Focus on Equities - First Quarter 2014 in Review
Equities rebound in February and March, finishing the quarter on a positive note, led by U.S. equities
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
Risk aversion injected into markets...
After a "risk-on" year in 2013, the first quarter of 2014 proved to be a more challenging environment for equities. Concerns about economic growth in emerging markets, geopolitical turmoil in Ukraine, and somewhat softer macro data in the U.S. injected more risk aversion into markets, while profit-taking and tempered expectations for a repeat performance of stellar 2013 returns likely drove down investor risk tolerance in the first quarter. With investors taking a more cautious approach toward equities, it was not surprising to see equity markets get off to a particularly rough start in January, though most major global indices rebounded in February and March, finishing the quarter in positive territory, led by U.S. equities. For the quarter, the Standard & Poor's (S&P 500), Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned 1.81%, 2.05%, 1.12%, 0.66%, and -0.43%, respectively. From an investment style perspective, small-cap stocks underperformed their large-cap counterparts, while value stocks outperformed growth stocks as investors' risk appetites subsided. The rotation from expensive growth stocks to value stocks, if it continues, could suggest a more favorable outlook for higher-quality stocks.
Sector performance on the other hand tells a mixed story. Utilities, healthcare, and materials were the top performing sectors in the first quarter, while consumer discretionary, telecomms, and industrials lagged. While we would expect to see performance of cyclical sectors lead defensive sectors as the outlook for economic growth continues to improve, we may not see the same degree of leadership from the industrials and materials sectors as was the case in prior recoveries, since these sectors will likely be impacted by slower growth from China.
...as weather holds back economic growth in the U.S...
Extreme weather in the U.S. likely held back economic growth in much of country during the quarter. However, the question investors have been asking is, how much of the recent softness in economic data can be attributed to poor weather alone? As the quarter wore on, investors gained comfort in the view that weaker economic data was more a byproduct of inclement weather, rather than reflecting a broader economic slowdown. Comments from Fed Chair Janet Yellen during the quarter also seemed to support this theory. We tend to agree, and continue to expect the U.S. economy to strengthen and expand in 2014 with the likely return of more normal rates of consumer activity as winter turns to spring, and the potential for some lost consumer activity to be recovered later in the year.
...but the general positive trend remains.
Although recent market commentary has focused largely on what is happening at the Federal Reserve, we believe an important driver of economic activity in the U.S., and by extension Fed policy, is the continued improvement in the health of the consumer balance sheet. This gives consumers better access to consumer loans and mortgages, supporting the continued recovery of the housing and automotive industries, among others. At the same time, gains in housing prices have dampened recently as a result of the expected negative impact of tapering on mortgage rates. Seasonal winter doldrums likely had a temporary negative impact on housing activity that should be reflected in upcoming data releases. Therefore, the pace of consumer balance sheet reconstruction may slow somewhat over the next quarter or two as housing activity picks up, but the general positive trend remains.
Initial jobless claims maintained their downward trend throughout the quarter, approaching its post-recession low after the four-week moving average of claims fell to 317,000 in the most recent release. Continued improvements in the labor market should support consumer spending and the U.S. housing sector – keys to the success of the U.S. economic recovery.
Anemic economic activity in Europe continued to highlight the threat of deflation...
A global backdrop of low inflation persisted in the first quarter despite the continued aggressive easing actions by the world's largest central banks. There are several drivers contributing to low inflation that we believe are likely to persist in the near-term. As an example, anemic economic activity in Europe continued to highlight the threat of deflation, as inflation in the eurozone dropped to just 0.5%. While European Central Bank (ECB) President Mario Draghi indicated a willingness to intervene should further downside risks to price stability materialize, there appear to be few catalysts capable of driving an increase in demand-side inflation with the euro area's economic recovery remaining tepid.
...while investors worried about a hard landing in China.
The main risk on investors' minds so far this year has been the potential for slower GDP growth in emerging markets, particularly China. Worries about a hard landing in China returned to the forefront of investor concerns as the China HSBC Manufacturing PMI declined further in February, signaling the first contractions of both output and new orders since last July. Political upheaval in Ukraine, which culminated with Russian forces occupying the Crimea region, injected further risk aversion into investor sentiment. Although tensions have eased, the situation continued to negatively impact emerging market stocks and currencies, which were already coming under pressure due to the prospect of a slowdown in China and the reversal of the carry trade, which in turn is deflationary. We expect the Ukraine situation to be a continued source of headline market risk in the near-term until a more final diplomatic solution is reached.
We believe the U.S. can still compensate for a dampened global growth outlook.
The contrast in economic conditions between the U.S. and both Europe and China (and other emerging markets) should continue to draw more investment to the United States in the near-term, and Fed tapering will most likely add to this effect, both in equities and in other asset classes. We expect the dollar to continue strengthening slowly, which may provide another reason for foreign investors to favor US securities over investments available in their domestic markets. This also supports our outlook for continued low inflation in the near-term.
On the whole, the resiliency and low volatility of interest rates in the wake of Fed tapering is a positive sign, since it indicates that – at least for a while – tapering need not produce the kind of jump in interest rates that many analysts had feared. Should this environment continue, equities could indeed continue to recover from their early 2014 setbacks. This will depend to a large degree on the quality of the upcoming earnings season. We also believe the U.S. can still compensate for a dampened global growth outlook, and we expect the economic recovery to reaccelerate in the second-half of the year on the heels of continued improvement in the housing and labor markets. However, sharp changes in interest rate expectations remain a risk factor as they can drive mortgage rates higher still, negatively impacting housing activity and weakening this major component of the U.S. economic recovery.
This commentary represents the opinions of the author as of 4/1/14 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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