June 2012 Equity Market Commentary
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Progress on the policy front in Europe helped drive a relief rally in the global equity markets in June with a bounce seen in equities across the board. For the month, the Standard and Poor's 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 4.12%, 3.83%, 4.99%, 7.05%, and 3.91%, respectively. Value stocks outperformed growth names, with the Russell 1000 Value Index returning 4.96% while the Russell 1000 Growth Index returned 2.72%, though growth stocks remained firmly in the lead for the year to date.
Within the Russell 1000 Index, telecommunication services, healthcare, and energy were the top performing sectors during the month while consumer discretionary, information technology, and industrials sectors lagged.
Temporary Relief in Eurozone Sovereign Debt Crisis, but Recession Deepens
The eurozone remained the epicenter of weakness in investor sentiment throughout June as data released during the month continued to point to a deepening recession in the region. Core European economies continued to show signs of weakness, indicating they are not immune to the crisis engulfing the region. German and French manufacturing PMI remained firmly in contraction territory in June while German bond spreads relative to U.S. Treasuries stayed wide. German retail sales also declined unexpectedly in May and Germany's unemployment data came in worse than expected. This mirrored the overall worsening unemployment picture in the region with unemployment in France rising to 9.6% in the first quarter of 2012, the highest rate since 1999 and up from 9.3% in the prior quarter, and Greek unemployment rose to 22.6%. The United Kingdom also has been experiencing a significant drop in economic activity.
Despite some promise of progress on the policy front in Europe, the underlying economic fundamentals in the region continued to deteriorate. Â Eurozone manufacturing PMI sank further into contraction territory and the June reading of the Eurozone Index of Economic Confidence was the lowest since October 2009. Data for industrial production and construction output also declined considerably. Meanwhile, eurozone Core Consumer Price Index CPI was 1.6% in May, while headline CPI was 2.5% on a year-over-year basis. Deflation in Europe is not out of the question, which could be a significant problem.
The banking crisis accelerated in Spain during the month with the country's financial system badly in need of a capital injection. Spain hoped its banks would be allowed to tap European Stability Mechanism (ESM) funds directly without additional austerity measures rather than having to seek a full bailout similar to those accepted by Greece, Portugal, and Ireland.
Eurozone officials agreed to a €100 billion bailout for Spanish banks. However, despite opposition from the IMF, the debt still went through the government, which will increase Spain's debt load. Not surprisingly, both Moody's and Fitch credit agencies downgraded Spain's credit rating by three notches while investors responded to the country's "admission" of the problems in its banking sector by pushing yields up even higher on Spanish sovereign debt. Concern also continued to mount that bailouts of eurozone countries that subordinate private government bond holders to official creditors were having the adverse effect of scaring away investors from the sovereign bond market, which could further accelerate and exacerbate the sovereign debt crisis and the likelihood of contagion.
The New Democracy party emerged victorious in the much-anticipated Greek elections mid-month and was able to form a coalition government. The election results were followed by a global sigh of relief hoping Greece would adhere to the international bailout agreement, though the outcome does not change the underlying problems affecting the Greek economy and the eurozone as a whole.
After much nervous anticipation, market participants responded to the glimmer of hope coming from the European leaders' two-day summit held at the end of June with what looks like a short-term relief rally. Viewed by many as the region's last chance to come up with concrete measures to combat the eurozone sovereign debt crisis, there were some important breakthroughs with Germany appearing more flexible on many of the proposed solutions.
There was broad agreement to create a single bank supervisory body for the eurozone which would eventually allow bailout funds to recapitalize banks directly rather than first being channeled through the government, a move that would reduce Spain's debt burden once implemented. The leaders also announced that Spain's bailout loans would not receive preferential treatment over private creditors. Additionally, talks focused on more immediate steps to address rising borrowing costs of Spain and Italy with further details expected to be finalized in the coming weeks. The 10-year yields on Spanish and Italian government debt responded favorably by declining at the end of the month. We believe that these stepsâ€”while important and heading in the right direction—are just that, steps toward, but not a resolution of the crisis. This will be a long process that will continue to challenge countries, politicians, and markets in the short- to medium-term.
