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. In addition to longer-term funding stress, the falloff in investment in European banks by U.S. money-market funds was a short-term stressor. 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 likely reduce returns and hurt their long-term profitability. This trend is also likely to apply to U.S. and other globally exposed banks.
The ECB lending program initiated towards the end of the year seemed to be successful and was received positively by investors. The ECB provided 489 billion euros in cheap three-year loans to European banks and lenders in the first tranche of “Longer Term Refinancing Operations (LTRO),” with additional funds available at the end of February. However, the belief that banks would use the cheap financing to purchase sovereign bonds, thereby pushing sovereign yields down, did not seem to play out in the fourth quarter.
At the time of writing this commentary, LTRO seems to be having a modest impact on sovereign yields to start 2012. In addition, the Standard & Poor’s rating agency downgraded the sovereign debt of France from AAA to AA+ with a negative outlook, a development long anticipated by the markets. As expected, the downgrade of France’s AAA rating led to a downgrade of the EFSF to AA+ as well.
Global Inflation Slows Toward End of the Year
In 2011, inflation became more of a focus for investors worldwide as food and energy prices increased globally in the first half of the year, causing concerns about global economic growth, especially in emerging economies. Crude oil hit 20-month highs during the first quarter in response to geopolitical instability in the oil-producing countries of the Middle East and North Africa. Another element impacting prices was 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 year.
However, the slow pace of global economic growth had a dampening effect on global inflation, allowing for global easing of monetary policies by central banks in the fourth quarter which, in turn, should help stimulate economic growth. Decreasing commodity prices are a positive for global economic growth in the near term, although the secular upward trend in commodity prices may persist in the long term, with emerging-market economies most severely affected since they rely more on commodity inputs for their fast economic growth.
China, which had been fighting inflation with a series of measures during the first half of the year, unexpectedly cut reserve rates for its banks on the heels of lower inflation numbers and lower-than-expected PMI data in the fourth quarter, 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 less orderly downturn in China’s economic growth will likely spell trouble for global economic growth. This, combined with the potential risk of a significant negative event in Europe, could serve as a further shock to investor confidence sometime in 2012.
In the United States, core inflation remained stable and low, allowing the Fed to maintain its stimulative policy of a near-0% interest rate. Inflation expectations in the United States 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.
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 2. Under the agreement, a special committee of lawmakers was tasked with finding another $1.5 trillion in reductions. The congressional "super committee" (the Joint Select Committee on Deficit Reduction) was not able to come up with a sufficient agreement on a package of spending cuts and tax increases by its November deadline. Although a backup package of spending cuts was to be automatically triggered if the committee failed to find at least $1.2 trillion in savings, it remains to be seen whether the previously agreed-to 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. government debt credit rating.
Despite the last-minute agreement, S&P followed through on its threat to cut the credit rating of U.S. government debt in light of the political indecision in Washington surrounding a concrete and credible 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. Investors also increased purchases of safer assets like gold and silver, with the price of silver setting several new 30-year highs during the year.
However, even before the downgrade, investors were 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 significant underlying causes of the equity market volatility during the third quarter.
U.S. Housing Market Bottoming Out
The U.S. housing market, an important piece of the puzzle in U.S. economic recovery, is likely to continue its bottoming-out process into 2012 with prices continuing to firm up and likely to improve in some regions, starting a long-term upward trend, which means housing would no longer continue to be a drag on the economy. Housing affordability in the United States is at an all-time high which, combined with a pick-up in rents, should help provide support for housing pricing. The 30-year fixed mortgage rate dipped below 4% in October for the first time ever, indicating that the Federal Reserve’s (Fed) "operation twist," designed to push longer-term Treasury yields down, is having that effect. However, while the refinance share of mortgage activity reached a 2011 high in the fourth quarter, financing for new borrowers is still hard to come by as banks’ lending standards remain high.
High foreclosed home inventories continued to dampen improvements in the housing market. Though foreclosure activity declined 34% in 2011 compared to 2010, much of the drop was attributed to delayed filings caused by documentation and legal issues and is expected to pick back up in 2012. An estimated total of over four million homes have been repossessed by banks in the past five years. RealtyTrac, the online marketer of foreclosed properties, expects the number of home repossessions to increase around 25% in 2012 from the more than 800,000 properties seized during 2011.
Financial Sector Regulation
The Financial sector continued to be held under the regulatory microscope throughout 2011. As part of the Dodd-Frank financial services reform, the U.S. Securities and Exchange Commission (SEC) 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. At the time of writing this commentary, the SEC has delayed implementation of the new fiduciary standard in order to conduct a more detailed cost-benefit analysis of its impact. If passed, this regulation could significantly impact the retail investment industry’s product offering and business model, with potentially negative implications for profitability.
