May 2012 Equity Commentary
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Despite a good corporate earnings season, softer U.S. economic data, and a lack of visibility with respect to the upcoming policy measures surrounding the expiration of the Bush tax breaks, the payroll tax holiday, and debt ceiling negotiations, kept investors on edge in May. The worsening recession and the continuation of the sovereign debt crisis in Europe and the slowdown in China also continued to drive investor sentiment down and encouraged movement out of risky assets during the month. Both equities and commodities were down with oil trading at a seven-month low, U.S. stockpiles high, and Saudi Arabia pumping the supply up. U.S. and German bonds were in high demand as investors’ flight to safety intensified. For the month, the Standard and Poor’s 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -6.01%, -6.15%, -6.62%, -11.35%, and -11.16%, respectively. Value stocks held up better than growth names in May, with the Russell 1000 Value Index returning -5.86% while the Russell 1000 Growth Index returned -6.41%.
Within the Russell 1000 Index, the more defensive telecommunication services, utilities, and consumer staples sectors were the top performing sectors during the month, while the energy, financials, and materials sectors lagged.
Eurozone Sovereign Debt Crisis Intensifies
The European crisis continued to intensify during the month with economic recession deepening and the sovereign debt crisis threatening financial system contagion in the region. Eurozone unemployment increased to 10.9% in March from 10.8% the previous month, already a 15-year high. While the German economy continued to help offset declining GDP in peripheral European economies during the month, most of the eurozone is now in recession. At the same time, eurozone CPI in April indicated a 2.6% year-over-year increase, down from 2.7% the prior month but still greater than forecast.
Eurozone manufacturing PMI fell to 45 in May, the lowest reading since June 2009, from 45.9 the prior month. The services PMI also fell more than forecast, declining to 46.5 from 46.9 in April. These data clearly point to the continued disconnect between investor expectations and the economic realities in the region.
Even more worrisome, the weakness in manufacturing was led by declines in Germany and France manufacturing PMI. Data released during the month also indicated Germany’s capital investment, construction investments, and domestic demand all declined more than forecast in the first quarter of 2012. As we anticipated, the eurozone’s core economies are being further infected by the severe recession in the peripheral European countries, where the sovereign debt crisis is far from subsiding and the banking system is still at risk of contagion.
Spain in particular came back into focus. As evidenced by investor actions last year, the ability of bond vigilantes to significantly increase sovereign debt spreads for countries in economic trouble could further intensify the sovereign debt crisis. The yield on 10-year Spanish sovereign debt continued to increase and hovered around 6.5% at the end of the month as pressure mounted on the country’s financial institutions. The Spanish government had to nationalize Bankia, Spain’s fourth-largest bank, as Moody’s downgraded the credit ratings of 16 Spanish banks. Since Spain is simply “too big to fail” and too interconnected, it is hard to imagine the rest of the eurozone not experiencing serious aftershocks from any trouble that may be brewing in Spain.
French and Greek voters made it clear they want some relief from the austerity measures by supporting “pro-growth” political parties. French voters elected Socialist Party candidate Francois Hollande as president, choosing a leader who vowed to incorporate growth-boosting measures across the eurozone and scale back the austerity measures built into the region’s Fiscal Compact. Greek voters also overwhelmingly rejected the two main parties in the outgoing coalition, instead casting votes for more extreme far-left and far-right parties, an outcome that led to a political stalemate with the country’s political parties unable to form a coalition government. New elections set for mid-June are shaping up to be a referendum on Greece’s status in the eurozone. The country’s creditors, especially Germany, held firm that Greece must keep its austerity pledges in exchange for bailout funds needed to avoid a looming potential default. Meanwhile, the run on Greek banks accelerated during the month and Fitch downgraded the sovereign debt of Greece deeper into junk territory, cutting it one rating to CCC from B-. The probability of Greece’s exit from the eurozone continues to increase, with potentially unforeseen ripple effects in the eurozone.
