Asset Management

Earnings vie for attention as economy treads water

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

July 20, 2012

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Equity markets moved higher for much of the past week, advancing on a somewhat better-than-expected start to second-quarter earnings season in the U.S., while generally shrugging off mixed economic data. The S&P 500 Index gained nearly 1.5% for the week through July 19, while the MSCI EAFE and MSCI Emerging Markets indexes climbed 2.3% and 1.7%, respectively. From Memorial Day through July 19, the S&P 500 is up roughly 5%, led by defensive sectors such as healthcare, utilities, and consumer staples. The middle of the past week (July 18) marked the first time in weeks that technology outperformed, and this continued the following day, with other cyclical sectors (materials and consumer discretionary) participating as well. Equity markets traded down through mid-day Friday, reflecting concerns over downward revisions to Spain’s growth estimates.

In fixed-income markets, U.S. Treasury yields remained at or near recent lows, with the yield on the bellwether 10-year security trading in a tight range. Over the past two weeks, the 10-year yield never closed higher than 1.54%, and never lower than 1.50%—an indication that demand for safe-haven assets has remained steady as fears of a synchronized global slowdown persist.

Article Highlights

  • Second-quarter earnings season is off to a relatively strong start.
  • Technology and other cyclical stocks have joined the recent rally in more defensive sectors.
  • Higher-yielding fixed-income securities have gained despite the weakening economy.
  • The economic outlook is partly to mostly cloudy, but bright spots are tempering the gloom.
  • We see some scope for upward market moves in the third quarter.


“Spread credits” (lower-rated, higher-yielding non-Treasury bonds and structured securities) rallied over the past week despite such fears, which were reinforced by some relatively downbeat economic releases. Although a weakening economic environment typically dampens enthusiasm for spread credits, it appears that some fixed-income investors have concluded that, since there is no end in sight to extremely low interest rates, they will not shy away from certain categories of riskier assets to capture whatever incremental yield they can. Moreover, although Federal Reserve Chairman Ben Bernanke was noncommittal in his July 17 testimony regarding a specific timetable for further monetary stimulus, some investors see the increasingly likely prospect of Fed action as putting a floor under the pricing of spread-sector credits, making investors more likely to invest in these securities even as the uncertain economic environment persists.

Mixed economic data inspire neither confidence nor panic

The past week brought a spate of headline data that was not particularly encouraging, with some key indicators reinforcing a deceleration in the U.S. recovery. On the down side:

  • Weekly first-time unemployment claims shot up by 34,000, after falling to a nearly four-year low the week before. The jump in claims—more than economists had forecast even after considering unusual seasonal factors—indicated that businesses remain reluctant to hire.
  • Retail sales fell 0.5% in June, the third consecutive month in which consumers curtailed their spending on most goods and services.
  • Existing-home sales fell 5.4% in June, to their lowest level since October 2011, tempering other recent data that has pointed to a housing recovery.
  • The index of leading indicators published by The Conference Board fell 0.3% in June, weighed down by weak business orders, consumer confidence and building permits.

Adding to the relatively subdued assessment was the Fed’s most recent “Beige Book,” released on July 18, which indicated the economy was growing at a “modest-to-moderate” rate, a slight downgrade from the Fed’s previous survey.

In contrast, other indicators were somewhat more positive. The balance of evidence is consistent with a slow 2% growth rate for the U.S. economy rather than a sharper slowdown. On the plus side:

  • Housing starts surged to an annualized rate of 760,000 in June, their best performance since autumn 2008. While building permits fell slightly, homebuilder confidence jumped to its highest level since early 2007, months before the start of the Great Recession.
  • Industrial production edged up 0.4% in June, after a 0.2% drop in May, and the capacity utilization rate (measuring the actual output of industry relative to its potential output) moved closer to its historical long-term average of about 80%, continuing a rebound from its trough of 67% in mid-2009.
  • Second-quarter corporate earnings have generally been better than recently reduced expectations, and are essentially tracking patterns seen in the past two quarters.

Outlook: Some scope for upward movement in markets

A continuation of global central bank easing to stimulate growth

  • Looking ahead, there is potential for strong market performance in the third quarter as long as certain encouraging macroeconomic trends continue. Some of the themes we are watching closely include:
  • Lower gasoline prices, which will boost consumers’ purchasing power
  • Further gains in U.S. housing
  • A rebound in prices for copper, oil and other commodities, which may signal better growth in China during the second half of the year
  • Increased toll road traffic, which has been a reliable indicator of growth historically.

Of course, many uncertainties remain, including the path ahead for Europe and the looming “fiscal cliff” of automatic spending cuts and tax increases that will take effect in the U.S. in 2013, absent a political compromise. In such an environment, vigilance and caution are as critical as ever. Nonetheless, if the balance of global uncertainty tips more in favor of optimism and there are no major shocks to the system, the third quarter could see a return to favor for higher-beta stocks (i.e., those that tend to be more aggressive in terms of risk and return potential relative to the market as a whole).

In fixed-income markets, the recent resilience of spread sectors, driven by the ongoing demand for yield in the stubbornly low interest-rate environment, could bode well for the performance of non-Treasury investment-grade bonds, higher-rated corporate high-yield bonds, and higher-rated categories of structured fixed-income securities. In addition, the markets are entering a period of lighter issuance, so technical factors may favor spread credits in the ensuing weeks.