William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
October 12, 2012
U.S. and international equity markets had a bumpy ride in the second week of October, with the S&P 500 Index, the MSCI EAFE Index and other broad benchmarks losing roughly 2% through Thursday. Although there was little fresh news regarding the European sovereign debt situation, and markets had already digested the Federal Reserve’s announcement of another round of quantitative easing (QE3), the beginning of third-quarter corporate earnings season gave investors pause. Several companies issued negative pre-announcements and lower guidance for the remainder of the year.
Fixed-income markets were also unsettled. Yields on “spread products” (higher-yielding, non-Treasury securities) largely moved sideways over the course of the past week, with some up days and some down days. In general, U.S. fixed-income investors tended to shy away from riskier assets, evidenced in part by a third consecutive week of outflows from U.S-based high-yield funds. In this “risk off” environment, demand for safe-haven assets ticked up, driving up prices and lowering yields in the U.S. Treasury market. The yield on the bellwether 10-year Treasury security fell during the week, closing at 1.7% on Thursday and drifting lower in early Friday trading.
First-time unemployment claims plunge, surprising the markets
Initial claims for unemployment benefits fell sharply, to 339,000, from an upwardly revised 369,000 for the previous week. Claims had remained within a very tight range for months, neither rising above the 400,000 threshold that would signal a substantial deterioration in the health of the labor markets, nor falling below the 350,000 level that would suggest an improving jobs picture.
The outsized decline in claims for the most recent week could indicate either that volatility in these releases remains a factor to contend with, or that the job market is making further gains; most likely, it is a combination of both. Meanwhile, the drop in the number of people receiving continuing unemployment claims (as opposed to first-time filers) was more modest, and probably more indicative of the actual pace of improvement in the jobs arena.
Despite recent strengthening in employment, housing and consumer confidence data, we do not expect the Fed to slow its QE3 asset purchases any time soon on the basis that the economic recovery no longer needs support. On October 10, the Fed released its “Beige Book” assessment of the economy, generally reinforcing the Fed’s view that growth remains modest. U.S. consumers appear to be more optimistic, reflected in the University of Michigan/Thomson-Reuters Consumer Confidence Index, which in October surged to its highest level since September 2007.
In Europe, a sense that bad news could lead to good news
The past week brought few new developments in the European sovereign debt crisis. One exception was in Spain, where ongoing debt and bank solvency issues caused the government’s credit rating to be downgraded to near “junk” status by Standard & Poor’s. Despite the downgrade, however, the yield on the benchmark 10-year Spanish bond held relatively steady during the last week, widening by only about 10 basis points (0.1%) — primarily because the downgrade was widely anticipated and already priced in by the markets.
Ironically, as Spain’s condition deteriorates, debt investors have grown more confident, believing that the lower credit rating will push the Spanish government closer to accepting European Central Bank (ECB) funding and related austerity measures — thereby assuring a principal return on Spanish bonds. This belief is essentially holding debt yields in place as events unfold further.
Asia sees signs of progress amid regional concerns
With the exception of further weak signals from Japan, most Asian economic data was neutral to positive over the course of the past week, with price and confidence data showing general improvement. For the month to date through October 11, Japan’s stock market was down nearly 4%, while Pacific stock markets outside of Japan were essentially flat (+0.21%), based on MSCI indexes.
In China, the Shanghai Stock Exchange “A Share” Index has been moving higher, implying that the Chinese government has begun to apply stimulus measures to address the economic slowdown there. All eyes are focused on China’s third-quarter GDP growth rate, scheduled for release next week. Of growing concern is a recent territorial dispute between China and Japan, which has already caused some disruption in trade flows and could pose threats to the regional and global economies.
Modest global growth continues, but progress varies by region
The global economy continues to push forward at a modestly positive pace, with little evidence to suggest a significant change in that trajectory — although the International Monetary Fund (IMF) has lowered its 2012 global growth forecast slightly, from 3.5% to 3.3%. Forecasts for 2012 have also been trimmed. Of the major economic regions, the U.S. remains the most stable, while Europe continues to experience weakness that is pulling even the stronger eurozone economies closer to recession. Absent an accumulation of negative surprises, we think the U.S. and global economies can continue to muddle through in the near term.
Against this backdrop, equity markets are looking for direction after a long rally. The recent market pullback looks and feels like a mid-course “reset,” tempering optimism that has come off bullish highs. In our view, U.S. equities are no longer “cheap,” having risen above fair value, although valuations are still attractive relative to bonds. Meanwhile, third-quarter corporate earnings releases have generally been underwhelming to date, although earnings season is just getting under way. A meaningful number of disappointments will negatively affect equities, and spread-sector fixed-income markets would likely underperform in sympathy.
Investor demand for yield remains strong, but we think fixed-income markets will trend sideways over for the next several weeks, up to the November election and toward the looming U.S. “fiscal cliff” — clearly the issue to watch post-election. Notwithstanding some volatility, the constant buying of mortgages by the Fed via QE3 should continue to support spread sectors, barring any major geopolitical or surprise economic events in the interim.
The information provided herein is as of October 12, 2012.
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.
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). Past performance is no guarantee of future results.
Please note that equity investing involves risk.