Stock Markets Start Second Quarter Strong but Then Retreat
By Natalie Trunow, Chief Investment Officer, Equities, Calvert Investment Management, Inc.
After an impressive earnings season got the second quarter off to a strong start, equity markets retreated in May and June over multiple concerns about global economic growth prospects related to potential contagion resulting from the sovereign debt crisis in Europe, the end of the QE2 program, and political ambiguity surrounding the raising of the U.S. debt ceiling. For the quarter, the Russell 1000 Index and the Standard & Poor’s 500 Index returned 0.12% and 0.10%, respectively, while the MSCI EAFE Index was up 1.83% and the MSCI Emerging Markets Index returned -1.04%. Small caps underperformed their large-cap counterparts with the Russell 2000 Index returning -1.61%. Growth stocks outperformed value stocks, with the Russell 1000 Growth Index returning 0.76% and the Russell 1000 Value Index posting an -0.50% return during the quarter.
Most equity indices were still up for the year through the end of June; we don’t see the recent correction developing into a major one this year. Despite the more recent negative sentiment in the market stemming from investors refocusing on the risks globally and particularly in Europe, we believe that—absent any major new shocks to the system—the second half of 2011 has the potential for upside surprises in both earnings and GDP growth.
The top-performing sectors for the quarter were the generally defensive healthcare, consumer staples, and utilities sectors, while the more cyclical energy and financials sectors lagged. Financials continue to be the worst-performing sector year-to-date, while healthcare names have now overtaken energy stocks in the leadership position for the year with a 14.15% return for the year through the end of June.
Another Strong Earnings Season
The quarter began with equity markets seeming to trade mostly on earnings data, ignoring the mixed macro picture. In general, U.S. companies once again showed strength, beating analysts' estimates on earnings, and in many cases, on the top line. In fact, 67.7% of S&P 500 companies beat analysts' earnings estimates, led by companies in the technology and healthcare sectors. Apple's net income almost doubled and its top line also beat analysts' estimates on higher iPhone demand from Verizon Wireless customers. With that said, margins for many U.S. companies are coming in at lower levels than a year ago.
Defensive Sectors in Favor as QE2 Ends
The market’s rotation toward more defensive sectors was prompted by the impending completion of the Federal Reserve’s stimulative QE2 program in June, a sell-off in commodities markets, the intensifying sovereign debt crisis in Europe, generally softer economic data, and high debt levels in the U.S. Completion of the QE2 program can be seen effectively as a tightening, which can be a negative for the stock market if the economic recovery and improvements in the earnings cycle are not self-sustaining—which we don’t think is the case. If bank lending stabilizes and business borrowing and consumer spending continue to recover, the removal of QE2 may not be as much of an issue, but will result in a potentially slower, more gradual recovery than the markets originally anticipated.
The sell-off in commodities markets was partially due to the demand destruction effects of high prices for oil and increases in margin requirements for commodities traders. The end of QE2 is also credited with having a negative impact on commodity prices. Prices for crude oil, gold, silver, and other commodities fell in May and June as traders sold out of speculative positions.
Banks Struggle with the Effects of Regulation
Despite the fact that the Fed allowed banks to increase dividends and repurchase shares during the quarter, bank stocks continue to underperform the market. The banks are saddled with a variety of issues, not the least of which is being ordered by regulators to pay back homeowners for losses on their foreclosed homes due to unsatisfactory documentation. Slow loan growth, balance sheets in need of restructuring, and long-term impairments and costs due to regulatory scrutiny are adding to the malaise.
In addition, new rules on swipe-fee revenue were introduced at the end of June, and U.S. banks are still balancing the need to meet higher capital requirements with the demand for lending from smaller businesses that are vital to economic growth. Such lending has seen a pick-up recently, which should help offset the impact of the end of QE2. Bank exposure to sovereign debt was also a negative for the sector during the second quarter.
Bank of America agreed to pay $8.5 billion as part of a settlement with a group of investors over claims that mortgage-backed securities sold by its Countrywide unit were not properly managed. While alleviating some of the uncertainty around mortgage-related concerns, the deal raises expectations for what future settlements may look like and is a reminder that banks still face challenges from the financial crisis.
Eurozone Debt Crisis and Global Risks
Concerns about global economic growth prospects related to potential contagion in Europe that could be caused by sovereign debt default continued to impact investor sentiment. Equity market sentiment continues to be generally negative despite some recovery at the end of June, particularly after the Greek parliament’s approval of austerity measures. The Greek debt crisis is now 21 months old and the E.U. is continuing to “push the can down the road” and buying time in hopes that the crisis dissolves without a default spiral and without major repercussions on the global financial system. Additionally, Portugal received approval for a three-year, $3.86 billion International Monetary Fund bailout loan in May.
