Focus on Equities for August 2013
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
The overall global economic picture continues to be challenging, although we expect global economic growth to improve in the long run, with the U.S. in the driver's seat...
U.S. economic indicators were largely flat to weak at the outset of August, but finished on a positive note, with second quarter GDP (annualized) revised upward from 2.2% to 2.5%.
U.S. employment data continues to improve, more recently showing notable strength in the service sector. Unemployment claims data continue to post new post-financial crisis lows. Particularly encouraging is the fact that improvements in employment have come from the private sector of the economy, where productivity and contribution to future economic growth is the largest. If the employment cuts in the public sector hadn't occurred, unemployment rate figures would likely have been significantly better.
Consumer confidence in the U.S. is at its highest level since the start of the recession. Gains in household wealth from rising housing prices, equity markets and improvements in the employment picture play a significant role in this trend.
The S&P/Case-Shiller 20 City composite showed that housing price gains have yet to soften in the face of fears surrounding rising mortgage rates.
The sequester continues to have a negative impact on the economy, particularly the defense sector, but its effects should dissipate later in the year.
U.S. manufacturing, which has been a weak spot most of the year, saw signs of life this past month, with an ISM Manufacturing readout of 55.4, better than expectations and the highest level since June of 2011.
...While Europe and China show signs of stabilization...
Europe is still in a recession. The European Central Bank revised its GDP growth projections for 2013 from -0.6% to -0.4%, but the region's economy is still shrinking.
Despite rumors of a third Greek bailout and other negative headlines, data out of Europe showed signs of improvement in August. While Germany continues to remain the growth engine in the region, the peripheral economies are finally starting to show improvement, with forecasted GDP expected to turn positive for all but Greece by mid-2014. The region remains plagued by persistently high unemployment however, indicating that recovery will continue to be fragile, prone to volatility and susceptible to political challenges and social unrest.
The Chinese economy seems to be stabilizing. August saw several positive developments: the manufacturing sector saw its first flash PMI increase in five months, along with improved retail sales.
Markets will likely continue to be nervous about tapering of QE3 in the U.S...
Fears of the U.S. Federal Reserve tapering its quantitative easing (QE) program and fears of conflict in the Middle East had negative impacts on market psychology in August.
The month of August saw a short-term return of volatility to markets. Large-cap U.S. equities pulled back less than 3% for the month. Weakness in U.S. macroeconomic data was largely offset by improvements in Europe and Asia.
Meanwhile, for the month, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -2.90%, -2.76%, -3.18%, -1.27%, and -1.69%, respectively. Growth stocks saw a strong reversal of their underperformance relative to value stocks. Within the Russell 1000 Index, early cycle names dominated, with materials, technology, and energy as the strongest performers, while financials, utilities, and consumer staples lagged.
...With potential additional challenges coming from the next earnings season...
The second-quarter earnings season saw both a return to revenue growth—a welcome sign—and an improvement in earnings growth over the prior quarter. Unlike past quarters, in which investors focused solely on top-line growth or beating EPS expectations, those companies that beat on both the top- and bottom-line performed best in the second quarter, while those missing on both metrics did worst. This suggests a returned focus on company fundamentals and likely a positive environment for active managers going forward.
Sounding a cautious note, however, several bellwether companies that reported late in the season, including Wal-Mart and Cisco, reduced their forward guidance, citing everything from consumer weakness to fears of rising rates.
But our market outlook remains positive at this juncture...
The U.S. economy is on a self-sustained path to recovery with more robust economic growth, which will be necessary for continued earnings growth for U.S. companies. We continue to believe that the U.S. economy can accelerate further in the next six to 12 months, beating consensus estimates and overcoming the negative impact of the sequester, and the impending withdrawal of economic stimulus by the U.S. Federal Reserve.
Despite summer softness, we believe that the U.S. economy will continue to recover and pick up steam over the next six to 18 months, and support the continued improvement of corporate revenues and earnings. This should be positive for the equity markets.
As confidence sets in at both the consumer and corporate level, we expect consumers to continue to increase spending and companies to expand capital expenditures and increase inventories.
Rising interest rates can be a negative for the economy and the housing market but even more importantly, a disorderly increase in rates can cause markets some indigestion. Having said that, even with the anticipated increases, rates remain at historically low levels and an increase in rates at the long end of the curve to 3% or 4% can be easily absorbed by an accelerating U.S. economy.
Despite the long-term positives, investors should expect (and welcome) volatility in the fall as a sign of a healthy market, with some profit taking possible. Near-term dangers include conflict in the Middle East and another round of debt ceiling battles in October and November. We see these short-term pullbacks as attractive investment opportunities for long-term investors.
...With the market favoring smaller cap and cyclical names, high-yield, "bond-like" securities are likely to continue to suffer in the rising rate environment...
High-dividend-yield stocks tend to have lower earnings-growth profiles and are likely to underperform in an accelerating economic growth environment. Despite the sell-off earlier this year, these stocks are still quite expensive following an almost five-year period of risk-aversion trade and "search for yield" by investors in the aftermath of the financial crisis. Stocks with lower absolute levels of dividend yields but higher growth rates in dividends are likely to fare better.
...The global ESG picture continues to grow in importance, driven by an unprecedented flow of information, consumer awareness and technological improvements.
Our ESG integration process is designed to merge "values and valuation" while leveraging Calvert's well-developed edge in gathering and analyzing sustainability information. We believe that integrating ESG information into investment decisions and considering the impact of these factors on companies' global value chain and supply-chain issues is becoming increasingly important and relevant and results in an advantaged investment thesis.
On a positive ESG note for August, China's shift from coal to cleaner sources of energy got a boost with Beijing's approval of the first floating terminal for liquid natural gas (LNG).
General interest in, and attention to, environmental, social, and governance (ESG) factors and how they impact company valuations has been picking up this year. One of the drivers for this transition is the new four-year mandate for the Obama administration in the United States, which should give the president the political capital to drive for significant growth in green jobs and alternative energy. In addition, there have been many relatively small advances in government regulations relating to ESG over the last few years that haven't yet made a big impression on investors. However, we expect to see the aggregation of these incremental advances in ESG regulation beginning to have a larger positive effect in 2013 and beyond.
More importantly, U.S. consumers are more aware of and educated about ESG matters and how they 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.
This commentary represents the opinions of the author as of 9/24/13 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.
Calvert Investment Management, Inc., 4550 Montgomery Avenue, Bethesda, MD 20814