Asset Management

Markets are calmer amid relatively benign data

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

August 10, 2012

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Global equity markets posted generally positive results for much of the past week, with major benchmark indexes gaining between roughly 1% and 3% through Thursday, August 9, amid very light trading. An increased appetite for risk was evident, particularly early in the week, as U.S. small-cap, emerging-markets and eurozone stocks outperformed the S&P 500 Index. Enthusiasm waned as the week wore on, however. Heading into Friday, markets appeared vulnerable in the wake of weaker-than-expected Chinese export growth and other signs of deceleration in China’s economy.

Bond markets also displayed a preference for risk, balanced by caution. Demand for safe-haven U.S. Treasuries eased, sending their prices lower and yields higher. On August 9, yields on 10-year and 30-year Treasuries closed at 1.69% and 2.78%, respectively—their highest levels since late May and well above their recent respective lows of 1.43% and 2.45%. Meanwhile, increased demand for higher-yielding, non-Treasury fixed-income securities (“spread product”) drove their prices higher and yields lower. As a result, the yield spread between Treasuries and non-Treasury sectors of the market narrowed considerably. This narrowing, or compression, of yields was particularly pronounced for higher-quality, investment-grade corporate paper (rated “A” or higher) and less so for bonds rated “BBB” or lower. Investors appeared to be tempering their desire for yield with prudence, given the potential for negative developments in the European debt crisis and other macroeconomic concerns.

Article Highlights

  • Equity markets post modest gains in quiet trading sessions
  • Treasuries underperform, while higher-yielding bond sectors continue to rally
  • U.S. data releases have begun to surprise on the upside
  • China’s outlook remains murky, but further stimulus is likely
  • Markets anticipating U.S. “fiscal cliff” and continued European uncertainty.

Reality versus expectations: some encouraging signs

Recent economic indicators point to some improvements in growth prospects worldwide, at least relative to expectations:

  • Citigroup’s Economic Surprise Index for the U.S., a measure of whether major economic data releases are beating consensus forecasts, has turned up decisively, indicating that data are surprising on the upside. This index historically has been a fairly reliable indicator of the trajectory of U.S. growth, and, at current levels, is also associated with outperformance by economically sensitive sectors of the stock market relative to the broader S&P 500.
  • The proportion of individual countries with a rising Purchasing Managers’ Index (PMI)—a key measure of economic activity—has increased to 46% from 42%. This aligns with the observation that global activity reached a positive inflection point at mid-year after a sharp second-quarter slowdown. JP Morgan’s Global PMI output index rose 1.4 points in July, as strong readings in the service sector more than offset weaker manufacturing activity.
  • Weekly first-time unemployment claims in the U.S. fell by 6,000 for the week ended August 4, to 361,000, compared to consensus forecasts that claims would rise to 370,000.
  • Also on the employment front, job openings increased to 3.67 million in June, from 3.66 million in May. Compared to a year ago, job openings were up 16%.

Overall, the level of activity in the U.S. puts the economy on pace to reaccelerate from its 1.5% second-quarter growth rate to about 2%. Meanwhile, emerging markets have generally been responding positively to strong monetary stimulus measures. These favorable developments may not be enough to counter the slipping rate of activity in Europe, however.

China remains a wild card

Unlike U.S. economic releases during the past week, China’s data generally surprised on the downside:

  • Chinese exports rose just 1% versus a year ago (compared with consensus expectations of 8% growth), while imports increased 4.7% (versus an expected 7% rise).
  • Industrial output in China was up 9.2% in July versus a year ago but down from 9.5% in June and below the consensus 9.8% forecast.
  • July retail sales missed the mark, rising 13.1%—down from a 13.7% increase in June and below expectations for another 13.7% gain.

Separately, China’s inflation rate fell to 1.8% in July, a 30-month low and well below the government’s official target rate of 4% for the year.  Falling consumer prices should give policymakers freedom to enact further stimulus measures with little risk of overheating the economy.

Earnings and sentiment improve, “fiscal cliff” and European concerns loom

Equity markets have generally responded well to recent signs of economic progress and are anticipating further benefits from policy actions expected to be taken by the Fed and the European Central Bank (ECB) later this year. In the U.S., approximately 75% of S&P 500 companies have reported second-quarter earnings, with roughly two-thirds beating expectations, slightly above the long-term average. Short-term trading sentiment in the U.S., which had been quite bearish, has now moved firmly into a neutral zone. Should expectations and optimism continue to rise, we would be increasingly cautious about the prospect of a market correction if those expectations are not met.

In Europe, the pace of earnings revisions has slowed relative to the rest of the world, despite the prevailing economic gloom. In part, this reflects the dramatic cuts in earnings expectations that have already occurred. Consensus earnings for non-financial stocks in the Eurostoxx index have been cut 20% from what was expected in 2010. By comparison, consensus forecasts were cut 42% just after the failure of Lehman Brothers in 2008.

On the fixed-income front, if we were to see good news out of Europe in the coming weeks (for example, if German courts affirm that nation’s constitutional ability to support the European Stability Mechanism, or ESM), the recent rally in spread sectors could continue. As Treasury yields rise, the ability for yield spreads to compress further could increase dramatically. Moreover, fund flows into investment-grade corporate bonds remain very strong, providing a technical tailwind.

Issuance of investment-grade securities in the past week came in at roughly double expectations, as companies emerged from “blackout” periods and are choosing to issue new debt now, rather than wait until next quarter, which will likely see intensifying concerns about automatic spending cuts and tax increases (the so-called “fiscal cliff”) that will take effect unless a political compromise is reached. As in recent weeks and months, the European debt crisis and, to a lesser extent, the relative strength or weakness of U.S. labor markets, will set the tone going forward.