Third Quarter 2012 Equity Market Review
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Despite the continued economic and sovereign debt crisis in the eurozone and a material slowdown in the emerging markets, particularly in China, global equity markets were strong in the third quarter due to a better-than-expected corporate earnings season in the U.S. and the continued global monetary easing cycle. There were some promises of stabilization in Europe, but equities mainly responded to increasing speculation about possible Federal Reserve action regarding a third round of quantitative easing (QE3), which materialized in September. For the quarter, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 6.35%, 6.31%, 5.25%, 6.98%, and 7.89%, respectively. Value stocks slightly outperformed their growth counterparts during the quarter with the Russell 1000 Value Index returning 6.51%, while the Russell 1000 Growth Index was up 6.11%.
Within the Russell 1000 Index, Energy was the top-performing sector in the third quarter but was still lagging considerably on a year-to-date basis. Consumer Discretionary and Telecommunication Services were the other top-performing sectors, while Consumer Staples, Industrials, and Utilities sectors lagged.
Better-Than Expected U.S. Corporate Earnings Favor Small-Cap Companies
Equity market performance at the start of the third quarter was driven to a large extent by U.S. corporate earnings announcements, as well as some negative earnings pre-announcements. While 66% of S&P 500 companies beat earnings estimates, the top-line results were less than stellar, with 41% of companies topping revenue forecasts and reported revenues rising just 0.7% on a year-over-year basis.
Smaller-cap companies outperformed their large-cap counterparts in terms of earnings growth and revenue surprises, which helped small-cap stock prices outperform in August and September. U.S. large-cap, multinational companies with large earnings exposures to Europe and emerging markets are the most vulnerable to a significant slowdown in global economic growth, though softer earnings for U.S. companies are likely to result in more realistic earnings expectations going forward, paving the way for better stock market performance later in the year and possibly into 2013.
U.S. Economy Continues Gradual Recovery Despite Global Economic Slowdown
U.S. economic data continued to show signs of softness during the quarter, though the economy's overall trajectory remained positive. U.S. manufacturing, the driver of the U.S. economic recovery in the past four years, continued to show signs of slowing, weighed down by the global economic slowdown and particularly the softer growth in China. The ISM Manufacturing Purchasing Managers Index (PMI) was in contraction territory for three consecutive months before unexpectedly expanding in September, in contrast with the weakness exhibited in some of the recent regional manufacturing surveys. Demand for autos has also remained strong, an encouraging sign.
On the jobs front, payroll data released during the quarter indicated that U.S. private businesses were in "wait-and-see" mode again this summer before any policy resolutions get passed and before they can have more visibility into 2013. Public sector employment continued to contract, but the unemployment rate managed to tick down to 8.1% in August, though the decrease was unfortunately due to a large drop in the labor force. As of the time of this writing, the unemployment rate had dropped to 7.8%, an encouraging sign for the labor market. Continuing claims also steadily declined throughout the quarter, indicating the overall unemployment environment may continue on a very slow path to recovery.
The ISM Non-Manufacturing Index rose to a three-month high in August, a welcome sign as the U.S. service sector represents a larger part of the economy than manufacturing. Although the U.S. consumer continued to be negatively impacted by high unemployment, consumer spending patterns remained promising. Consumer confidence, helped by strength in the housing and equity markets, has also been showing signs of improvement.
Inflation remained tame, which helped consumer confidence and kept the global easing cycle on track. However, market participants are anticipating a rise in food prices over the next few months as the impact of the Midwest drought earlier in the year takes effect. Gas prices have already been rising for some time.
U.S. second-quarter GDP growth was revised down from 1.7% to 1.3% because of farm inventories being significantly lower than initially estimated. The GDP numbers were negatively impacted by a decrease in government spending, while the private sector posted a respectable growth rate, a promising development.
Fed Continues Monetary Easing Policy
Throughout the quarter, the Federal Reserve (Fed) maintained that it was ready to act should economic conditions in the U.S. deteriorate and warrant further action. Speculation regarding potential stimulative action by the Fed, referred to as the "Bernanke put," helped push equities higher during the quarter.
Citing concern over the lack of improvement in the job market, the Federal Open Market Committee (FOMC) announced a third round of quantitative easing (QE3) in mid-September, making an open-ended commitment to purchase $40 billion of mortgage-backed securities each month until substantial improvements in the labor market are seen. The FOMC maintained that the Fed's accommodative stance would remain in place even after the economic recovery showed signs of strength, while also extending their zero-interest-rate policy (ZIRP) to at least mid-2015.
U.S. Housing Activity Continues to Pick Up
With mortgage rates at record lows, the housing market continued to recover during the quarter. As we have commented for several months now, housing can provide a positive surprise for the U.S. economy and equity markets through the powerful multiplier effect it can have on the economy through the consumer. Along with equities, housing is a significant driver of consumer wealth and confidence, and any incremental pickup in activity and the overall health of the housing market cannot be underestimated.