The extent of the potential contagion will determine how much of an impact it will have on systemically important financial institutions and the global economy. Specifically, if multiple peripheral European states default (or especially if Spain defaults), the impact on global economic growth could be significantly negative. While we don’t see a high probability of the U.S. going into recession due to a sovereign debt default by Greece, this possibility still seemed to be driving the market sentiment in June. Still, the sovereign debt crisis, austerity measures, rising inflation, and looming interest-rate hikes are likely to keep the eurozone’s economic growth subdued.
Inflation continues to be more rampant outside of the U.S., particularly in emerging markets. China, the world’s second-largest economy, is allowing its currency to appreciate as the country battles inflation, which is currently at 5.5%. The yuan appreciated above 6.5 per U.S. dollar during the second quarter for the first time since 1993. If the fight against inflation, aggressive capital spending, and a hyperactive real-estate market are not successful, China’s economy may have a hard landing, which will have a pronounced negative impact on the world economy. Credit and asset bubbles that may be developing in that country continue to be a potential source of risk, which seems to be largely overlooked by investors.
U.S. Economic Recovery Slows But Continues
Despite increases in food and energy prices, the latest data shows that core inflation remains low (1.2%) and unemployment high (9.2%). These two main areas of focus for the Fed continue to call for an accommodative monetary policy. Some of the components of core inflation, however, were spiking during the second quarter. With the housing market collapse, fewer people are buying houses and more of them are renting, pushing rental vacancy numbers down and rents up. Rents are a large component of the data that make up the core inflation rate the Fed is focused on. At the same time, the Fed’s recent position is that the economy is expanding at a moderate pace. If and when the growth rate accelerates—and we think it can happen in the next 12 months—policy will likely become less accommodative.
Home sales data showed improvement during the second quarter as pending home sales jumped significantly in May, increasing by 8.2% month-to-month and 13.4% year-over-year, beating economic forecasts by a wide margin. As a forward-looking indicator, this suggests that home sales may rise in the coming months and is a sign that the residential real estate market may be rebounding from its prolonged slump.
Decreasing commodity prices are a positive for global economic growth in the near term, although the secular upward trend in commodity prices may persist in the long term. However, if this break in commodity prices continues, it should reduce risks to top-line inflation, lifting a drag on economic growth and providing additional stability to the Fed’s accommodative stance. Core inflation rose 1% year-over-year in April, while top-line inflation grew 2.25%, offsetting gains in personal income. Consumers have been constrained by high food and energy prices, making the overall recovery less buoyant. However, the U.S. manufacturing sector continues to be strong. Factories, particularly auto parts and computer manufacturers, are likely to rebound in the second half of this year from the impact of the disasters in Japan earlier in 2011.
Although this soft patch in the economic recovery is having a negative impact on the equity markets, we believe that it is a temporary one and that the markets were not paying enough attention to the macroeconomic risks on the way up and were focusing almost exclusively on the earnings season earlier in the quarter. The recent retrenchment is appropriate given the risks in the system. Negative ramifications from supply-chain disruptions caused by the events in Japan, extreme weather in parts of the U.S., job cutting at the municipal level, and the expiration of QE2, are having a short-term negative impact on economic growth and employment.
The U.S. still looks better than the rest of the world markets, with Japan continuing to suffer from the effects of recent natural disasters, Europe in the midst of a sovereign debt crisis, and emerging markets pinched by higher inflation.
Despite the summer doldrums in equity markets and growing investor pessimism, we do not subscribe to the double-dip recession sentiment that became more prevalent during the second quarter. QE2 rolled off at the end of the quarter which, if bank loans continue to grow, should have less of an impact on the markets. Moreover, the portion of demand not met due to the catastrophic events in Japan should not be a permanent loss in global GDP, but rather a deferral into the second half of 2011 once the supply chain is restored, creating a significant possibility for an upside surprise.
As demand recovers, we may see positive earnings surprises from U.S. companies, beating pessimistic consensus estimates. Fuel prices are also retreating somewhat, which should help consumer spending. The pull-back in oil prices to a four-month low in June—after the International Energy Agency said crude will be released from strategic reserves—should help global economic recovery and mitigate inflation concerns.
We believe that the U.S. economy can withstand a mild shock from a European default crisis provided it doesn’t engulf U.S. banks. We also believe that the current softening in the economic data is temporary. If a political agreement is reached in July for deficit reduction and an increase in the debt ceiling in the U.S., equity markets are likely to react positively.
This commentary represents the opinions of its author as of 7/19/11 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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