2013 to be a Year of Transitions for Equities
Stocks are poised to overcome risk aversion and political dysfunction as ESG factors gain more attention in 2013.
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Equity markets started 2013 having gained a tremendous amount of ground since the depths of the financial crisis. The Standard & Poor's (S&P) 500 Index of U.S. stocks, for example, posted a total return of more than 110% from the end of February 2009 through December 31, 2012. The S&P 500 Index climbed 16.00% for 2012, with the MSCI EAFE and MSCI Emerging Markets Indices up 16.54% and 18.63%, respectively. In the United States, the hotly contested presidential election, contentious fiscal cliff debates, and uncertain tax policies that fueled a lack of market confidence and stymied business expansion across many economic sectors have been temporarily addressed, providing more stability in investment expectations. A recovering U.S. housing market, a decline in unemployment, record-high exports, and encouraging year-end manufacturing data fueled by an attractive U.S. dollar exchange rate have all helped boost U.S. equity market sentiment.
We anticipate that U.S. equities will continue to perform well in 2013 as investors look past the political dysfunction in Washington and move more money into stocks as they become more comfortable with risk. Value stocks generally performed better than growth companies in 2012, and we believe that value stocks may also outperform in 2013. We also think that small-cap equities are poised to post better returns than large-caps. Finally, environmental, social, and governance (ESG) issues could become major factors in individual stock performance in 2013. As a result of these broad equity market trends, active equity managers focusing on ESG analysis should be well-positioned to help investors benefit in 2013.
Stocks Start the Year Strong, but Challenges Loom
The equity markets started 2013 with a powerful relief rally in response to the 11th-hour U.S. fiscal cliff deal, with the S&P 500 Index gaining 5.18% in January. Uncertainty, however, is likely to loom over the markets and economy until the U.S. debt ceiling and budget negotiations are resolved, presumably in March. Congress appears polarized over entitlement reforms, taxes, and debt reduction, but we remain hopeful that reason and compromise will prevail. At the moment, there seems to be little marketplace focus on how the dysfunctional U.S. political process could negatively impact the credit rating of U.S. government debt. Any discussion of a downgrade by a credit-rating agency could once again upset investor sentiment and ignite market volatility. Overall, however, the United States remains in the driver's seat of the global economy, with the rest of the world benefiting from continued U.S. economic growth, however tepid.
U.S. Recovery Gaining Momentum, Led by Housing
The overall macroeconomic backdrop in the United States is continuing to improve. U.S. corporate balance sheets and fundamentals remain strong and consumers are continuing to deleverage. The U.S. manufacturing sector is also recovering and should start to contribute a larger proportion of overall economic growth in 2013. These positives, however, are somewhat offset by less than stellar corporate earnings, a surprising pullback in consumer confidence in January as reported by the University of Michigan, and somewhat tepid expectations for gross domestic product (GDP) growth in 2013 of 2.5% to 3.0%. In addition, the fiscal cliff deal is going to have a net negative impact on the incomes of most Americans through tax increases and the expiration of the payroll tax holiday. The economic impact from the fiscal policy drag in the United States will likely detract 1 to 1.5 percentage points from GDP growth in 2013, but much of that may be offset by continued improvements in the housing, consumer, and labor markets.
Looking ahead, we believe that the recovery in the U.S. housing market will be a central catalyst for economic growth over the next 12 to 18 months, as consumer confidence, income, and spending improve. Home inventories, including shadow inventory, have retracted to their 2007, pre-bubble levels, providing a solid base for longer-term recovery. With the rise in new and existing home sales, many sectors of the economy—from construction to regional banks to raw-material providers—stand to benefit. At the same time, the smaller inventory of houses for sale will help push home prices higher. In 2012, home prices rose for the first time since 2006 on an annual basis. The U.S. Federal Reserve's $40 billion purchases of mortgage-backed securities each month appear to be working, as mortgage rates dropped in 2012 and remain at or near historic lows.
