Second-Half 2013 Outlook: Calvert Chief Investment Officer Roundtable
Calvert’s chief investment officers (CIOs) foresee market volatility but think that the U.S. economy will continue to grow even as the Fed tapers down its monetary stimulus.
Calvert Fixed-Income CIO Cathy Roy and Equities CIO Natalie Trunow recently discussed their outlooks for the financial markets in the second half of 2013. They gave their opinions on subjects including the Fed's QE tapering, the growth rate of the U.S. economy, sources of volatility from areas outside the United States like Japan and Europe, and the growing emphasis on ESG factors in the markets.
Federal Reserve (Fed) Chairman Ben Bernanke's June statements about the impending tapering and eventual end of the Fed's quantitative easing (QE) program triggered a sell-off and volatility in both bonds and equities. What are your views on the Fed's QE exit strategy and the implications for markets in the second half of 2013?
Cathy Roy: We are anticipating that the Fed will announce the actual start of QE tapering at the December Federal Open Market Committee (FOMC) meeting. The risk, of course, is that the Fed could start cutting back on its QE bond purchases earlier in the year, potentially announcing it in the September FOMC statement.
As various Fed officials have tried to make clear since Bernanke's statement about tapering on June 19, the timing of any QE tapering is very dependent on how the economic data looks going forward. However, markets never like uncertainty, so I expect bond market volatility to stay elevated for much of the second half of the year. The markets also seem to be having a difficult time differentiating between the upcoming end of QE and the timing of when the Fed will eventually hike interest rates; although the Fed has tried to clarify that there is no connection between the two, this issue could also contribute to continued volatility in bonds.
Natalie Trunow: When the economic data showed enough strength in late spring to make it possible for the Fed to begin QE tapering sooner rather than later, equities dropped as a natural result of discounting less aggressive future stimulus from the Fed. Another dynamic that contributed to the sell-off in equities in late June was that stocks had posted very impressive returns for the year through May, and some investors simply took the opportunity to sell and book their profits.
On a broader level, the Fed wants to telegraph to the markets that the QE tapering will be gradual, and I think that they've done a good job of doing that so far. It would become increasingly difficult for the Fed to keep up its $85 billion per month pace of QE buying, and the Fed can't wait until the economy reaches a target unemployment rate, for example, and then abruptly stop its QE purchases. Most importantly, I believe that it is the volatility of interest rates that the Fed will be managing through its actions and statements, not just the level of interest rates. I think this is important because a sharp spike in interest rates could cause disorderly activity in the securities markets and negatively impact the housing market, which is a key driver of the U.S. economic recovery.
Once interesting aspect of the rise in interest rates is that, if the increase is well-telegraphed and gradual, it could motivate some prospective real estate buyers to purchase before rates move higher. However, if interest rates jump abruptly, that would likely make potential buyers pause in hopes of a short-term pullback in mortgage rates. The housing sector has a strong multiplier effect on the U.S. economy and impacts broader economic growth.
What is your outlook for the U.S. economy in the second half of 2013? Could another partisan battle over raising the debt ceiling derail economic growth?
Natalie Trunow: The U.S. economy, unlike most of the rest of the world, seems to be on a path of self-sustained recovery. I don't think that the impact of the sequester or the withdrawal of the Fed's monetary stimulus will prevent the U.S. economy from continuing on that path. Corporate earnings continue to be relatively healthy. The job market has been improving, and I anticipate that it will continue to improve—however, it can't improve quickly enough for those who are unemployed. In fact, further improvements in the unemployment rate will continue to depend heavily on the workforce participation rate. If more unemployed people who are not currently seeking work think that conditions have improved enough to resume their job search, that could keep the unemployment rate elevated. I think that the U.S. jobless rate could drop to 6.7% later in 2014 if the economy continues to grow at its current pace.
Importantly, the private sector of the economy has been showing steady gains, especially relative to the public sector, which bodes well for long-term employment. These improving economic fundamentals in the United States should make another credit rating downgrade less likely.
Cathy Roy: We anticipate that U.S. economic growth will stay relatively sluggish in the second half of the year with gross domestic product (GDP) probably growing at a rate of about 2% plus or minus 0.5%. I agree with Natalie that there is definitely a risk that higher interest rates could threaten consumer spending in interest-sensitive areas like housing, but I don't think that rates will rise enough to pose a risk to economic growth. Inflation has been very low, and we don't see inflation rates rising in the near future.
