Appetite for risk outweighs fear in 2012
Global equity markets produced positive returns in the fourth quarter, continuing the third quarter’s strong advance. The quarter got off to an inauspicious start, however, in response to the looming U.S. “fiscal cliff,” uncertainty surrounding the November 2012 elections, the economic impact of Hurricane Sandy, and other macro-level concerns. U.S. markets declined between 4% and 8% from October 1 through mid-November, while non-U.S. markets fell a lesser 2%.
Market fears eased in the second half of the quarter, reflecting better U.S. economic data, calmer European debt markets, surging Chinese activity, and rising optimism that Japanese policymakers would reverse the deflationary conditions that have plagued that economy for many years. These favorable macroeconomic factors drove a December rally, enabling markets to finish the quarter and year on a strong note. The chief beneficiaries were international markets, and to a lesser extent, the more volatile segments of the U.S. market—particularly value and small-capitalization stocks. Meanwhile, as risk appetites increased, the U.S. market saw a sharp rotation out of U.S. large-cap stocks, which were flat to slightly negative for the quarter.
During 2012 as a whole, markets wavered between “risk-on” and “risk-off” sentiment. Ultimately, investors chose risk over fear: U.S. and global equities were strongly positive, with most markets recording double-digit gains for the full year. Despite ongoing structural challenges in their economies, European markets performed very well, outpacing their U.S. counterparts, while Japan’s full-year MSCI index return
(+8.2%, most of it coming in the fourth quarter) was half that of the S&P 500 Index (+16%). At current levels, valuations appear more attractive for international equities relative to U.S. stocks, and for emerging markets versus developed.
Economic landscape continues to improve, with caveats
In December, real GDP growth—the broadest measure of economic activity—was revised upward for the third quarter, to 3.1%, from 2.7% in the government’s previous estimate. While the advance estimate of fourth-quarter growth came in at -0.1%, we would caution against reading too much into this negative headline number. The economy’s modest contraction in the fourth quarter was driven by sharp declines in two areas: federal government spending and business spending on inventories. In both cases, it appears that fiscal cliff uncertainty was the culprit, causing businesses to slow inventory growth by $40 billion and federal agencies and departments to reduce spending due to uncertainty about the future of their budgets. In particular, defense spending was down more than 22% at an annual rate.
However, other components of GDP growth were strong, in some cases exceptionally so. Based on consumer spending and long-term investing decisions, the economy expanded by about 1.8% in the fourth quarter. Personal consumption expenditures (+2.2%) grew in line with previous quarters, while business investment (+8.4%) surged and housing-related investment (+15.3%) rose, underpinning the theme of continuing strength in the U.S. housing market.
Further progress toward resolving the nation’s fiscal uncertainties should help economic growth recover from the fourth quarter’s temporary speed bump. We expect GDP in the first quarter of 2013 to begin to move slowly back toward its underlying growth rate, which we continue to forecast at 2.5%, on average, for the year.
In addition to an easing of cliff-related uncertainty, trends in housing, unemployment claims, retail sales, manufacturing, and auto sales have also been encouraging. We appear to be on the cusp of a new demand cycle that should support relatively stronger, more stable growth. The Index of Leading Economic Indicators published by The Conference Board rose 0.5% in December—slightly ahead of expectations and the strongest reading since last September. Of concern is a drop in consumer confidence, which in January hit its lowest point in more than a year, likely reflecting the initial shock of smaller paychecks as the 2% increase in the payroll tax kicked in as part of the fiscal cliff deal.
Although the U.S. managed to avoid going over the fiscal cliff on January 1, the agreement reached was far from comprehensive. Uncertainty over spending and tax policies—in particular, the threat of sequestration (automatic spending cuts that will kick in if no compromise is reached)—still looms over the economy and the markets. In the near term, markets have been granted a temporary reprieve from the contentious debate on the U.S. debt ceiling, as the House of Representatives voted on January 23 to raise the debt limit for approximately three months.
In Europe, despite high unemployment and recessionary conditions, the economy appears to be stabilizing, and fears of an imminent euro breakup have diminished. In China, key indicators suggest the economy has managed to avoid a “hard” landing, with GDP growth, manufacturing activity and other gauges of economic health rebounding after a sharp mid-2012 slowdown. Meanwhile, Japan’s negative inflation rate in December underscores the fundamental weakness in the Japanese economy, as well as the challenges the nation will face in stimulating economic growth and meeting the Bank of Japan’s new 2% target inflation rate.
The outlook for equities
Heading into 2013, U.S. equity fundamentals remain generally positive. Corporate balance sheets are flush with cash, and a majority of fourth-quarter earnings reports for S&P 500 companies have been coming in ahead of analysts’ scaled-back expectations. January market returns have been very good in the U.S., almost at levels we would have hoped to see for the full year. While the extended nature of this market advance, coupled with rising bullish sentiment, has perhaps set the stage for a correction, this is a market that has continued to “grind higher,” so far confirming the extremely bullish technical signals sent over the first few trading days of the New Year.
In the near term, the Fed has indicated that it will continue its stimulative monetary policies, including its purchase of $85 billion per month in Treasuries and mortgage securities, in light of downside risks to the U.S. growth outlook. As the year progresses and economic indicators regain positive momentum, equity markets will likely get ahead of the Fed, anticipating a shift to tighter monetary policies and the eventual end of quantitative easing (QE3) before these occur. Driven by the increasing likelihood of such policy moves later in 2013, assets may rotate out of fixed-income funds and into equities, potentially leading to better-than-expected equity market returns.
A possible risk to equities in this scenario is that the quickening pace of the U.S. economic recovery may be perceived as too rapid, which could lead to inflationary concerns and a global interest-rate tightening cycle. Such an outcome could ultimately put a cap on equity valuations.
On balance, we believe the conditions exist to make 2013 another positive year for equities, though of course there are no guarantees. In particular, U.S. equity markets must navigate the unpredictable outcome of the fiscal debates in Washington this spring. A case can be made for a bullish view if those contentious issues are settled, particularly given continued improvement in U.S. housing and employment, which are key drivers of favorable market results.
Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Please note that equity investing involves risk.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).