Focus on Equities for July 2013
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Trending in July
- U.S. equities posted their strongest monthly performance since October 2011
- The U.S. economy continued to buck the trend of a global growth slowdown
- We continue to believe that U.S. small-cap stocks can sustain their recent recovery and outperform their large- cap counterparts.
July 2013 Major Index Returns
|Standard & Poor's 500||5.09%|
|MSCI Emerging Markets||1.73%|
U.S. macroeconomic data released during the month continued to confirm that U.S. economy is on a path to a self-sustained recovery despite the negative impacts of the sequester. The second- quarter gross domestic product (GDP) number came in at a better-than-expected 1.7%, improving on the first-quarter growth rate of 1.1%. As we anticipated, most of the negative impact of the sequester was frontloaded and most impactful in the first half of the year.
In July, equity markets saw the strongest monthly performance of domestic equities since October 2011. Investors focused on positive corporate earnings reports and improving domestic macroeconomic factors while focusing less on continued weakness in global economic growth. Most equity markets recovered from the June sell-off induced by the tapering scare despite lingering concerns over economic challenges in the eurozone and slowing growth in China, although emerging markets didn't rebound as much. For the month, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 5.09%, 5.35%, 7.00%, 5.62%, and 1.73%, respectively. Value and growth stocks performed largely in line with each other, with only slight outperformance on the value side this month. Within the Russell 1000 Index, the health care, industrials and materials sectors were the strongest performers, while telecoms, consumer staples, and utilities lagged.
Top-Line Growth and Low Expectations Help Earnings Sentiment
With strong year-to-date performance in equities, the start of the second-quarter earnings season in July provided a sigh of relief to investors braced for any sign of weakness in corporate growth. By month end, over half of the companies in the Russell 1000 had reported. After almost no revenue growth in the first quarter, companies reported aggregate sales growth of 4%, with the strongest growth coming in the consumer discretionary, financials, and utilities sectors. The consumer discretionary sector continues to be strong, driven by recovering consumer balance sheets post-financial crisis and aided by the convincing recovery in the housing market where inventories remain at historic lows.
Continued downward earnings revisions for U.S. corporations helped 70% of companies that have reported so far post positive earnings surprises, a trend that has lasted for several quarters, albeit with a lower margin. We believe that going forward, better-than-expected economic growth will be key to maintaining healthy earnings results for U.S. corporations.
U.S. Economic Improvement Slow but Steady
"...most data point to continued recovery in the housing market despite increases in mortgage rates from historic lows."
With growth fears ranging from Europe to Asia, U.S. macro indicators continue to support the theme that the U.S. is continuing to buck the trend of a global growth slowdown. While U.S. GDP was revised downward for the first quarter, second-quarter GDP surprised to the upside at 1.7%. June payrolls defied subdued expectations and posted a repeat of May's 195,000 jobs added, while initial jobless claims have settled into a range similar to pre-financial crisis levels.
On the housing front, data has softened slightly from June levels, but most data point to continued recovery in the housing market despite increases in mortgage rates from historic lows. Weak existing home sales were largely offset by new home sales. Housing starts and permits surprised to the weak side but were largely driven by multi-family housing, while single-family starts and permits were essentially flat. Prices as measured by the S&P Case-Shiller 20 City composite fell in May, but were masked by a strong run-up in prices that lasted a year and a half, driving the index up north of 12%. Despite the disappointment relative to expectations, May's home price increase was still the highest monthly increase since 2005. We believe that historically low housing inventories will continue to support price recovery in the housing market.
Investors maintained a close eye on Federal Reserve (Fed) policy statements throughout July but were rewarded with little new information related to the size or timing of a tapering of the Fed's quantitative easing (QE) program. At month end, Fed Chairman Ben Bernanke reiterated the policy of purchasing $85 billion of Treasury and mortgage-backed securities per month while noting that persistently low inflation could hamper economic growth.
China Puts the Brakes On
In July, the People's Bank of China (PBOC) communicated a policy focused on prudent monetary policy and stabilization of growth in investment and foreign trade. Manufacturing numbers were indeed better but may not stay in positive territory consistently. The Chinese leadership lowered its 7.5% growth target to 6.5%, a worrisome trend with negative implications for global economic growth and the materials and industrials sectors.
China's leadership continues to attempt a soft landing. Following the lending crisis in June, which saw interbank lending rates shoot up to record levels, China reaffirmed that money supply and credit levels had returned to normal. China's leaders did caution, however, that efforts to slow parts of the economy that had grown too quickly would continue. To that end, China ordered more than 1,400 companies across 19 industries to curb production, especially those related to basic materials and other industrial inputs. As a result, U.S. companies dependent on growth in the Chinese economy are likely to underperform the market.
"U.S. equities remain attractive both relative to
other asset classes and relative to global equities."
While the consensus remains convinced that tapering can start as early as September, we feel that it is less important whether the Fed starts tapering in September or later in the year. What we believe is more important is the fact that the stimulus will gradually be withdrawn, interest rates will gradually increase, and the U.S. economy will have to perform on its own, which we believe it is now well-positioned to do. This should breathe new confidence and optimism into securities markets.
We believe that the U.S. economy can accelerate further in the next six to12 months, beating consensus estimates by overcoming the negative impact of the sequester and the impending withdrawal of economic stimulus by the U.S. Federal Reserve.
We also believe that, with risk aversion subsiding and signs of recovery becoming more convincing, U.S. corporations are likely to increase capital expenditures, which should help boost productivity and further support economic recovery in the long run. We continue to believe that U.S. small-cap stocks can continue their recent recovery and outperform their large- cap counterparts. At the same time, higher dividend yielding securities may face the same headwinds as the fixed-income asset class.
U.S. equities remain attractive both relative to other asset classes and relative to global equities. We believe that we may be entering a secular upward trend in U.S. interest rates, which should benefit equities. U.S. equities are especially attractive relative to fixed income by historical norms, which should provide an additional boost to the asset class through asset flows in the next three to five years, barring significant adverse events.
China will remain a significant focus and driver of equity markets. Any signs of a hard landing, housing market collapse, or political instability will send ripple effects across global securities markets. Profitability in the economy remains quite low, with profit margins continuing to shrink post financial crisis. Chinese consumer sentiment is waning, leaving less hope for local consumer-driven economic growth away from export-driven sectors. With Europe still in recessionary mode, we don't expect Chinese exports to recover in the near future.
Problems abound globally, but U.S. gains in the private sector, housing, and employment are likely to continue to lift consumer and investor sentiment as well as provide a real base for continued economic growth and market appreciation in the long run.
As the second-quarter earnings season winds down, however, investors will place renewed focus on things such as QE tapering, a changeover at the helm of the Fed, sequester drag, and continued global growth weakness. As a result, we may see some short-term volatility and profit- taking post earnings season, which could amount to a temporary pullback of 5% to10%. We view these corrections as welcome signs of a healthy market and opportunistic entry points, as the market may be discounting too rosy a picture too soon (we have not seen such a persistent up-market move through July since the late nineties).
ESG Integration Factors Key to Valuation
In this volatile and uncertain environment, we continue to believe that environmental, social, and governance (ESG) factors will gain importance in determining a company's market valuation. 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.
This commentary represents the opinions of the author as of 8/9/13 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. Calvert may have acted upon this research prior to or immediately following publication. In addition, 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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