Confidence among U.S. homebuilders has reached a six-year high while the number of foreclosed homes for sale has now fallen considerably, providing some support for home prices. Other data released during the quarter continued to show increases in sales of both new and existing homes with housing starts and building permits posting solid gains.
Eurozone in Recession Despite Some Progress on Policy Front
In the eurozone, data released during the quarter confirmed the region, including its core economies, is in recession. Eurozone GDP contracted at a seasonally annualized rate of 0.2% in the second quarter on a quarter-over-quarter basis and shrank 0.5% on a year-over-year basis.
Manufacturing PMI in the region fell further into contraction territory, consumer confidence in the eurozone reached its lowest level since early 2009, and the unemployment rate was at a record high.
Inflation continued to fall at the onset of the third quarter, which was a positive for further monetary easing as the European Central Bank (ECB) cut interest rates 25 basis points to 0.75%. The Bank of England (BOE) also launched another round of quantitative easing in a measure to stimulate economic growth. However, inflation in the eurozone increased more than forecast in September, which may limit the ability of the ECB to introduce additional easing measures.
With the Spanish economy continuing to fall into deep recession and pressure mounting on Spain's financial institutions, the yield on 10-year Spanish debt surged above 7.5% in July; however, the yield gradually fell back below 7% as the ECB signaled it would intervene to preserve the euro and may return to buying government bonds. Yields on Spanish and Italian government bonds continued to decline later in the quarter as investors responded favorably to the ECB's open-ended commitment to purchase sovereign debt. Although details of the program will need to be finalized, this represents a promising step in addressing the region's sovereign debt crisis.
Greece's coalition government reached a deal on a new austerity package as the country awaits the decision by international creditors on whether the next tranche of Greek bailout aid will be released.
The German Constitutional Court ruled in favor of the European Stability Mechanism (ESM), clearing the way for the bailout fund to be operational by mid-October. However, despite some positive developments, the eurozone's policy solutions continued to be fraught with challenges. There were questions as to whether the ESM would be able to directly recapitalize banks on legacy loans, meaning Spain's banks would not be able to access funds directly. Implementation of the proposed European Banking Union also appeared to likely take longer than initially planned.
Overall, we see the eurozone's troubles as having a continued negative impact on earnings of larger-cap U.S. and Chinese companies with heavy exposures to Europe.
Hard Economic Landing in China More Probable
China continued to weaken, impacted to a large degree by deteriorating export revenues. While Chinese inflation remained tame, the economic slowdown in China has been quite severe, and, as we have commented in the past, a hard landing in China is not out of the question. China's economic slowdown is already impacting global economic growth and corporate earnings (especially for commodity-related and manufacturing companies) as well as emerging markets, while making the overall macroeconomic backdrop riskier for the next several quarters.
Chinese real GDP increased 7.6% in the second quarter, the slowest pace in more than three years. Foreign direct investment (FDI) in China also continued to decline as investors may be losing confidence in China's growth story, and China's HSBC Manufacturing PMI has been in contraction territory for eleven consecutive months
Statements by Chinese officials during the quarter confirmed they would increase fiscal and monetary policy easing to stabilize economic growth in the second half of the year. The People's Bank of China (PBOC) lowered the one-year deposit rate by 25 basis points and also cut lending rates while boosting the discount banks can offer on loans, demonstrating China's shift to monetary easing in the face of a slowing economy and cooling inflation. We believe that the non-performing loan issue that plagued Chinese banks in the past may become an issue again, causing further stress on the economic system.
Our medium- and longer-term forecast remains the same, calling for potentially choppy equity markets for the next few months with significant downside risk. The outlook could possibly turn positive once policy measures due later this year are enacted, the U.S. presidential elections are behind us, and better visibility into 2013 helps improve investor confidence.
We believe that the U.S. economy can continue to grow despite external growth shocks once the fiscal cliff and the policy issues in the U.S. are resolved. As global economic growth continues to slow, the U.S. remains one of the few areas of positive growth, recovering consumer and housing sectors, and enviable corporate health.
The global economic slowdown is negatively impacting the manufacturing sector, highlighting the importance of a continued rebound in consumer spending. Our forecast is that further improvements in the housing sector can help further improve consumer confidence, which in turn can support consumer spending at levels sufficient for economic recovery in the U.S.
It is clear that the eurozone's economic troubles are not anywhere near being resolved, although market participants seem satisfied with the promised policy response for the time being. We view the current state of calm regarding Europe as temporary, with concerns likely to flare up again and cause market volatility in the near future.
We see continued challenges in the global macro backdrop leaving equity markets vulnerable to negative news, especially given that most of the positive catalysts, including QE3, are now out and the markets had a healthy run. Any negative news from Europe and/or China, or negative earnings announcements in the U.S., will likely trigger a risk aversion trade.
This commentary represents the opinions of the author as of 10/10/12 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.
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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