I don't foresee a repeat of the debt ceiling debacle of the summer of 2011, when the political standoff over raising the debt ceiling caused Standard & Poor's to downgrade its credit rating on U.S. government debt. However, there is always the possibility that a brief political scare could impact the markets in the fall of this year when we get close to the debt ceiling. The Tea Party conservatives seem less interested in holding the country hostage now than they did two years ago, but who knows for sure?
Natalie Trunow: I also believe that the upcoming political debate about raising the debt ceiling has the potential to create some market volatility, but I don't think that it will be a major problem as it was in 2011. The U.S. political environment seems a little bit less contentious now. On a related subject, I think that the sequester, which is the result of the debt ceiling agreement from two years ago, will have its strongest effects on the U.S. economy during the third quarter of 2013. However, I also think that the economy is strong enough to overcome the negative effects of the sequester and keep growing.
Outside the United States, there was considerable volatility in Japanese markets in the first half of 2013, but investors didn't seem as concerned about the eurozone. How do you think Japan and the eurozone will fare in the second half?
Cathy Roy: The recent volatility in Japanese government bonds that resulted from the Japanese government's massive QE program definitely created some volatility in other bond markets, and I think that it should also create some flows into U.S. bonds as Japanese institutional investors look for stability. The sharp move upward in Japanese government bond yields in April set the stage for a move higher in bonds issued by other governments—including Germany, the United Kingdom, and the United States—to maintain their values relative to each other. This was happening before Ben Bernanke's June 19 announcement about QE tapering, which greatly accelerated the move upward in U.S. Treasury yields. After their jump higher, Treasury yields started to pull yields on other sovereign debt upward.
Natalie Trunow: The initial spike in Japanese stock prices that occurred after the Bank of Japan's announcement of the giant stimulus program was too abrupt to be sustainable. Most major international investors were underweight Japan relative to their benchmarks before the announcement, so their rush to get into Japanese companies and probably some short-covering contributed to the price jump. The selloff that followed the spike in the Japanese stock market shows that investors haven't yet equated the announcement of major monetary stimulus with a successful implementation of that stimulus. However, going forward I think that markets will give Japan the benefit of the doubt and that the country has a good chance of outperforming other developed countries as a result of the expansionary QE program.
The eurozone, on the other hand, is still a mess, with recessionary pressures likely to be stronger than investors anticipate. I don't think that equities investors have punished eurozone markets as a whole enough to adequately reflect this. There could be a sell-off in eurozone stocks if investor sentiment turns more negative later in 2013 and into 2014. However, for active managers, there could be some good buying opportunities in some European stocks.
Cathy Roy: Although the odds of a euro collapse have certainly diminished since European Central Bank President Mario Draghi's July 2012 commitment to do "whatever it takes" to save the euro, there is definitely a chance that eurozone events could move back to the forefront of investors' consciousness later in 2013. For example, the outcome of Germany's federal elections in September, when Angela Merkel will try for a third term as German chancellor, could easily impact fixed-income markets. The polling results leading up to the German elections could also move markets. In any case, negative news out of the eurozone would probably create demand for less-risky assets, including U.S. Treasuries.
How do you see environmental, social, and governance (ESG) factors impacting the markets going forward?
Natalie Trunow: For a variety of reasons, ESG factors and how they impact company valuations have been getting more attention in the markets. U.S. consumers are more aware of and educated about ESG matters and how these issues impact themselves and the economy. This is positive for both the U.S. economy as a whole and for companies that are poised to benefit from the push toward improvements in ESG factors—as well as for portfolio managers who can identify those trends and benefit from them. We believe that Calvert's specialization in ESG integration and active portfolio management puts us in a good position to find the companies that manage their ESG impacts sustainably. Calvert's legacy in ESG allows us to have a differentiated view on companies, and it is becoming increasingly clear that ESG factors will continue to play a more meaningful role in companies' fortunes and investors' assessments of impacts, risks, and opportunities related to those factors.
For our internally managed portfolios, Calvert uses a multi-pronged ESG integration process for equities analysis designed to merge values and valuation while leveraging Calvert's well-developed edge in gathering and analyzing sustainability information. Our equities integration process starts with a firm understanding of the secular forces driving sustainability's expanding impact on companies' valuations. We assess global value chain information, such as potential supply chain bottlenecks, using a framework that involves over 98 ESG and regulatory factors in each major geography. Calvert's equities and sustainability analysts collaborate on management contacts and other portions of company research. The equities analysts apply ESG information, both quantitative and qualitative, to the appropriate segments of the company valuation process. We believe that the result is an advantaged investment thesis coupled with an enhanced ability to move ESG integration forward into the mainstream.
