Calvert News & Commentary

Worries About U.S. Debt Weighed on Equity Markets in July


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

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

The uncertainty about the debt ceiling and a possible downgrade of the credit rating of U.S. debt, combined with worries about European sovereign debt problems and a lackluster U.S. economic recovery, weighed on equity market sentiment in July.

After months of partisan gridlock in Washington, U.S. political leaders finally reached an agreement and enacted legislation to raise the debt ceiling on August 2—the date on which the U.S. Treasury said that it would have been unable to meet its obligations if a deal on the debt ceiling hadn’t been reached (also the date this article was written). The deal will raise the debt ceiling through 2013 in two installments, with at least $2.4 trillion in spending cuts over 10 years ($900 billion initially). Under the agreement, a special committee of lawmakers will be tasked to find another $1.5 trillion in reductions. A backup package of spending cuts is automatically triggered if the committee fails to find at least $1.2 trillion in savings.

We had expected that some kind of agreement would be reached before the deadline, avoiding a default on U.S. government debt. However, the risk premium attached to U.S. Treasury securities may increase anyway, pushing yields and borrowing costs up in the long run.

All major equity indices globally continued to fall during the month of July, though most equity indices were still up for the year through July 31. The Standard & Poor’s 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -2.03%, -2.17%, -3.61%, -1.57%, and -0.38%, respectively. In July, the three top-performing sectors in the Russell 1000 were Energy, Information Technology, and Utilities, while Industrials, Telecommunication Services, and Health Care lagged. Energy and Information Technology were the only economic sectors in the Russell 1000 to eke out a positive return for the month, with Energy now back in the lead for the year-to-date period, although not by as wide a margin as it was earlier in the year.

Growth stocks are also firmly in the lead as the Russell 1000 Growth Index outperformed the Russell 1000 Value Index again this month with returns of -1.00% and -3.32% respectively. For the year through the end of July, the Russell 1000 Growth Index was up 5.76% while the Russell 1000 Value Index was up 2.40%.

Strong Start to Earnings Season

Earnings season is upon us and, through the end of July, 77% of the S&P 500 companies that had reported beat their earnings estimates for quarter, with the Technology sector reporting strong earnings. Google, Apple, and AMD beat analysts’ estimates by wide margins on both earnings and revenue, contributing to the sector’s leading performance for the month.

Additionally, cash-rich U.S. companies continued to use their cash reserves for mergers and acquisitions. During the month, Express Scripts agreed to buy Medco Health for $29.1 billion, which was a significant premium over Medco Health’s stock market value prior to the acquisition announcement. Apple is also rumored to be considering a purchase of Hulu, an on-line TV service.

Growth Slow but Sustainable

The macro picture, while still firmly on investors’ minds, is becoming less of a concern with the acceleration of the earnings season in the U.S. and the resolution of the U.S. debt ceiling saga.

Data released during July showed that fewer than expected jobs were added and the unemployment rate climbed back up to 9.2% as of June. This employment data will continue to depress consumer confidence and spending for some time. We believe, however, that this setback in job creation may be driven in part by the supply chain disruption in Japan earlier in the year and is likely to recover in the second half of the year. Payroll tax breaks for U.S. companies should also play some role in job creation later this year as well.

Markets were disappointed to learn during the month that Federal Reserve Chairman Ben Bernanke does not see a need for QE3 at this point. While a new quantitative easing program could help the economy, we believe that the Fed’s current posture signals its comfort that economic growth, however slow, is self-sustainable, and we believe that economic growth through private-sector activity is healthier than growth prompted by stimulus. However, if government spending cuts are large enough and are enacted too quickly, they could slow economic growth by as much as 1% to 2% and negatively impact unemployment. In a similar dynamic, recent gains in private employment were offset to a large degree by job losses at the federal, state, and local government levels.

One of the stronger headwinds to economic growth, the housing market, seems to be stabilizing, which should provide a considerable boost to consumer confidence. Home prices at the lower end of the spectrum are showing some signs of bottoming out and firming up. The continued trend of increasing rent prices is also positive for housing prices.

Debt Ceiling Negotiations

U.S. policymakers continued to “play with fire” by failing to come to a concrete agreement for raising the U.S. debt ceiling during July. Political posturing ensued despite apparent recognition by both parties that if the political impasse caused the U.S. to default on its obligations, however briefly, or to lose its AAA (S&P) credit rating, the economy and jobs would be seriously jeopardized. The Moody’s and S&P credit rating agencies warned that the credit rating on U.S. debt may be cut because of the political indecision in Washington about a concrete plan for deficit reduction.

Nevertheless, both bond and equity markets seemed to indicate that while there was a short-term hiccup due to the lack of a resolution to the debt ceiling debate, long-term expectations have not been significantly impacted by the prospects of either a short-term default or a U.S. debt credit rating downgrade.

However, some of the ripple effects of a potential U.S. debt downgrade were beginning to be felt in the mortgage REITs market with a rise in repo rates. Mortgage REITs were down 7% for July.

Eurozone Sovereign Debt Crisis

In addition to measures announced this month by European policymakers allowing the $635 billion rescue fund to buy the debt of peripheral European nations, eurozone banks pledged to be part of a bond exchange and debt buyback package which will write down Greek securities by 21% and give Greece $229 billion of new funds. The move will cost Europe’s largest banks close to $30 billion. The package is likely to trigger a default rating on Greece’s debt from Fitch Ratings, which warned that such action could result in a “selective default” rating. The action will not, however, trigger payments on credit default swap contracts.

The European banking sector may be further hurt on earnings as European Union bank earnings exclude potential write-downs of $14 billion on Greek debt. Overall, the risk of contagion in Europe is still elevated with Spain and other peripheral European countries very much in the danger zone and facing tough choices in restructuring their economies. The second round of bank stress-tests in Europe concluded in July with five Spanish banks failing the tests and seven more passing by a narrow margin. Further consolidation in the European banking sector is likely to follow and, in the longer run, banks may shift to holding less risky assets which will reduce returns and hurt their long-term profitability. This trend is likely to apply to U.S. and other globally exposed banks.


While the economic growth in the first half of the year has been slow and certainly below consensus expectations (first-quarter 2011 GDP growth was revised downward to only 0.4%), we still believe that there is room for a pick-up in growth in the second half of the year. Some of the shortfall in the first half of 2011 was related to the ripple effects of the global supply chain disruptions caused by the events in Japan. Some of the economic activity lost as a result of those events is likely to be coming back on-line in the second half of this year, which should help boost GDP growth. Specifically, auto manufacturing and sales can improve in the second half of this year and add to GDP growth. Exports could also provide a boost to GDP with the trade-weighted dollar at record lows.

It looks like the budget deal has enough spending cuts and indirect tax increases to potentially avoid a downgrade in the credit rating of U.S. debt. Although this is no great bargain that will bring the budget deficit under control any time soon, it is a step in the right direction for the long term. In the short term, there will be a negative impact on GDP growth from decreases in government spending and indirect tax increases, which will need to be offset by a pick-up in private sector activity and possibly new targeted spending initiatives. This will likely be negative for the equity markets in the short term. In the long run, however, better clarity about the future direction of the debt issue may remove the uncertainty and help private-sector activity. While we may see more volatility in the short term and potentially a further sell-off in the equity markets, we believe that there is a possibility of an upside GDP growth surprise later in the year. We see a double-dip recession scenario as avoidable at this juncture.

This commentary represents the opinions of its author as of 8/3/11 and may change based on market and other conditions. The author’s 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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