A Strong Start to the Year in the Equity Markets
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
A good fourth-quarter earnings season and continued improvements in macroeconomic data continued to drive improvements in investor sentiment and the equity markets in February. Equities continued their good start to the year as inflation remained tame and central bankers globally continued to expand their balance sheets to unprecedented levels to stimulate their economies. For the month, the Standard and Poor's 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 4.32%, 4.39%, 2.39%, 5.77%, and 6.01%, respectively. Through the end of February, emerging market equities were up over 18% year to date, recovering somewhat from their particularly bad performance in 2011. Growth investment style significantly outperformed value style for the second consecutive month, with the Russell 1000 Growth Index returning 4.78% while the Russell 1000 Value Index returned 3.99%.
Within the Russell 1000 Index, the more cyclical information technology, energy, and consumer discretionary sectors were the top performers for the month, returning 7.25%, 6.05%, and 5.25%, respectively, while the materials, healthcare, and utilities sectors lagged.
Another Solid Earnings Season
With the quarterly earnings season almost over, the S&P 500 Index has surpassed 2011 highs and is not far off the levels last seen in May of 2008. While positive earnings revisions for the S&P 500 were not as good as in prior quarters, the top-line numbers driven by the economic recovery were more encouraging.
Through the end of February, 98% of S&P 500 companies reported, with 61% beating earnings estimates and 55% beating revenue forecasts. This important improvement in top-line performance is pointing to the sustainability of the positive momentum in the corporate sector. Aggregate earnings per share for S&P 500 companies grew 7.7% in the fourth quarter of 2011 compared to the fourth quarter of 2010 while declining 6.6% compared to the third quarter of 2011.
Gradual U.S. Economic Recovery Continues
In the U.S., improving jobs data were a significant boost to equity market performance in February with the welcome improvements in the unemployment rate compounding the positive effects from a reasonably good corporate earnings season. Markets reacted positively to the 243,000 gain in non-farm payrolls and the unexpected drop in the unemployment rate from 8.5% to 8.3%—the lowest number in three years—as well as strong private employment gains across all sectors. Initial jobless claims dropped throughout February with the four-week moving average of unemployment claims falling to 354,000. Continuing claims numbers also declined steadily during the month.
The manufacturing sector continued to provide significant support to the U.S. economic recovery. Regional manufacturing data for February came in better than expected, though at the time of this writing, new data revealed that the national manufacturing PMI unexpectedly slipped in February due to a slowdown in factory orders and shipments.
Housing market fundamentals continued to improve with prices stabilizing and housing activity improving, especially in multi-unit housing, with data on housing starts and building permits surprising on the upside. With mortgage rates at historic lows, confidence among U.S. home builders increased in February to the highest level since June 2007. This slow firming of the housing market environment is important as it assures that the sector, while not providing much growth, is not the drag on the economy that it has been for many quarters following the burst of the housing bubble. Data released by the Mortgage Bankers Association during the month also indicated that mortgage delinquencies and foreclosures ticked down slightly in the fourth quarter of 2011.
Consumer confidence, as measured by the Conference Board, surged to 70.8 in February, the highest level in a year, while other measures also indicated consumer confidence was increasing. Higher consumer confidence in the U.S. is being driven by better performance in the equity markets, stabilization in the housing market and a better employment picture.
Upward revisions to personal income growth in the third and fourth quarters of 2011 pushed the savings rate up significantly in those periods, allaying concerns that consumer spending was being fueled by dipping into savings, which would have been an unsustainable trend in the long run. However, personal incomes rose just 0.3% in January, while consumer spending increased only 0.2%. After adjusting for inflation, real consumer spending was unchanged for the third consecutive month. Retail sales and consumer spending still have room for improvement as oil and gasoline prices continue to stay high, weighing on consumers' ability to spend. Retail sales increased less than expected in January, though the International Council of Shopping Centers (ICSC) indicated February same-store sales were up 6.7% compared to a year ago.
Overall, key U.S. economic indicators continued to show gradual improvement, with the Leading Economic Indicators (LEI) Index increasing in January for the fourth consecutive month. Fourth quarter GDP was revised up to 3% from the previously reported 2.8% pace, and U.S. GDP growth forecasts are up to 2.3% for 2012.
The Fed and Potential Further Quantitative Easing (QE3)
Despite the visible improvements in the macroeconomic data, the U.S. Fed announced extension of its low interest rate policy through the end of 2014 and indicated that an additional set of asset purchases, or quantitative easing (QE3), is possible. If the U.S. economy continues on a path to recovery, QE3 won't be necessary and could possibly be harmful as excess supply of cheap money tends to create speculative bubbles that hurt the economy in the long run. The move appears to reflect the Fed's heightened focus on unemployment, which has become an increasingly important part of the Fed's dual mandate of price stability and maximum employment this election year. In his testimony before the House Financial Services Committee, Fed Chairman Ben Bernanke indicated that QE3 was less likely in the near term, but was still an option should the economic recovery stall.