Discussions continued on how growth policies might be enacted in the eurozone, but little was put forth in terms of concrete proposals. European Central Bank (ECB) President Mario
Draghi revealed that ECB officials didn’t even discuss a potential rate cut during the most recent meeting and there were no major announcements from the eurozone leaders’ summit held at the end of May, though France’s new president, Francois Hollande, joined Italy in calling for the introduction of eurozone bonds. Things seemed to be somewhat on hold until the Greek elections, set for June 17.
Gradual Economic Recovery in the United States
The manufacturing sector continued to provide a boost to employment and the U.S. economy, although some of the data this month were mixed. The Empire State Manufacturing Index unexpectedly increased to 17.1 in May from 6.6 in April, indicating that manufacturing in the New York region expanded more than forecast. However, the Federal Reserve Bank of Philadelphia’s General Economic Index was surprisingly weaker in May, declining to -5.8 from 8.5 the previous month. This was the first time manufacturing in the Philadelphia region contracted since September 2011. At the time of this writing, the national manufacturing PMI came in at 53.5, signaling continued economic expansion, but missed expectations of 53.8 and was slightly off of last month’s reading of 54.8. Meanwhile, vehicle sales remained strong and April’s industrial production increased by the most since December 2010. Capacity utilization and business inventory data also remained strong.
With the services sector still in recovery, the most recent data were not as robust. The ISM Non-Manufacturing Index dropped more than forecast in April, declining to 53.5 from 56 the prior month.
The pull-forward of economic activity due to unseasonably warm weather earlier in the year, as mentioned in earlier commentaries, continued to dampen economic data, including hiring and consumer spending. At the time of this writing, the unemployment rate had ticked up from 8.1% to 8.2% in May. The change in non-farm payrolls was disappointing, although public sector jobs accounted for a large portion of the losses. Additionally, U.S. GDP grew at a 1.9% annual rate from January through March, down from the previously estimated 2.2%.
Personal incomes in the United States increased a modest 0.2% in April, while consumer spending advanced 0.3%. Real consumption also increased 0.3%, while the savings rate dropped slightly to 3.4%. All of these data point to continued slow economic recovery in the United States, though investors seemed to focus more on the worse-than-expected employment numbers rather than the increases in consumer spending and incomes in April. With fewer jobs being created than expected and sluggish income growth in the United States, we expect the recovery in the consumer sector to continue to be slow.
Gasoline prices softened during the month, providing another source of support for the U.S. consumer. Confidence among U.S. small businesses rose to a 14-month high in April and consumer confidence as measured by the University of Michigan Consumer Sentiment Index rose to 79.3 in May, the highest level since October 2007.
Data reported during the month also indicated consumer credit rose by $21.4 billion in March, the largest advance in more than 10 years and far greater than the $9.8 billion consensus forecast. The increase was driven by a surge in student loans, while auto loans and revolving debt, which includes credit cards, also showed solid growth. Growth in unused credit lines at U.S. banks with more than $20 billion in assets, a potential gauge for future increases in business lending, also increased 17% year over year in the fourth quarter of 2011.
J.P. Morgan acknowledged $2 billion in trading losses stemming from inadequate risk management at the firm and the market moving against its derivative positions (bets) linked to corporate debt. This headline is likely to intensify debate over the Volcker rule, which limits banks’ ability to trade with their own capital and is set to take effect in late July pending agreement on the final details. Despite this being a significant setback for the banking industry, we believe that the U.S. banking system is generally in much better shape than its European counterparts. Having said that, the Volcker rule and increased regulatory scrutiny of the banking industry will likely make the industry less profitable from a historical standpoint.
U.S. Inflation and Potential for QE3
Inflation in the United States remained low, leaving room for the Federal Reserve to do another round of quantitative easing. Having said that, we believe that the overall macroeconomic data reported so far this year supports the notion that the U.S. economy is on a self-sustaining path to recovery and may not need further monetary stimulus.
