Asset Management

Markets driven by three usual suspects: Europe, economy, and earnings

William Riegel, Head of Equity Investments

July 27, 2012

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Capital markets continued to be buffeted this week by the three usual suspects: Europe, the economy, and earnings. The overarching concern was for Europe’s sovereign debt issues. This centered on Spain’s possible need for a sovereign bailout, weakening regional government finances in Spain and Italy, and questions over whether the International Monetary Fund (IMF) funding needed to prevent a Greek euro exit would remain available. Later in the week, markets were soothed by a statement from European Central Bank (ECB) President Mario Draghi indicating that the ECB was prepared to do whatever it takes, within its mandate, to preserve the European Currency Union.

The week brought a steady flow of second-quarter earnings announcements, as well as several U.S. economic releases. Most indications, including an advance estimate of second-quarter GDP growth, pointed to slowing growth and a number of economic activity measures offered negative surprises. In the spirit of “what is bad is good,” the weaker tilt sparked speculation about further Fed easing. There are increasing expectations of a possible announcement next week for an extension of low rates to 2015 and the possibility of a third quantitative easing program that could be announced in September.

Article Highlights

  • Weakening conditions in Europe draw investor focus, with potential for relief coming into view.
  • Earnings dip from first-quarter levels but remain on solid footing.
  • U.S. economic data tilts negative on unpleasant manufacturing surprises.
  • Positive indications from China emerge as possible source of support for global growth.
  • Change in composition of market activity may indicate a turn in investors’ degree of conviction.

Following four straight days of declines, equity markets rebounded late in the week, indicating a likely positive result for the week. Similarly, fixed-income markets were largely driven by global macroeconomic concerns, with U.S. Treasury yields dipping lower, while the margin of incremental yield, or spread, required for lower-quality credits increased somewhat during the week.

Europe remains focal point

Most market-related developments this week took a back seat to mounting problems faced by Europe, where sovereign debt concerns have been exacerbated by a continued deterioration in economic activity for the region. This was most recently reflected in a purchasing managers’ index (PMI) reading that showed German activity shrinking at the fastest pace in three years. Together with other indications, this has caused previous projections for new growth in the eurozone during the second half of the year to be put on hold.

Without much to cheer on the economic front, investors pegged their hopes on an apparent change in tone from the ECB, signaled by Draghi’s strong affirmation of the ECB’s commitment to preserve the eurozone’s monetary union. The ECB president’s comments were interpreted by many investors to imply that the ECB is prepared to use its balance sheet to provide more direct support for eurozone member states. Speculation is growing that this could take the form of a reactivation of the Securities Markets Programme (SMP), a new Long-Term Refinancing Operation (LTRO) program with more liberal collateral rules, or other measures.

Second-quarter earnings picture firms up

Earnings season continued in full force during the week, with about half of S&P 500 companies reporting second-quarter earnings so far. Although earnings growth has tapered off from first-quarter levels, about two-thirds of companies have beaten expectations, and reported earnings have increased by close to 9% over last year. Although a high-profile miss by Apple drew attention this week, there have been positive results for technology-sector companies that are more dependent on enterprise spending than consumer purchases. Financial-sector earnings have been strong, based on comparisons against much lower earnings in previous periods. Many companies struggled with an increasing difficulty in growing revenues, particularly as an appreciating U.S. dollar reduces the value of revenues earned abroad.

Durable goods orders indicate further slowing in U.S. while employment shows improvement

Economic releases this week mostly confirmed further slowing in the U.S. economy, as reflected by:

  • A June Chicago Fed national activity reading improved compared to May’s reading, but confirmed ongoing below-trend growth.
  • A “flash” U.S. manufacturing purchasing managers’ index registered its worst level since December 2010, reflecting the increasing drag of export declines on manufacturing activity.
  • Durable goods orders for June, excluding volatile orders for aircraft and other transportation-related equipment, fell by 1.1%, the biggest decline since January.
  • An initial reading of second-quarter gross domestic product came in at 1.5%, which, while above consensus forecasts, still indicated a marked slowdown from 2% growth in the first quarter.

To some extent, these indications of slowing were offset by weekly initial unemployment claims and continuing claims readings that came in lower than expectations. While markets were relieved to see some relative strength in these weekly numbers, these numbers are often volatile in the short term, placing greater importance on longer-term averages.

Looking to Asia, indications from China are showing signs of improvement. Purchasing managers’ activity has increased, home prices have risen, loan growth has turned positive and announced infrastructure programs are increasing. Although we are apprehensive that a replay of the 2008-2010 expansion may create the risk of greater imbalances down the road, reacceleration in the second half of the year would bolster world growth and markets.

Outlook: trends in market activity may indicate market participants’ increased conviction

Our outlook, which takes into account continued economic slowing, also considers downside risks to be limited to some degree by the Fed’s and ECB’s increased readiness to implement measures promoting growth and preventing extreme market and/or economic shocks. We see encouraging signs in the composition of market activity, which has favored more cyclical groups even in the absence of positive guidance or strong reported earnings from such companies. At the same time, investors are demanding better performance from more stable companies in order to justify valuations that have been reached on the basis of the companies’ “safe” status. We think that such trends, along with signs of improving volume, could be a signal that a better third quarter is in the offing.