Banks remained saddled with a variety of other issues as well, not the least of which was being ordered by regulators to pay back homeowners for losses on their foreclosed homes due to unsatisfactory loan documentation. Slow loan growth, balance sheets in need of restructuring to meet higher capital requirements, and long-term impairments and costs due to regulatory scrutiny and litigation added to the malaise. Additionally during the year, the Fed announced its intent to adopt the bank capital plans laid out in Basel III, an international regulatory framework for banks, which includes conducting annual stress tests.
Strong Corporate Earnings
In general, U.S. companies showed strength throughout the year, beating analysts’ estimates on earnings, and in many cases exceeding revenue forecasts as well. Nearly three-quarters of companies in the S&P 500 Index beat consensus earnings estimates for each of the first three quarters in 2011.
Cash-rich U.S. companies continued to look for sources of growth in 2011 and used their impressive cash reserves for mergers and acquisitions. Express Scripts agreed to buy Medco Health for $29.1 billion during the year, which was a significant premium over Medco Health’s stock market value prior to the acquisition announcement. Merger and acquisition activity continued with the announcement of one of the largest ever acquisitions in the energy industry, as Kinder Morgan offered to buy El Paso Corp. for $21.1 billion, a 37% premium. The acquisition would create the largest natural-gas pipeline operator in the United States. Additionally, Duke Energy agreed to buy Progress Energy for $13.7 billion. The combined company would become the largest U.S. electric utility. Also, Microsoft acquired Skype for $8.5 billion.
Continued Slow, Gradual Growth for the U.S. Economy
Despite the many risk pockets in the global market environment, the U.S. economy continued to proceed on the path of gradual recovery, driven primarily by continued health in earnings reports and macroeconomic data. Bank lending began improving while a weak U.S. dollar supported strong exports. The manufacturing-led recovery in the United States was complemented by improvements in consumer spending as the year progressed. The increased spending, however, seemed to be coming at the expense of a lower savings rate, with the U.S. savings rate at its lowest level in nearly four years. The combination of healthy manufacturing and consumer sectors of the economy will be the key to a self-sustained, robust economic recovery and continued earnings growth for U.S. companies.
Improvements in the household employment and temporary employment numbers were another welcome positive sign. The seasonally adjusted unemployment rate fell from 9.4% at the start of the year to 8.5% in December 2011 (and to 8.3% in January 2012), though some of the decline was due to a drop in the labor force participation rate. Unemployment claims in the United States were also slowing. The initial jobless claims four-week moving average was down to 375,000 at the end of the year—the lowest level since June 2008. We believe that these marginal improvements in the employment picture helped drive improvement in consumer confidence.
The health of U.S. consumer balance sheets also continued to improve, with consumer debt as a percentage of income declining, indicating that the consumer is deleveraging successfully. The quality of the U.S. government balance sheet, on the other hand, continued to deteriorate, with the U.S. budget deficit for the fiscal year ending September 30 reported at $1.3 trillion, the second-highest deficit level on record. Moreover, the U.S. policy stalemate in Washington continued to be frustrating and disappointing for both the country’s citizens and market participants. 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. At the end of December, Republicans finally agreed to a payroll tax break extension, albeit for two months instead of an entire year.
We believe that the market impact of a recession in Europe can be offset by economic expansion in the United States and emerging markets. We remain constructive on the U.S. economy and equity market going forward, especially given the strength of corporate earnings in the United States and the attractive valuation multiples of U.S. equities.
U.S. bank lending is improving. However, big bank risks in Europe that can impact systematically important U.S. institutions could upset that trend. A sustained recovery in U.S. financial stocks will continue to depend on orderly resolution of the European sovereign debt crisis. In 2012, significant portfolio underweights in the Financials sector, while beneficial over the past several quarters, will likely separate the “haves” from the “have nots” in investment manager alpha land.
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.
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.
As the U.S. economic recovery continues to gain momentum, smaller-cap names are likely to outperform large caps, while high-dividend stocks—the long-term darlings of investors—may lose momentum.
Similarly, the subsequent supply chain disruption caused by floods in Thailand may mean somewhat slower growth earlier in 2012 but is likely to have a positive multiplier effect later on as activity is restored and pent-up demand met. Overall, the debt crisis and recession (exacerbated by the fiscal drag from austerity measures) 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.
The downside risks for 2012 are some of the same issues we discussed over the past several months—European recession and a potential hard landing in China. Fiscal drag globally and in the United States will likely be a negative for global economic growth. Easing moves in several countries, especially within emerging markets, should provide some support for global economic growth. The U.S. economy, while not immune to the eurozone’s recession, seems to be gathering positive, self-sustained momentum. We expect these trends to continue well into 2012 with the United States likely outperforming other developed economies.
This commentary represents the opinions of the author as of 2/16/12 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.