The release of the most recent Federal Open Market Committee (FOMC) minutes during the month also suggested there was little change to the Fed’s stance. Officials reiterated they were prepared to step in with an accommodative policy should economic conditions deteriorate, but did not believe further action was warranted at this time. This “Bernanke put” has been providing support for U.S. equity markets so far this year as investors rely on future liquidity injections in the event the economy falters.
Housing Activity Continues to Improve Slowly
On the housing front, most data continued to point to an improving environment in the sector. Mortgage applications, as measured by the Mortgage Bankers Association (MBA) Mortgage Applications Index, increased throughout the month while the National Association of Home Builders (NAHB) Confidence Index increased to 29 in May, representing the highest level of confidence among home builders in five years. With mortgage rates already at historic lows, the average rate for a 30-year fixed mortgage dipped to 3.75% during the month, setting another record low.
Housing starts as well as both new and existing home sales increased in April from the prior month, while the national median existing home price was up 10% from the same period one year ago, representing the largest year-over-year gain since January 2006. The national mortgage delinquency rate dropped to a seasonally adjusted 7.4% in the first quarter of 2012, the lowest level since 2008, though the percentage of mortgages in foreclosure remained little changed from the prior quarter at 4.4%.
Growth in China Slows
In China, the economic slowdown continued with the reading for China’s HSBC Manufacturing PMI indicating further contraction in May, declining to 48.4 from 49.3 in April. This was the seventh consecutive month with the HSBC Manufacturing PMI below 50. The official China PMI for May also dipped to 50.4 versus a consensus expectation of 52. In another potential sign of China’s slowing growth and cooling demand for commodities, reports surfaced during the month that Chinese commodity buyers were deferring or defaulting on their obligations to accept coal and iron ore deliveries, causing coal and iron ore prices to decrease as a result.
China’s exports and imports both rose less than expected in April, impacted by weakness in Europe and a slowdown in domestic consumption. The country’s industrial production increased 9.3% in April, well below the 12.2% consensus forecast and down from an 11.9% gain the prior month, increasing the likelihood of fiscal policy easing measures. China’s new yuan loans and M2 money supply also increased less than anticipated. Home prices in China also continued to fall in April, indicating that the housing bubble in that country may be bursting. This could exacerbate the potential hard landing there.
In the United States, the overall economic picture continues to be positive. Gradual improvement in housing activity—one of the biggest drivers of the U.S. economy—is encouraging.
Our view remains that—despite solid economic and earnings data in the United States—the quickly approaching fiscal cliff, the end of operation twist, and pending policy actions in the second half of the year which are surrounded by uncertainty will likely cause some market volatility. The United States, once again, may face a credit rating downgrade from rating agencies should political paralysis ensue. Unfortunately, we are unlikely to avoid choppiness in the equity markets until after the conclusion of political negotiations (which are likely to go to the “11th hour” again) surrounding the U.S. budget ceiling; the expiration of the Bush tax breaks, payroll tax breaks, and extended unemployment benefits; and the conclusion of the U.S. presidential elections. Overall, the sovereign debt crisis and economic recession in Europe as well as potential fiscal cliff shocks to the U.S. economy accompanied by a contentious political process will likely deal a blow to investor psychology in the next several months and could prompt the Fed to use the remaining few monetary weapons in its arsenal as early as June. Having said that, we believe once the seasonal compensation in economic activity is finished, the U.S. economy should be able to continue to expand gradually. If we do see more stimulus from the Fed this summer, it (along with the political stalemate) may trigger another credit rating downgrade of U.S. government debt, which in turn could have similar implications to those we observed last year.
At that point, and possibly after another threat of a U.S. government debt credit rating cut, the skies may finally clear up for a longer-term recovery in the equity markets. Having said that, we remain quite positive on the long-term (three- to five-year) prospects for U.S. equities and view potential near-term volatility as a buying opportunity given the attractiveness of current equity valuations and the health of U.S. corporate earnings.
This commentary represents the opinions of the author as of 6/8/12 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.