If QE3 is in fact enacted, it will come on top of the unprecedented $2.3 trillion of bond purchases already done by the US Fed in the first two successful rounds of QE. "Operation Twist", announced in September of last year, has achieved its goal of lowering longer-term borrowing costs by replacing $400 billion of short-term debt in the Fed's portfolio with longer-term Treasuries. The yield on the benchmark 10-year Treasury note was about 1.98% at the end of February, down from 2.13% on September 1, 2011.
European Sovereign Debt Crisis
Europe continued to provide a negative backdrop to investor confidence and was a drag on the global economy, with European Union (EU) GDP coming in at a -0.3% annualized rate in the fourth quarter. Eurozone industrial production was also down and the unemployment rate in the eurozone reached 10.7%, the highest in 15 years. German exports and industrial production were down sharply in December in particular, while peripheral European economies continued to suffer from the austerity measures and a more severe than expected recession with consumers hit most. This underlying economic weakness is likely to continue to fuel the sovereign debt issues, although the introduction of the Long Term Refinancing Operation (LTRO) in December of 2011 seems to have reduced the investor perception of the probability of a tail risk event—such as a global financial crisis—for the time being. The second round of the LTRO resulted in loans of 530 billion euros to 800 lenders, with the combined LTRO assets totaling 1 trillion euros helping drive down yields on Spanish and Italian sovereign debt.
A tentative deal on the Greek bailout appeared to have been reached by all involved parties, with Germany agreeing to permit a full bailout, private investors accepting significant haircuts on their bond holdings, and the European Central Bank (ECB) agreeing to contribute its profits from purchasing Greek bonds at a deep discount. Markets seemed to expect that Greece would also likely be able to secure additional bailout funds from the IMF, although it is still not a sure thing and contagion in Europe is still a risk. Even though there were still questions to be resolved, the market participants responded to the Greek optimism favorably, driving up the prices of risk assets. However, the necessary fiscal austerity in the eurozone is likely to sharpen the economic crisis in the region, particularly in Greece, which may come back to haunt its credit standing.
Markets may be overly optimistic about China's agreement to buy up to $50 billion of bonds issued by the IMF. While China has indicated a willingness to invest in European securities designed to aid in the bailout, it seemed to be doing it quite cautiously in light of ongoing credit downgrades in Europe. Regardless of the outcome, China's involvement alone is unlikely to solve the European sovereign debt crisis.
Investors continue to focus on the symptoms of the EU sovereign debt crisis, EU sovereign debt spreads and policy solutions to the crisis. While these are important pieces of the puzzle, we believe that the crisis will not resolve itself even if these issues are addressed. The larger underlying drivers—the lack of effective, true fiscal and monetary integration within the union and, more importantly, the significant weakness of the underlying European economies exacerbated by the fiscal drag—are likely to make the EU crisis more protracted and severe than investors seem to currently believe.
Global Easing Cycle Continues while Geopolitical Risks Increase
Emboldened by generally tame inflation, the global monetary easing cycle has had a positive impact on the global economy, with central banks around the world making significant easing monetary moves in the past several months. In February, the Bank of Japan made such a stimulative move, announcing its intention to purchase $127 billion of bonds. On the flip side, the easing cycle is inflating the balance sheets of the world's six biggest central banks, which have more than doubled since 2006 to an unprecedented $13.2 trillion.
Continued low inflation and the global monetary easing cycle are supporting investors' optimism and forcing the risk-aversion trade into submission for the time being. The "fear index"—VIX, which measures equity market volatility—was down to 18.43 at the end of February from the high 40s in October 2011.
Geopolitical risks are rising, especially in the Middle East where Iran's nuclear ambitions are once again in focus. The shift of consensus on the global economic recovery to the positive, in combination with continued geo-political tensions in the Middle East, are pushing oil prices up. Oil reached a nine-month high in February and Brent crude exceeded $120 per barrel. A resulting rise in gasoline prices will likely continue to dampen consumer spending.
Despite the recent drop in the unemployment rate to a three-year low of 8.3%, concerns about weak labor force participation, and the slow rate of U.S. labor market improvement in general, seem to now be more in the forefront of Fed policy. The U.S. Fed has expressed a view that the unemployment rate may not improve further in 2012. While it is true that this severe and prolonged recession in the labor market may have caused some workers to give up on their search and prompted others to settle for part-time opportunities, we believe that there may be a silver lining to the short-term reduction in the U.S. workforce. While contractionary in the short term, there may be positive long-term benefits from the trend as a lot of the areas experiencing some of the bigger impacts are linked to the parts of the U.S. economy that were artificially inflated as a result of the real-estate and credit bubbles. This adjustment is healthy for the economy in the long run. In addition, there are significant demographic trends impacting the size of the workforce which may be difficult to quantify. Specifically, with baby-boomers entering retirement age, a higher retirement rate may be a part of what we are observing in the workforce participation data.
With such strong returns in the equity markets so early in the year and the earnings season practically over, we would not be surprised to see a temporary pull-back in equities, especially if some of the negatives in the global economic picture come into focus.
This commentary represents the opinions of the author as of 3/14/12 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.
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