William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
August 24, 2012
The U.S. equity market’s summer rally hit some speed bumps during the past week but appeared to be weathering the volatility heading into the final day of trading. The S&P 500 Index briefly touched a new intra-day high for the post-2008 financial crisis era on August 21.However, it subsequently gave back gains amid mixed global economic data and “will they or won’t they?” uncertainty about the Federal Reserve’s plans for further monetary stimulus. Nonetheless, through August 23, the S&P 500 remained in positive territory, up 1.9%) for the month to date and up 7.3% for the period since May 31.
Stocks with the largest market capitalizations, represented by the S&P 100 Index, have generally led the summer advance. In recent weeks, however, small-cap stocks have outperformed as investors proved willing to assume more risk. Meanwhile, European stocks have bested their U.S. counterparts since the end of May, with the MSCI Europe Index rising 13.8% through August 23. Positive global equity returns have been driven by improved sentiment regarding Europe, stronger-than-forecast consumer spending, and hopes that China will take further decisive action to stimulate its economy.
In fixed-income markets, “spread products”—lower-rated, higher-yielding, non-Treasury securities—took a breather after weeks of strong performance that saw their prices rise and yields fall. At the same time, the yield on the bellwether 10-year Treasury security has been volatile. A few weeks ago, with heightened fears about Europe’s debt crisis and a marked slowdown in U.S. and global growth fueling demand for safe-haven assets, the 10-year yield closed at an all-time low of just over 1.4%. As global economic data strengthened and Europe remained relatively calm, the 10-year yield subsequently climbed to 1.86%, only to fall back to 1.68% at the end of trading on August 23. Treasury yield movements bear close scrutiny not only because of their effect on investment returns, but also because they serve as barometers of the future direction of markets and economies.
U.S. data spark concerns about Fed’s next stimulus move
U.S. economic releases were mixed during the week. Weekly first-time unemployment claims rose more than forecast, while headlines about surging durable goods orders in July tended to downplay signs of weakness in some of the underlying data. Housing indicators remained decidedly positive:
On balance, recent U.S. data has been strong, including data on housing, leading economic indicators, consumer confidence, retail sales, industrial production, bank loans and other real-time measures of company activity. This has led some to believe that further monetary stimulus by the Fed is no longer on the table, at least in the short term. Some Wall Street analysts now see only a 50/50 chance that the Fed will implement a third round of quantitative easing. This increased pessimism has emerged despite the release of the Fed’s most recent meeting minutes, which suggested the growing likelihood of a “substantial” bond purchasing program.
Europe’s economy continues to contract, while Chinese manufacturing slows
There has been little evidence of economic improvement in the eurozone, where GDP shrank by 0.2% in the second quarter of 2012, compared with the first quarter, and by 0.4% versus the second quarter of 2011. Data released during the past week reinforced the bleak situation: Based on preliminary readings, the composite Purchasing Managers’ Index (PMI) of eurozone manufacturing and service-sector activity contracted for the seventh consecutive month in August. Hopes that a stronger German economy could help lift broader regional economic performance were unfulfilled, as Germany’s composite PMI decelerated at a faster rate in August than July and hit a 38-month low.
China’s manufacturing engine also lost horsepower, with its preliminary manufacturing PMI hitting a nine-month low. Although stronger policy measures to stimulate growth are broadly expected, weak performance by Chinese stock markets indicate that such stimulus has yet to enter the system.
All eyes on the Fed and Europe’s policymakers
Equity markets are looking ahead to a number of high-profile meetings at which major policy decisions may be announced, providing clarity on future stimulus measures and actions to address Europe’s ongoing debt problems. Remarks by Fed chairman Ben Bernanke and European Central Bank president Mario Draghi at the Fed’s upcoming annual summit in Jackson Hole, Wyoming, are among several potential triggers of market direction that will take place over Labor Day weekend and the first week of September.
In the meantime, some indicators suggest that we might see a short-term correction in equity markets. The “VIX” index (an estimate of stock market volatility) has moved to a new post-2008 low of 13.3, indicating that investors may have become complacent. However, the VIX has been known to remain at low levels for extended periods if—as has been the case for the past several weeks—there are no external shocks to provoke investor fear. Reinforcing the market’s complacency, some technical indicators of short-term investor sentiment have turned neutral to bullish, which could signal that we are due for a pause after the summer rally.
That concern is reinforced by rising commodity prices. Oil is again approaching $100 per barrel, and food prices are poised to soar as the drought takes its toll on U.S. and South American crops. These anticipated price increases could thwart stronger global consumer spending, which has been a key component of better-than-expected economic readings of late. However, the impact of these increases is more likely to be felt later in the year. As a result, in our view, any near-term market corrections should be shallow, and stocks may resume their upward movement, barring renewed panic over Europe).
Fixed-income markets are also preparing for significant post-Labor Day news flow. If the Fed decides not to intervene on the basis that recent stronger economic releases make further stimulus unwarranted, we would likely see a back-up in U.S. Treasury yields. With regard to non-Treasury sectors, additional good economic news or upside surprises are needed to support a rally in high-yield, investment-grade corporate, and emerging-market debt securities. On the other hand, we are likely to see yield spreads widen if no progress is made toward resolving the European debt crisis, if China’s economy decelerates further, or if U.S. employers scale back investment in labor and machinery given uncertainty surrounding fiscal and debt policy ahead of the November elections.
The information provided herein is as of August 24, 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.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).
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