Cathy Roy: Along the same lines, ESG issues are becoming increasingly important to consider when trying to determine the value of a corporate bond, for example. Calvert's credit research process combines fundamental analysis with an assessment of ESG factors. Our team of credit analysts examines the financial condition of corporate bond issuers as well as the structure, terms, and covenants of specific bond issues. From a fundamental research standpoint, the credit analysts collaborate closely with Calvert's sustainability research department analysts to evaluate a bond issuer's ESG risks. This robust ESG integration process helps us identify, and may lower the risks associated with, ESG factors across the fixed-income portfolios.
Cathy, what is your outlook for interest rates in the second half of 2013? Which areas of the fixed-income markets look attractive?
Following the quick increase in long-term interest rates in late June, we actually think that rates could stay relatively stable for the balance of 2013. We still believe that the 10-year Treasury yield will likely stay in a range of 35 to 40 basis points1 above or below the 2% level. In fact, the 10-year Treasury yield of about 2.65% in early July was at the top of what we see as the likely trading range for the 10-year note and could represent a buying opportunity. As I mentioned earlier, negative news out of the eurozone or geopolitical events could push risk-off money back into Treasuries, causing yields to drop. Also, we think that inflation will stay well below 2%, so there will likely be very little upward inflationary pressure on rates.
Both investment-grade and high-yield corporate bonds sold off significantly in late June, but at least part of the drop in those markets was likely the result of technical factors such as forced selling to meet redemption needs. The fundamentals supporting corporate credit, including the generally strong financial condition of many corporate issuers and continued low default rates, haven't changed, so we anticipate a rebound in the corporate debt market in the second half of the year. Within corporates, the financial and banking sector has outperformed in the last year or so, and we believe that it has room to continue to outperform since banks can do well in a low-rate or rising-rate environment.
We're also aware that there are significant risks that could throw the U.S. economic recovery off track or disrupt the fixed-income markets. The recovery in the housing market, which seems to be building up momentum, could be derailed by higher interest rates. Outside the United States, more volatility in the Japanese markets or an escalation of the problems in the eurozone could create volatility in the U.S. bond market. Of course, interest rates could move significantly higher, although we think that is unlikely. However, to offset this risk, we plan to keep the durations2 of our portfolios shorter than the durations of their benchmark indices to help mitigate the negative price effects of rising interest rates.
Natalie, where do you think equities markets will go in the second half? What types of equities seem to offer the most value now?
I think that the U.S. stock market could have a correction of 5% to 10% from the very top in 2013, but the economic fundamentals are improving—so later in the year the market should find a bottom and start recovering. As we predicted at the beginning of this year, value stocks outperformed growth companies in the first half of 2013, and small-cap shares outperformed large caps. I believe that both small caps and value stocks have room to continue to outperform in the second half. Small caps typically do well in an economic recovery, and the U.S. economy is really just starting to be able to stand on its own two legs and recover without massive Fed stimulus. Smaller-capitalization stocks should benefit from that as well as the fact that their earnings are less leveraged to the health of overseas economies. As the risk-aversion trade continues to subside, small caps should continue to benefit. On the flip side, stocks that pay higher dividends are likely to continue to suffer from lower risk aversion in the equity markets.
Looking outside the United States, I see promise in emerging markets in the long run, but more volatility and underperformance is likely in the second half of 2013. Good stock selection is becoming increasingly important in these developing countries. I never bought into the idea that emerging markets have decoupled from developed markets, although we are no longer in the contrarian camp on that issue. Prior to the financial crisis of 2008 and 2009, economic growth in the United States and Europe had been driving growth in emerging markets. Since then, however, growth in both the United States and, in particular, the eurozone has slowed considerably. The decoupling premise—self-sufficient local emerging-market economies driven by local consumer demand—hasn't panned out. There is simply not enough local demand in emerging markets quite yet to offset the lack of demand from developed markets when they slow down. Most developing countries don't have the sufficient economic, legal, and regulatory systems needed to form a solid middle class, which is the key to self-sustained local demand. As a result of all of these factors, I think that good stock selection through active management will become essential to successfully investing in emerging markets.
1. A basis point is 0.01 percentage points.
2. Duration measures a portfolio's sensitivity to changes in interest rates. Generally, the longer the duration, the greater the change in value in response to a given change in interest rates.
This commentary represents the opinions of its authors as of 7/25/13 and may change based on market and other conditions. The authors' 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.
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