William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
August 03, 2012
U.S. equity markets logged four consecutive days of losses during the past week, then rebounded sharply on the morning of Friday, August 3, following the release of better-than-forecast U.S. employment data for July. The jump in payrolls helped markets regain some of the optimism that had led most global equity benchmark indexes higher the week before and for the month of July as a whole. The MSCI Emerging Markets Index led July’s rally, advancing 1.95%, while the MSCI EAFE Index rose 1.13%. In the U.S., the S&P 500 Index and the broader Russell 3000 Index returned 1.39% and 0.99%, respectively, in July. A notable exception to last month’s solid equity performance was the Russell 2000 Index, which declined 1.38%, as small-cap companies failed to participate in the broader market rally.
In fixed-income markets, the yield on the bellwether 10-year Treasury traded at around 1.5% for much of the past week—down from its closing value of 1.61% at the beginning of July, but up from its record-low close of 1.43% on July 25. In the wake of July’s employment report, the 10-year yield began to climb toward 1.6% again. Although demand for safe-haven assets has generally kept Treasury yields low, higher-yielding fixed-income categories (“spread sectors”), such as corporate bonds and commercial mortgage-backed securities (CMBS), have also fared well, as investors continue to search for yield. For the month of July, based on Barclays indexes, corporate bonds gained 2.88% and CMBS 1.66%, while Treasuries returned 1.01%. The Barclays U.S. Aggregate Bond Index, a broad measure of investment-grade bond market performance, returned 1.38%—virtually matching the 1.39% gain of the S&P 500.
July’s unemployment report offers a positive surprise
Total nonfarm payrolls grew by 163,000 in July, beating consensus forecasts of 100,000 and tracking exactly July’s ADP National Employment Report, which measures private-sector job creation. The national unemployment rate, meanwhile, ticked up one-tenth of a percentage point, to 8.3%. Another positive sign for the job market was the trend in weekly first-time unemployment claims. The four-week moving average of claims fell to its lowest level since March, consistent with improved hiring patterns. Reinforcing this data was a 2% drop in announced layoffs last month, to the lowest level this year, according to a widely used gauge published by outplacement firm Challenger, Gray & Christmas. Announced layoffs were down 45% from July 2011 levels.
Other economic indicators released during the week were mixed:
Markets underwhelmed by the Fed and European Central Bank
Prior to the release of July’s employment numbers, markets were fixated on the Federal Reserve and the European Central Bank (ECB), both of which held much-anticipated meetings during the week—and both of which disappointed investors by failing to announce decisive and specific policy moves. Although the Fed did not offer specific new measures to stimulate the economy, its statement promised renewed “action” if needed. Investors are now hoping that the Fed will announce a third round of quantitative easing (QE3) or some other form of monetary stimulus at its September meeting.
In Europe, the ECB disappointed inflated expectations that it would immediately begin direct and indirect purchasing of government bonds to support European debt markets. However, in keeping with earlier strong statements, ECB president Mario Draghi signaled strongly that some action will come if other policymakers do their part and push ahead with economic and fiscal reforms. Importantly, Draghi also said the ECB will consider other nonstandard policy actions, which some interpret to mean a form of quantitative easing—not immediately but down the road.
Mixed economic data and some potentially bullish market indicators
U.S. GDP growth, which came in at a tepid 1.5% in the second quarter, could move back up to the 2% trend line later this year if consumers become less conservative in their spending and the fiscal drag on GDP caused by decreased state and local spending ebbs. This would provide a surprise to consensus expectations, but may also temper the Fed’s need to enact further quantitative easing. The key impetus for Fed action (or inaction) will be the August employment numbers, to be announced on September 7.
Meanwhile, Europe’s economy continues to falter. Germany’s Purchasing Manager’s Index (PMI) of manufacturing activity, for example, slipped to 43 in July—well below the critical 50 threshold and clearly a wake-up call that even Germany’s strong economy is vulnerable to weakness in southern European demand. The unemployment rate in the eurozone has reached 11.2%, and up to 500,000 layoffs or more in the European auto industry may be forthcoming in the months ahead, as demand for cars and trucks in the region declines for the fifth straight year.
Although real-time European economic indicators are weaker, some global signs point to stronger growth in the second half of the year, which may benefit Europe. For example, a global basket of base metals, U.S. gasoline demand, and Chinese electricity consumption tracked by Credit Suisse appears to have bottomed in June and has begun to turn upward. In addition, the weakened euro is helping some European companies at the margin, with a number of large firms raising their earnings estimates based on better export activity.
In equity markets, short-term trading sentiment has risen back up to the neutral zone, and even hedge funds have begun to increase their net exposure to stocks. However, a key Bank of America-Merrill Lynch index of long-term sentiment shows that Wall Street strategists’ allocations to equities have hit an all-time low of 43%. Although there are never any guarantees, historically this indicator has been a reliable forecaster of future equity returns, and at its current level would be associated with a very strong expected 12-month return for the S&P 500.
Fixed-income sentiment, for now, assumes that the sluggish U.S. economy will not fall into outright recession—an assumption that is likely bolstered by July’s better-than-expected jobs data. Against this backdrop, and with hopes of eventual further stimulative action on the part of the Fed and other central banks, many fixed-income investors remain focused on high-quality investment-grade corporate bonds. These high-quality “spread” products continue to provide higher yields than Treasuries while offering lower credit volatility than bonds issued by many governments in the developed world.
The information provided herein is as of August 3, 2012.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Past performance is no guarantee of future results.
Please note that equity investing involves risk.