2012 Second Quarter Equity Market Review

William Riegel, Head of Equity Investments

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Global equity markets produced negative returns during the second quarter, reversing the optimism that had prevailed in the first three months of the year, when major equity benchmark indexes posted double-digit gains. The markets’ second-quarter decline reflected a variety of investor fears—including the potential for a breakup of the European Union and increased apprehension over our own "fiscal cliff," which triggered stagnation in the U.S. recovery. The slowdown in the U.S. was exacerbated by a sharp deceleration in global demand, evidenced by cooling growth in China and other emerging markets.

In the U.S., most gauges of employment growth reflected this slowing economic activity. For example, the unemployment rate in June remained stuck above 8%. In addition, manufacturing activity also decelerated, with the Institute for Supply Management’s Purchasing Managers’ Index (PMI) dipping below 50 in June—the threshold that separates economic expansion from contraction. Although declining oil prices trimmed U.S. gasoline costs, people did not spend the money they saved at the pump on other goods. On the positive side, there was steady improvement in several housing indicators, including new and existing home sales, housing starts, building permits and median home prices.

Risk appetites plunge, favoring defensive sectors

The S&P 500 Index declined 2.75% for the quarter, and the broader Russell 3000 Index was down 3.15%. Given the fragile economic backdrop, the second-quarter pullback in stocks was characterized by a move away from relative risk and toward relative safety. This risk-averse environment led to outperformance by defensive, low-beta stocks (i.e., those that tend to be less aggressive in terms of risk and return potential and more resilient in periods of economic uncertainty).

Accordingly, within the S&P 500, defensive sectors such as utilities (+6.55%), telecommunications (+14.13%), and consumer staples (+2.88%) were more resilient than energy (–5.99%), financials (–6.83%), and information technology (–6.68%), which are more economically sensitive. Based on specific Russell market-cap and style indexes, large caps (–3.12%) held up better than both mid caps (–4.40%) and small caps (–3.47%), while value (–2.26%) outperformed growth (–4.02%). Foreign developed and emerging-market equities underperformed their U.S. counterparts, with the MSCI EAFE Index and MSCI Emerging Markets Index declining 7.13% and 8.89%, respectively.

Markets’ focus on macro themes proves challenging for active stock pickers

Unlike the first quarter, which afforded greater opportunities for active equity fund managers to outperform, the second quarter saw a return of heightened volatility and macro-driven market moves that reflected a general desire among investors to “de-risk” their portfolios. In such an environment, stocks tend to move more in lockstep, which hinders the ability to deliver outperformance by picking superior individual stocks based on fundamental, bottom-up research.

Outlook: Economic headwinds and market volatility continue

The near-term macroeconomic outlook is mixed at best. U.S. GDP forecasts have been revised downward, reflecting a more tenuous job market, weaker manufacturing activity and declining consumer confidence. Although surveys indicate a need for increased hiring, U.S. employers are taking a wait-and-see attitude before committing to more jobs and capital expenditures. This reluctance can have a self-fulfilling negative impact on overall activity.

Consensus forecasts for second-quarter global growth are higher than U.S. estimates. However, they face the possibility of downward revisions since China’s growth rate declined from 8.1% in the first quarter to 7.6% in the second—the slowest expansion of the Chinese economy since the 2008-2009 financial crisis. In the eurozone, the faltering economy is close to falling deeper into recession.

Against this backdrop, the S&P 500 continues to trade below its historical average price-to-earnings (P/E) ratio, suggesting that stocks are attractively valued and may offer selective long-term investment opportunities. Three weeks into second-quarter earnings season, results were generally coming in somewhat better than expected. However, it’s worth noting that expectations had been reduced during the quarter, as corporate management teams generally guided down earnings assumptions and negative pre-announcements dominated the landscape. In the current environment, firms have faced difficulty in growing revenues. This is particularly true for multinationals that have much of their sales denominated in currencies that have weakened relative to the U.S. dollar. With about one-fourth of all S&P 500 companies reporting, roughly 67% had positive earnings surprises in the second quarter, essentially tracking patterns seen in the past two quarters.

In Europe, valuations have reached multi-decade lows that align with the region’s uncertainties, both political and economic. Asia faces similar low valuations. As a result, each region is increasingly attractive despite the risks.

Market performance could improve in the second half of the year if certain encouraging macro trends continue: lower gasoline prices, which will boost consumers’ purchasing power; a continuation of global central bank easing to stimulate growth; further gains in U.S. housing; and a rebound in prices for copper, oil and other commodities, which may signal higher growth in China. Additionally, as past measures have been limited in their effectiveness, an increasingly specific set of policy actions remains available to preserve the currency union in Europe. If these policies move to implementation, they could provide the basis for better activity going into 2013.

Beyond the macro issues, equity market sentiment among Wall Street strategists remains negative, and net hedge fund exposures to equities are extremely low—contrarian indicators that historically have proven bullish for global equity returns.

That said, we are also mindful of the confidence-draining macro burdens facing the global economy, particularly the ongoing debt crisis in Europe, as well as the threat posed by the U.S. “fiscal cliff” of automatic spending cuts and tax increases that will take effect in January 2013 if no political compromise is reached. We remain committed to investing in fundamentally strong names through the market’s volatility, balancing our search for superior returns with vigilant risk management, which we believe will continue to be of utmost importance in months ahead.

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