Gradual Recovery in the U.S. on Track, but Downside Risks Remain
While the overall economic picture in the U.S. continued to be positive, some economic indicators have begun to be impacted by the economic recession in Europe and a slow-down in the emerging markets. U.S. manufacturing activity in particular showed signs of slowdown during the month, likely driven by near-term uncertainty about policy outcomes domestically as well as the tumultuous global economic landscape. As of this writing, the release of the ISM National Manufacturing PMI for June indicated manufacturing activity shrank for the first time in nearly three years. Additionally, U.S. factory orders data reported during the month showed an unexpected decline in April, while the prior month's decline was revised down as well. This represented the first consecutive monthly declines in factory orders since February/March of 2009.
At the same time, the U.S. service sector continued to show signs of recovery. The ISM Non-Manufacturing Index increased slightly in May, rising to 53.7 from April's 53.5. This was a particularly encouraging development as the services sector represents a larger portion of the economy than does manufacturing.
The U.S. consumer also continued to show signs of recovery. Consumer credit increased $6.5 billion in April, the eighth consecutive monthly increase, while revolving debt, which includes credit cards, fell by $3.4 billion, pointing to continued improvement in the health of consumer balance sheets. Personal incomes rose 0.2% in May, in line with expectations. The International Council of Shopping Centers chain store sales figures increased 1.7% in May on a year-over-year basis. Real consumer spending was up 0.1% as prices fell more than anticipated and sales of motor vehicles remained strong.
The U.S. CPI declined 0.3% in May from the prior month, a slightly larger drop than anticipated, and was 1.7% on a year-over-year basis compared to 2.3% in April. Core CPI, which excludes the more volatile food and energy components was 0.2% compared to the prior month and 2.3% on a year-over-year basis, in line with expectations. The Producer Price Index (PPI) also declined 1% in May, a significantly greater drop than forecast, and was just 0.7% on a year-over-year basis. Gasoline declined 8.9% on a month-over-month basis, contributing to the unexpected large drop. These data support the low inflation expectations and should allow the Fed to continue with quantitative easing initiatives if necessary.
On the jobs front, initial jobless claims increased throughout June, rising to 387,000 at the end of the month. The total number of job openings, while down from the prior month, remained high, indicating firms may be reluctant to hire new employees due to both global and domestic economic and political uncertainty. As a result, recent net job growth figures were driven more by the drop in layoffs than a pickup in hiring, a phenomenon also observed last year. We believe that hiring is likely to resume once pending policy measures clear political hurdles and companies have better visibility for the next several quarters.
Consumer confidence numbers reported during the month were also weaker but the Index of U.S. Leading Economic Indicators (LEI) still managed to increase 0.3% in May, exceeding expectations.
Moody's downgraded the credit ratings of 15 global banks, including several of the largest U.S. banks. Morgan Stanley, Goldman Sachs, J.P. Morgan, and Citigroup were all downgraded two notches, while Bank of America was cut one notch.
Housing Activity Continues to Pick Up
The residential housing market in the U.S. continued to show signs of improvement in June with historically low mortgage rates and low home prices supporting housing activity. Given the significant size of the U.S. housing market and its impact on consumer wealth, confidence, and, indirectly, spending, any good news is doubly good for the U.S. economy as it leverages the positive impact on consumers, which represent two-thirds of the U.S. economy. Confidence among homebuilders, particularly in the West and Midwest regions, reached a five-year high in June.
Building permits surged in May, rising 7.9% on a month-over-month basis and exceeding expectations by a wide margin. Sales of previously owned homes were up 9.6% year-over-year while the Federal Housing Finance Agency Home Price Index increased for a third consecutive month in April, rising 0.8% from March.
Sales of new homes also surged in May, rising 7.6% from the prior month to a 369,000 annual rateâ€“a twoâ€“year high. As a result, inventory of new homes declined to 4.7 months of supply, the lowest since 2005, while the median sales price increased 5.6% on a year-over-year basis. Pending home sales were also strong.
