Asset Management

Markets rebound on Chinese GDP news, but global concerns remain

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

July 13, 2012

Equity markets struggled for much of the past week, with the S&P 500 Index down 1.5% in the first four trading days, and foreign developed and emerging-markets equities losing more than 2% and 3%, respectively, based on MSCI indexes. Investors continued to worry that economic weakness in the U.S. and China, coupled with a recession in Europe, may signal the beginning of a globally synchronized slowdown. On Friday the 13th, however, the release of China’s GDP growth rate for the second quarter — significantly lower than in the first quarter, but no worse than consensus forecasts — sparked a major “relief rally” that put global equity markets on track to recoup their losses from earlier in the week.

In fixed-income markets, global growth concerns continued to drive demand for the safe haven of U.S. Treasuries. The yield on the bellwether 10-year Treasury fell to as low as 1.48% on July 12 before edging back up in the wake of China’s GDP release. Meanwhile, many non-Treasury fixed-income sectors—including U.S. mortgage-backed and commercial mortgage-backed securities, investment-grade and high-yield corporate bonds, and global emerging-markets bonds—have generally held up well in July, despite the prevalent gloom. This reflects, in part, investors’ continuing search for higher yields as the historically low interest-rate environment persists. Investors also recognize that many corporate issuers have low levels of debt and strong cash flows, making their bonds an attractive alternative to lower-yielding Treasuries.

Article Highlights

  • Relief over China’s GDP number sparks a Friday rally in global equity markets.
  • Demand for Treasuries continues, but higher-yielding bond sectors also perform well.
  • Despite a third consecutive “summer slowdown,” there may be reasons for cautious optimism.
  • Slow global growth is increasingly reflected in equity prices, presenting potential opportunities.
  • However, the U.S. economy remains vulnerable to external shocks.


This year’s summer slowdown: similar, but not the same

For the third year in a row, the U.S. economy is decelerating at mid-year, and equity markets reversed course after a strong first quarter. Manufacturing, employment, and consumer confidence levels have clearly weakened, and consensus forecasts of second-quarter GDP growth have been revised downward. While no mainstream economists are predicting a recession at this point, most acknowledge that the current slowdown is significant. Moreover, the global economic backdrop remains bleak.

That said, the current situation differs from those of the past two years in some important respects:

  • Oil prices are down 12% from year-ago levels and 22% from their February peak, providing the world with the equivalent of a substantial tax cut.
  • Almost every central bank in the world is now in easing mode—loosening monetary policy by lowering interest rates, reducing banks’ reserve requirements, and/or purchasing longer-term securities to boost liquidity and stimulate demand. This was not the case during the economic soft patches of 2010 and 2011, when central banks were tightening in Europe and emerging markets.
  • This is a presidential election year in the U.S. Statistically, U.S. stocks have posted negative second-half returns in only four of the last 21 election years, according to Ned Davis Research. Of course, there is no guarantee that this historical pattern will hold in 2012.

In addition, data released in the second week of July showed pockets of resilience within the broader U.S. slowdown:

  • Consumer credit grew by $17.1 billion in May, suggesting increased confidence that could bode well for future spending.
  • The weekly leading indicator published by the Economic Cycle Research Institute ticked up for the fourth week in a row.
  • After creeping higher throughout the second quarter, first-time unemployment claims fell sharply in the most recent week, to 350,000—their lowest level in nearly four years. However, an important caveat is that seasonal factors and the July 4th holiday had a beneficial effect that will likely be short-lived.

Market outlook balances favorable indicators with downside growth risks

The U.S. and global economies remain in slow-growth mode. Notwithstanding the exuberance of the Friday the 13th equity market rally, China’s economy expanded at its slowest pace since the first quarter of 2009. One key indicator of China’s growth trajectory—the Shanghai “A” stock market—has yet to move. A spike would indicate that Chinese authorities are going into full stimulus mode. In the meantime, the potential success of China’s efforts to spur its economy has yet to be determined.

Europe continues to champion economic and fiscal reforms in theory, but has been slow to deliver tangible results, and the eurozone economy remains precarious at best. Interestingly, European stock markets have begun to reflect this reality, with relative valuations on European equities (especially in southern-tier markets such as Italy and Spain) reaching extremely attractive levels.

In the U.S., weak employment is dampening earnings expectations, resulting in negative revisions. Although we are not in a recessionary slide, the economy remains vulnerable to external shocks, such as a potential confrontation between Israel and Iran, and credible scenarios that envision a break-up of the European Union. Nonetheless, we think there is a case to be made for U.S. growth to reaccelerate in the second half of the year, bolstered in part by recent technical trading patterns suggesting an upward bias for stocks, as well as extremely low net hedge fund exposures to equities, a contrarian indicator that historically has proven bullish for U.S. equity returns.