Asset Management

Concerns about China and Europe trump strong U.S. data

Lisa Black, Head of Global Public Fixed-Income Markets
William Riegel, Head of Equity Investments

Key points:

  • Equity markets were uninspired over the past week, as the latest round of improving U.S. economic data was more than offset by fresh concerns about accelerated weakness in Europe and China.
  • Fixed-income markets saw a modest shift away from “riskier assets” and toward safety, with demand for U.S. Treasuries pushing their prices up and yields down, reversing a nearly two-week trend.
  • Geopolitical tensions, oil prices and the U.S. housing market will command investors’ attention in the weeks ahead.

The U.S. economy continued to show signs of resilience during the week, evidenced by another encouraging drop in first-time unemployment claims, a rise in key leading economic indicators and steady homebuilder confidence that remained at a five-year high. Although housing starts dipped in February, January results were revised upward, and housing permits—which are forward-looking—rose to their highest level since October 2008. This bodes well for the continuing, albeit painfully slow, path to a housing recovery that is needed for sustainable, long-term GDP growth.

In Europe, anxiety over Greece and the sovereign debt crisis was displaced by renewed worries about a broader weakening of the regional economy. Preliminary “flash” estimates of February’s Purchasing Managers’ Index (PMI) showed economic activity in the eurozone contracting for the sixth time in the past seven months. Nonetheless, although Europe has stalled, it is not collapsing, and growth prospects vary by country.

Globally, growth data remains favorable. Leading global economic indicators are up, global earnings estimates have rebounded and global PMI indexes are at levels associated with an annual growth rate of more than 4%. Japan is growing above trend, and the rest of Asia (excluding China) is booming.

China, however, remains a puzzle. Housing prices continue to tick down, and the Chinese government has signaled its intention to drive them even lower. These public statements, along with prior readings of steel, cement and auto demand in January, all point to slower growth in China. This has raised a bearish chorus that now calls for a GDP growth rate below 8%—which, in the bear’s opinion, represents a “hard” landing for the Chinese economy. Adding to concerns was the release of China’s preliminary PMI data for February, indicating a slowdown in the manufacturing and service sectors, with potential repercussions for global growth.

While the recent economic news out of China has been disappointing, it’s not clear whether the weakness marks the beginning of a deeper, sustained slowdown or a temporary soft patch that can be worked through over the next few months, particularly if China decides to pursue further monetary easing to stimulate demand. As global investors, we meet frequently with large multinational companies, some of which reported significant improvement in their Chinese business for February. In addition, one of TIAA-CREF’s global equity analysts, currently in China to conduct company research, reports that steel and cement shipments have begun to rise for the specific firms she is visiting. Although such improvement has not been reflected in Chinese equity markets, the bearish point of view may be at or near an unsustainable extreme.

Against this backdrop, the S&P 500 Index fell by about 1% for the week (through March 22), but was still up 2.1% and 11.3% for the month and year to date, respectively. Foreign developed and emerging equity market returns, as measured by MSCI indexes, have been slightly negative for the month but remained solidly in positive territory for the year to date.

Meanwhile, the 10-year U.S. Treasury yield fell by 10 basis points during the week, reaching 2.29% on March 22. This is still higher than the year-to-date low of 1.83% and last year’s low of 1.72%, but also substantially below the 2011 peak of 3.75%. On balance, despite the past week’s move toward Treasuries, we continue to see relatively strong demand for corporate credit and other higher-yielding, non-Treasury fixed-income sectors.

Looking ahead, global stock markets remain healthy but are due for a pullback. Among the many potential catalysts that could drive a correction are geopolitical tensions involving Israel and Iran (with far-reaching implications for global oil prices), more anxiety over Europe, and daunting fiscal issues in the U.S., which will come into sharper focus as we head into the presidential election campaign.

Perhaps in anticipation of these risks, equity markets have been skewing toward the relative stability of large-capitalization stocks. Since February 15, the S&P 100 Index (representing the 100 largest S&P companies by market cap) has led all other U.S. indexes by more than 200 basis points. Fixed-income markets are paying close attention to the potential dampening effect of higher gasoline prices on consumer spending. If the U.S. housing market continues to improve and fears of a confrontation in the Middle East begin to ease, we could see Treasury yields resume their upward climb.

The information provided herein is as of March 23, 2012.