Eurozone and Emerging Markets Slowing
The European Central Bank (ECB) revised its 2013 GDP forecast from 0.5% expansion to 0.3% contraction. With unemployment in the euro region reaching a record high of 11.7% in 2012, and manufacturing, as measured by PMI, contracting, the fiscal drag from Europe appears to be worse than anticipated (a scenario that we anticipated more than a year ago despite more-optimistic consensus forecasts). The ECB's statements succeeded in calming markets in 2012, but we believe that the implementation of some new ECB policies may be difficult, which could give investors pause. Europe has now slipped into a double-dip recession, which will continue to negatively impact emerging markets through weak exports.
In general, we see the eurozone's problems dragging on and hurting global economic growth. This would particularly affect larger-cap stocks with significant foreign earnings components. The issues in the eurozone will likely also continue to impact stocks in China and other emerging-market economies with significant trading exposure to Europe. Growth rates in the emerging markets and "BRICs" (Brazil, Russia, India, and China) are, in fact, slowing to a more normalized level, which in turn negatively impacts global demand for industrial commodities and companies in the supply chain.
A Year of Transitions Ahead
Overall, we believe 2013 may unfold as a year of inflection points and reversals, with the U.S. equity market again delivering positive returns despite the political dysfunction in the nation's capital. As risk aversion subsides and investors are less willing to accept tiny—or negative—inflation-adjusted yields from Treasuries, we may finally see the performance spreads between equities and fixed-income securities reverse from their historically low levels and return to longer-term historical averages. From a relative valuation point of view, stocks are now very attractive relative to bonds.
Unlike the situation in the previous four years, however, we believe that positive asset flows may accompany attractive equity returns as retail and institutional investors gain confidence in the U.S. market recovery. This would reverse a multi-year trend of outflows from equity funds. With risk aversion still relatively high among investors, these new flows may be reallocations from other asset classes rather than from investors' cash positions. In fact, if we see an inflection point in the fixed-income markets where bond returns turn negative, investors may be less willing to reallocate cash to risky assets. Even if this scenario occurs, we still think equities may attract incremental flows.
We see several other trends potentially reversing in 2013 as the global macroeconomic picture becomes less treacherous. The value discipline may outperform in 2013 (as it generally did in 2012), reversing a much longer term, multi-year cycle of underperformance. We also believe that small-cap stocks are poised to move higher and may outperform large caps in 2013. Finally, we may see the "risk-on, risk-off" investor sentiment of the past few years grow into a more steady "risk-on" approach by the end of 2013 or early 2014. These trends can provide a perfect environment for yet another reversal—in the performance of active equity portfolio managers.
ESG Factors to Have Larger Impact
Another aspect of the equity investing climate that we expect to start to reverse in 2013 is the general lack of attention to environmental, social, and governance (ESG) factors and how they will impact company valuations. The most obvious driver 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.
In fact, the widespread availability of information about ESG practices and their impacts on company performance is forcing companies to improve their standards. Events like the BP oil spill in the Gulf of Mexico, for example, receive far more attention now than they would have 15 or 20 years ago. As a result, the negative consequences of "externalities"—costs created by one company but paid for by everyone—are becoming more incorporated into public opinion. Rather than risking backlash from regulators or public opinion, companies are now starting to try to manage (or eliminate) the impact of these externalities from within in order to mitigate potential negative impacts on their brand value or consumer demand. This is a positive for society as a whole, but it is creating a more complicated investment landscape. 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.
Sector and Stock Trends for 2013
We are likely to see the performance leadership of certain market sectors shift in 2013 as investors become less risk-averse. The high-dividend-yielding stocks that outperformed in 2012, such as those in the Utilities and Telecoms sectors, became significantly overvalued relative to both other sectors and their own historical levels and may lose favor with investors. We also believe the commodity super-cycle may reverse and start a long-term, downward trend, which should also help relieve some commodity-related ESG pressures in the future.
At the same time, certain U.S. equity sectors, including Information Technology, Consumer Discretionary, Energy, and Materials, look cheap relative to their historical averages, as do the peripheral economies of Europe, including Spain, Italy, Portugal, Ireland, and Greece. The United States still looks attractive relative to Europe, however, especially on a risk-adjusted basis.
This commentary represents the opinions of the author as of 2/11/13 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.
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