Asset Management

Markets cast a wary eye at speed bumps on the path to recovery

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

Key points:

  • Equity markets wavered for a second week in a row amid further signs of decelerating growth in China, anxiety over Europe’s debt and fiscal challenges and weaker-than-expected readings on some key U.S. indicators.
  • In fixed-income markets, U.S. Treasury securities benefited from an uptick in demand for safer investments. The yield on the bellwether 10-year U.S. Treasury notes inched downward, while the recent rally in higher-yielding, non-Treasury securities moderated.
  • Current signs of softer economic activity, while not alarming, are a yellow caution light for investors as we enter the second quarter of 2012.

Equity markets began the week on a high note, with most U.S. indexes rising more than 1% on March 26, inspired by Federal Reserve Chairman Ben Bernanke’s remarks on the potential for additional stimulative action to keep the recovery going. The burst of euphoria was short-lived, however, as stocks began giving back their gains the next day and continued to drift downward through midweek.

While many U.S. leading economic indicators have remained favorable, over the past week there were a number of other signs that may point to a flattening of activity. These included a small drop in housing starts, stalled bank lending and durable goods orders that fell short of expectations. In addition, weekly first-time unemployment claims have stabilized at about 350,000—well below the 400,000 threshold that would indicate a worsening job market, but no longer falling at a pace that would signal a meaningful drop in the unemployment rate. Adding to the sense of mild disappointment was the final estimate of fourth-quarter U.S. GDP growth, which was unrevised at 3%.

This somewhat muted growth environment is currently being offset by consumer sentiment, which has held up well despite higher gasoline prices. Moreover, revisions to corporate earnings estimates have turned positive, and company surveys remain strong, especially in housing and airline traffic. That said, the downshift in some indicators—while not alarming—is a yellow caution light that we need to heed. In particular, we will watch closely for any signs that recent strength in the economy may be related more to a mild winter than to true economic acceleration.

For stocks, this is critical, because we have moved into a zone where the likelihood of a correction has risen dramatically. Short-term trading sentiment, as we have noted before, is at an extremely bullish—and thus vulnerable—level. At the same time, hedge funds’ net exposures have risen to a level indicating that these previously reluctant buyers are now chasing the market higher in an attempt to make up for poor investment results. In addition, the U.S. market looks “tired” from a technical standpoint, with the number of daily new highs steadily receding over the course of the past month.

International equity markets also fell during the week amid uncertain economic conditions. In Europe, readings on German and French manufacturing activity were below expectations, and Spain’s economy moved firmly into recession, with Spanish real estate prices plummeting and sovereign debt yields backing up. Through midweek, European stocks had dropped 1.75%, as measured by the MSCI Europe Index. In China, the Shanghai Composite Index was also down sharply, as corporate earnings have lagged estimates, and weak manufacturing numbers indicate that the Chinese economy continues to decelerate.

In fixed-income markets, there has been a “boomerang” effect for U.S. Treasuries. The yield on the bellwether 10-year note began the month at just over 2% and rose 36 basis points by March 19, reflecting stronger prospects for U.S. economic growth and less appetite for the safe haven of Treasuries. Since then, demand for Treasuries has increased, driving their prices higher and yields lower. The 10-year yield settled at 2.18% on March 29 as investors responded to the Fed’s cautionary tone on the strength of the recovery and to concerns about the effects of an economic slowdown in China.

Meanwhile, yields crept up in some non-Treasury sectors, including corporate high-yield bonds, commercial mortgage-backed securities and global emerging market bonds. If economic growth picks up again, we believe these types of assets should outperform Treasuries. If the economy stumbles, the Fed has indicated that it will step in to support the markets further, seeking to provide stimulus for as long as it takes to ensure a truly self-sustaining recovery.

The information provided herein is as of March 30, 2012.