Asset Management

Strong corporate earnings fuel optimism, but GDP growth slowing

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

Key points

  • Equity markets recovered from a slow start to the week amid a flurry of generally strong first-quarter earnings reports and mixed economic signals.
  • Fixed-income markets took a cautious view throughout the week. Evidence of further softness in U.S. employment growth, along with heightened anxiety over Europe’s debt problems, steered investors toward safe-haven Treasury bonds.
  • We remain cautiously optimistic about the near-term prospects for the economy and the markets, despite a disappointing GDP estimate; forward-looking housing indicators are particularly encouraging.

Equity markets stumbled out of the gate at the beginning of the week, largely due to further weakness in European manufacturing data and political uncertainty in France, where results from the first round of presidential voting clouded the outlook for a resolution to the eurozone debt crisis. As the week progressed, markets recovered as investors shifted their focus to solid U.S. corporate earnings releases and a mixed bag of economic indicators.

On the down side, durable goods orders tumbled 4.2% in March, far more than forecast. However, some analysts observed that the drop was not as bad as the figure suggested, since most of March’s decline was accounted for by aircraft orders, which are historically volatile. Meanwhile, consumer confidence fell for the second month in a row, and first-time jobless claims, which had declined steadily during the first quarter, remained elevated for the third consecutive week. Rounding out the week’s major data releases was the advance estimate of first-quarter U.S. GDP growth, showing that the economy expanded at a slower-than-expected rate of 2.2%, versus 3.0% in the fourth quarter of 2011.

Bright spot in housing
Early in the week, equity markets generally focused less on the disappointments and more on the glimmers of optimism found in a number of housing-related indicators. These included:

  • new home sales, which beat forecasts in March
  • pending home sales, which climbed to their highest level in nearly two years
  • a jump in the ISI Homebuilders Survey, which hit a six-year high. These positive signs came on the heels of first-quarter existing home sales, which were the strongest they have been in five years, as well as a steady rise in building permits, which is a forward-looking indicator.

Housing is critical to economic growth because of the tremendous multiplier effects it can have on jobs and the service economy. The malaise in the U.S. housing sector over the past several years has been an extraordinary drag on job creation and GDP growth. Falling home prices have eroded consumer wealth, while the overhang of unsold homes continues to hinder bank balance sheets and reduces their willingness to lend, which in turn dampens consumer spending, the largest component of GDP.

Because housing has been a net drag on U.S. growth for so long, even marginally positive changes could drive substantial improvement in consumer comfort and spending growth, while a fully stabilized housing market has the potential to create more than one million jobs in housing-related industries. Moreover, with the economies of the United Kingdom and the eurozone falling into recession, and China continuing to decelerate (albeit with signs of improvement at the margins), a recovery in the U.S. housing market—and more broadly, the ability of the U.S. to remain on a course of economic growth—has implications not just domestically but for the global economy.

Making up ground
By midweek, equity markets had made up much of the ground they had lost in the previous three weeks. Month-to-date through April 26, the S&P 500 Index was down just 0.48%, while foreign developed and emerging markets were both down about 2.2%, based on MSCI indexes. High-quality, large-cap growth names have outperformed small-cap and value categories in April.

Similarly, in fixed-income markets, U.S. Treasuries and other safe-haven investments outperformed high-yield and other lower-rated securities, both during the past week and for the month to date. As of April 26, the yield on the 10-year Treasury security was 1.95%, down from 2.22% at the beginning of the month.

The first quarter’s weaker-than-expected GDP number highlights continued uncertainty about the strength of the recovery. On balance, we do not anticipate the degree of economic sluggishness that triggered equity market pullbacks in summers of 2010 and 2011. However, recent slowing of momentum at the macro level suggests that further market advances, if they occur, will continue to be led by high-quality equity and fixed-income sectors, where investors tend to gravitate when the economy appears more vulnerable to downside risks.