Asset Management

Economic data support equity, non-Treasury bond markets

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

August 17, 2012

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U.S. equity markets started the past week flat but posted generally stronger returns as the week wore on, amid some better-than-expected economic data releases. For the month-to-date through August 16, the Russell small-cap and mid-cap indexes were up about 3.5%, outperforming the 2.83% return of the S&P 500 Index. August has seen investors grow more comfortable shifting some of their assets away from the perceived safer haven of large caps—a reversal of the risk-averse environment that prevailed in June and July.

Likewise, equity markets in developed countries outside the U.S. have generally outpaced the S&P 500 in August, with the MSCI EAFE Index rising 3.34%, led by double-digit gains in Spain (+10.92%), Italy (+7.75%), and Greece (+7.18%). In aggregate, the 5.60% rise in euro-based equity markets was effectively double the S&P 500’s return for the month-to-date period.

Article Highlights

  • Equities continue their August rally, but trading volumes are low.
  • U.S. Treasuries suffer, while higher-yielding bond sectors outperform.
  • Retail sales surprise on the upside, boosting optimism.
  • Markets set their sights on upcoming Fed and European policy moves.
  • Barring a shock to the system, financial markets have room to rise further.
  

In fixed-income markets, it was another good week for “spread products”—higher-yielding, non-Treasury securities, which tend to rally when investors increase their appetite for risk. Cautious optimism regarding the eurozone debt crisis and stronger U.S. economic data spurred demand for spread sectors, pushing their prices higher and their yields lower.

Meanwhile, demand for safe-haven U.S. Treasuries declined, causing their prices to tumble and their yields to jump. By midweek, yields on the 10-year and 30-year Treasuries were up to 1.83% and 2.95%, respectively (versus respective all-time lows of 1.43% and 2.46% less than a month ago).

The net result has been a significant narrowing of yields between Treasuries and spread sectors. In many sectors, spreads are at or approaching their tightest levels of the year. This recent preference for risk is reflected in the total returns of various Barclays bond market indexes. For example, month-to-date through August 16, the U.S. high-yield corporate bond index has gained 0.44%, while the long-term Treasury index (with maturities of 20 years or more) has lost 6.16%.

Key U.S. economic indicators tilt toward improvement
U.S. economic releases continued to offer pleasant surprises. The following were among key data points contributing to the improved economic landscape:

  • Employment. The four-week moving average of first-time unemployment claims dropped to its lowest level since late March, and continuing claims also fell.
  • Housing. Building permits, a key forward-looking indicator, rose to their highest level since August 2008, and homebuilder confidence reached its highest level in more than five years, as measured by the NAHB/Wells Fargo Housing Market Index.
  • Retail sales. Following three consecutive months of declines, retail sales jumped 0.8% in July, their biggest gain since February.
  • Industrial production. While the 0.6% gain in industrial production was in line with expectations, the capacity utilization rate (measuring the actual output of industry relative to its potential output) rose to 79.3% in July, its highest level since April 2008.
  • Consumer sentiment. The University of Michigan-Thomson Reuters index of consumer sentiment, seen as a gauge for the direction of consumer spending, climbed in August, versus an expected decline due to economic uncertainty.

Other data offset this positive picture. Housing starts were slightly lower, and two indicators of regional manufacturing activity offered disappointing reads: The Empire State Index turned negative for the first time since last October, and the Philly Fed Index fell more than expected, for its fourth straight monthly decline. The Conference Board’s Index of Leading Economic Indicators posted a slightly stronger-than-forecast gain in July, but this came on the heels of downward revisions for May and June. Overall, real U.S. GDP continues to grow slowly, at an annualized rate of about 2%.

China’s slowdown and eurozone weakness remain in focus
Economic releases out of China were weaker than expected, although we think the data still support a potentially faster rate of growth than that seen in the second quarter. At play is a cooling industrial engine, offset by better domestic consumption. Specific areas of slowing or weakness in China included:

  • exports;
  • loan growth;
  • money supply;
  • electricity consumption; and
  • industrial surveys.

Bears now interpret these releases to mean that China’s growth may be slowing to 7%, versus consensus forecasts of more than 8%. On the plus side, Chinese officials commented that inflation was low enough to set the stage for further economic stimulus.

European economic indicators also remained weak but were no worse than expected. Markets continue to fixate on whether Spain and Italy would be willing to sign a memorandum of agreement (MOU) with the European Central Bank (ECB), binding each country to sustain the fiscal discipline and economic reforms already enacted. Such a move is the stated prerequisite for ECB action to fully support those nations’ sovereign debt needs, which would help neutralize market fears of a euro collapse. During the past week, the markets’ confidence that the ECB will support funding for Spain and Italy was reflected in sharply lower yields on Spanish and Italian sovereign debt.

Meanwhile, Greece was able to secure short-term funding to repay a bond maturing on August 20. Although Greece’s second-quarter GDP contracted by 6.2%, this was a less severe decline than that experienced in the previous quarter. It is encouraging that the Greek government has reached a tentative agreement for further fiscal cuts, which in turn has elicited favorable comments from the “troika” of institutional creditors (the European Union, International Monetary Fund and ECB) holding the key to Greece’s October funding needs.

Outside of the eurozone, U.K. retail sales were stronger than forecast for July and revised upward for June. The surprising data offered hope that the U.K. recession is milder than originally thought and helped boost confidence in global growth prospects.

Markets eye upcoming policy meetings for direction
Equity trading volume has remained very light in August. For now, better economic data—plus hope—are the key market drivers, but policy will again take center stage in late August and the first week of September. Critical events include scheduled remarks by Fed chairman Ben Bernanke and ECB president Mario Draghi at the economic summit in Jackson Hole, Wyoming, on Labor Day weekend. This summit could provide clues on the likelihood of further quantitative easing by the Fed and foreshadow developments in Europe, where eurozone finance ministers and the ECB will meet separately in September. Many now expect the September ECB meeting to result in policy steps that could include rate cuts, an expansion of Long-Term Refinancing Operations (LTRO) and other actions to boost liquidity and support growth.

In U.S. equity markets, recent gains have made valuations less attractive, although they are still below average, suggesting further upside opportunities. Of greater concern are complacency and overly optimistic market views, reflected in an increase in hedge funds’ net exposure to equities and short-term measures of sentiment that are neutral but rising. While there is much to worry about in Europe, equity markets there have turned decisively higher, with 60% of European markets now trading above their rising 200-day moving averages. Despite that advance, the MSCI Europe index is still among the cheapest markets in the world. On balance, we expect markets to move higher entering the fall, unless oil prices spike above $100, Spain proves unwilling to sign an MOU, and/or China decelerates sharply or suffers an unforeseen economic or political event.

Meanwhile, bond market sentiment is now at a crossroads, potentially gravitating from a rally based on the prospects for a third round of quantitative easing (QE3) toward a rally based on firming economic activity (which could make QE3 less likely). We would need to see at least a few more weeks of solid U.S. economic releases for such a shift in market view.

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