Calvert News & Commentary

Focus on Equities for September 2013


Untitled Document

By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.

Natalie Trunow, CIO of Equities Natalie Trunow,
CIO, Equities

Later tapering by the Fed provided support to the markets in September...

Markets reacted positively to the Fed's decision to postpone tapering, even though the reason behind the decision was the Fed's desire to see more convincing data on economic growth. This hesitation followed a string of somewhat less exciting macro data in September, something that should have been a concern for the markets. However, the 'surprise' decision not to taper in September sent equities up and bond yields in retreat.

As markets digested the lack of QE taper—and largely gave back the equity gains won on the news—focus also returned to the Fed chair transition. With Larry Summers removing himself from consideration, President Obama nominated current vice chair Janet Yellen, whose nomination largely signals a continuation of current policy with little change.

The Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 3.14%, 3.49%, 6.38%, 7.42% and 6.53% respectively.

...but the relief is likely temporary as tapering may begin as soon as December and interest rates are likely to continue to creep up. In Equityland, higher dividend stocks are most vulnerable to this scenario..

Although the Fed fund rates are likely to stay low, we expect the asset purchases (probably not the MBS) to start being curtailed later in the year and gradually removed next year – an eventuality markets will have to get used to pretty soon. We continue to believe that bond and bond-like securities, e.g. stable value, higher-dividend-yielding stocks (e.g. utilities, telecom names) are particularly exposed to the creep in interest rates, especially because of their unprecedented popularity post-financial crisis and extreme historical valuations. The unwind from historical highs could prove painful for investors. This trend has already started in the utilities sector.

With political stalemate in Washington it's Déjà vu all over again...

The Government shutdown and debt ceiling impasse in Washington is fueling uncertainty and creating a negative feedback loop in the U.S. economy. Although labor conditions in the U.S. improved materially since the asset-purchase program began, recent reductions in public-sector employment were being felt in the July and August employment reports.

The U.S. Congress failed to approve a budget to fund the government beyond September 30, which resulted in the shutdown of the federal government. Equity markets appeared largely unconcerned with the event during September, despite the looming U.S. debt ceiling debate.

...Markets are nervous, driven by near-term uncertainty...

Interest-rate creep pushed mortgage rates up some, with a short-term negative impact on housing. Housing data was weaker in September, with housing starts, building permits, pending home sales, new home sales, and home prices all coming in flat-to-weaker than expected. consumer confidence and earnings may take a near-term hit.

Softer housing data during September was accompanied by poor retail sales and dampened consumer confidence.

Investment style matters. These days, equity styles seem to be driven by duration and interest rate expectations...

Style does matter a great deal. Growth style staged an impressive comeback during the month of September, rebounding with a vengeance, with growth stocks outperforming their value counterparts by 195 basis points. Within the Russell 1000 Index, early-cycle names outperformed defensives with industrials, consumer discretionary, and materials in the lead, while telecoms, utilities, and consumer staples lagged.

We believe, however, that this is a short-term reaction to better-than-expected tapering news and value names may recover and solidify their lead once the realization of imminent tapering and rising interest rates sinks in.

Once it's all said and done, however, U.S. economic growth is likely to continue...

which is good for the equity markets, but the fixed income asset class may continue to see volatility, especially given higher relative valuations compared to equities. U.S. initial jobless claims continue to inch downward and remain just above the 300,000 mark, continuing to set new post-financial-crisis lows.

Our long-term expectation for housing sector recovery continues to be one of the driving forces behind the improving U.S. economic growth forecast. Housing inventories are still very low and we believe that the positive multiplier effect derived by the economy from the housing upturn has long legs, and is likely to be felt for many quarters to come.

As discussed in prior outlooks, despite negative sentiment, the long-term drivers of economic recovery continue to gain strength. Investors continue to look beyond the headlines and focus on the coordinated global expansion currently unfolding both in the U.S. and abroad.

The path to recovery will not necessarily be smooth however. As demonstrated this month, key drivers of the recovery such as housing will see months where data appears soft. However, as long as the long-term trend continues to skew positive, equity investors will be rewarded. Manufacturing is pulling out of its seasonal slump and, while consumer figures have softened a bit, the broader trend of consumer balance sheet repair is well underway.

As confidence sets in at both the consumer and corporate level, we continue to expect consumers to increase spending and companies to expand capital expenditures and increase inventories. The sharp rise in rates that many feared would continue to 3% and beyond has tempered for the time being, and while consumers and companies alike must prepare for a rising rate environment over the medium and longer term, a gradual shift up will be regarded as a sign of an improving economy and not a near-term threat to growth.

Our ESG outlook...

for the next few months is less optimistic for the leading sectors but continues to be positive for ESG integration overall. Given our earlier comments in this piece with respect to interest rates and bond-like equities, we believe that some of the sectors that traditionally score low on ESG-metrics—like energy, commodities, and industrials—may snap back and outperform the rest of the market. This can hurt SRI investors from a sector allocation point of view. Higher exposures to IT and financial sectors may provide SRI investors some relief from this likely new trend. Another long-term trend we are observing is higher sensitivity of younger generations to environmental issues. Younger people are also less likely to buy a car than their parents and grandparents did at the same age. This means that the auto sector may see lower growth rates going forward.

Longer term, however, ESG factors and how they impact company valuations are likely to continue to garner more attention in the markets for a variety of reasons. U.S. consumers are more aware of, and educated about, ESG matters and how these issues impact their lives 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 related impacts, risks and opportunities.

...We also believe that ESG integration on an individual stock level is likely to produce increasingly positive results for investors...

For example, when we look at the electric utility, Portland General, we see management's missteps around social issues like indigenous peoples' rights as a reflection on the company's ability to sufficiently assess risks in their value chain. The company's miscalculation with regard to the Cascade Crossing transmission project reflected financially significant risks that we had already incorporated in our valuation models. It also signals enhanced strategic risk going forward.  The sector is in macro transition, with several peers also engaging in projects outside their traditional competency and also experiencing major problems. As the sector continues to evolve, Portland General's inability to effectively link its power-generating territories in the east to its areas of customer concentration in the west—without impacting Native American lands in between—effectively raises Portland General's strategic risk profile.

Governance issues also play a significant role in our company valuation work. For example, our review of American Tower's proxy revealed that over 70% of its CEO's compensation is determined by target incentives, led by revenue and EBITDA. The company's business model involves acquiring revenue-generating assets in sale-leaseback transactions. Typically, AMT acquires towers from wireless service providers, and leases space on those towers back to the service providers. Through this type of transaction, AMT management acquires revenues and EBITDA, raising debt in the process. The EBITDA measure particularly encourages management to acquire assets, or build assets rapidly, without a direct focus on shareholder value. The stock tends to trade higher for a time upon making acquisitions, though the longer-term risk profile for the name will increase upon large acquisitions.

This commentary represents the opinions of the author as of 10/16/13 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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