The S&P/Case-Shiller 20-City Composite Home Price Index increased 0.67% in April on a month-over-month basis. Although April's prices were still down 1.9% from the same period one year ago, this represented the smallest year-over-year decline since November 2010.
A low dollar has also been contributing to improvement in U.S. housing activity. According to data released during the month by the National Association of Realtors, international buyers accounted for 9% of total spending on residential real estate in the U.S. over the trailing 12-month period ending in March of this year. This represented a 24% year-over-year increase in sales to international buyers, who have been taking advantage of the weak dollar and historically low U.S. home prices.
More Accommodative Policy by the Fed as Global Easing Cycle Continues
Statements from the U.S. Federal Reserve during the month communicated an increased concern about downside risks to the U.S. economy stemming from the European crisis. While the Fed still seemed to expect a continuation of a slow, gradual recovery in the overall U.S. economy and labor market, low inflation in the U.S. and globally has left room for the Federal Reserve to continue its accommodative monetary policy.
The FOMC announced an extension of "Operation Twist" through the end of the year, whereby the Fed will continue purchasing Treasuries with longer maturities while selling short-term securities in an effort to further reduce long-term interest rates. The Fed also lowered its near-term growth and employment forecasts.
Outside of the U.S. the global easing cycle continued with the Reserve Bank of Australia cutting its benchmark interest rate by 25 basis points and the Bank of England announcing a $150 billion liquidity program during the month.
Risk of Hard Landing in China Increases
The Chinese economy continued to show signs of slowing growth during the month. Since Europe is a large trading partner for many emerging market economies, especially China, the negative spillover effect on those economies from the European sovereign debt crisis and economic recession should not be underestimated.
The HSBC China Manufacturing PMI remained in contraction territory in June at 48.2, down from 48.4 the prior month while industrial profits in China were down 2.4% year-to-date through May compared to the same period one year ago, the second consecutive month with a year-over-year decline. Also worrisome, a New York Times article published during the month claimed China deliberately misstated economic data to understate the true economic slowdown and its impact on the Chinese economy. It is therefore possible that the "hard landing" scenario is already in play and may take investors by surprise.
The Chinese government has responded with easing measures as the People's Bank of China cut its benchmark one-year bank lending rate by 25 basis points to 6.31%, signaling a shift to an accommodative monetary policy. The move was received positively by investors and helped ignite a rally in global equity indices.
Nevertheless, a hard landing in Chinaâ€”a more probable outcome than ever beforeâ€”would have a significant negative impact on the global economy and investor sentiment. Commodities markets will likely be hit hardest.
We believe that the relief rally following the European Union Leaders Summit at the end of the month, while a welcome sign, may be short-lived, as eurozone policymakers' promises are yet to be backed up by timely actions, and a whole range of upcoming policy decisions in the U.S. won't be resolved until later this year. Once we have more visibility into the "fiscal cliff" scenarios, however, market participants may feel better about investing in risky assets for the long term.
In the U.S., we believe that the housing sector can provide a positive surprise and support for the consumer and the economy overall, and that many market observers are not yet anticipating this scenario. If true, this will help investors gain the confidence in U.S. equities that we have all been waiting for.
The U.S. Supreme Court upheld President Obama's healthcare law, known as the "Affordable Care Act." Despite the decision, healthcare is likely to remain a hot topic during election season and may make it more difficult for a budget deal to be reached prior to the "fiscal cliff."
For the rest of the summer, however, policy issues will be in focus as they could trigger further U.S. credit rating downgrades and further erode investor sentiment.
With the fiscal cliff looming and political stalemates still firmly a part of the landscape, the threat of another U.S. credit rating downgrade is likely, and volatility in the equity markets is here to stay at least through the fourth quarter and until after the presidential election.
We continue to believe that the next few months should afford investors attractive entry points, especially in U.S. equities, where underlying fundamentals are still robust.
Overall, while a global economic slowdown is likely having a marginally negative impact on the U.S. economy, the U.S. is still likely to continue its slow expansion for the time being.
This commentary represents the opinions of the author as of 7/13/12 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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