Asset Management

Meandering markets wait for post-Labor Day cues

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

August 30, 2012

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U.S. equity and fixed-income markets appeared to be in a state of near-suspended animation at midweek, quietly drifting in a “no news is good news” environment. Absent major economic headlines out of Europe or other unexpected shocks, the S&P 500 was essentially flat at –0.01% for the week through August 29. Foreign developed and emerging stock markets underperformed returning –0.42% and –1.27% for the same period, respectively, based on MSCI indexes.

In fixed-income markets, the yield on the bellwether 10-year Treasury remained largely range-bound, closing at about 1.65% for the past five trading sessions as of August 29. Meanwhile, yield spreads between Treasuries and lower-rated fixed-income securities, such as high-yield bonds, commercial mortgage-backed securities and investment-grade corporate debt, were little changed. These “spread products” appear to be taking a breather after a substantial rally over the past six to eight weeks.

Article Highlights

  • Equity markets trend sideways on thin trading volume.
  • Treasury yields are stuck in a tight range.
  • U.S. and global economic data remain mixed.
  • Imminent Fed and European Central Bank (ECB) announcements loom large.
  • Volatility could rise in September, historically a weak month for equities.

Continued signs of slow but steady U.S. growth
Indicators released during the past week confirmed the U.S. economy’s positive but slow growth trajectory:

  • On August 29, the government’s second-quarter U.S. GDP growth estimate was revised upward, to 1.7% from 1.5%, generally in line with expectations.
  • The “Beige Book” report of anecdotal activity in the twelve Federal Reserve districts painted a picture of an economy that continues to grow gradually. The overall tone of the commentary was slightly more pessimistic than it had been in the previous report.
  • Weekly first-time unemployment claims were unchanged from last week, and have settled in a range around 370,000—below the worrisome 400,000 threshold that would signal deteriorating conditions in the labor market, but too high to make a serious dent in the unemployment rate.
  • Consumer confidence as measured by The Conference Board fell to a nine-month low in August, although it remained about 20 points higher than its October 2011 trough. Despite the drop in confidence, consumer spending rose 0.4% in July, the fastest pace in five months.

In addition, evidence continued to show that the U.S. housing market is stabilizing, both in terms of national price movements and in demand for new construction. Moreover, the Pending Home Sales Index, based on signed contracts to purchase existing homes, rose in July to its highest level in more than two years.

Global economic picture is mixed
Through midweek, there were few major data releases outside of the U.S. The most recent global indicators have been mixed, with a lack of compelling bright spots.

  • In July, the global composite Purchasing Managers’ Index (PMI) edged up, as an acceleration in service-sector activity offset a decline in manufacturing.
  • In Europe, France’s preliminary PMI reading for August showed improvement compared to July, while Germany’s PMI weakened; the eurozone as a whole remains on a recessionary path.
  • China’s pattern of slowing growth continued in July but has yet to elicit any meaningful policy response from Chinese officials. Many observers believe that forthcoming August data will dictate whether more stimulus will be applied to the economy. A rebound in the Shanghai Stock Exchange “A” Share Index would be an early indicator that such stimulus has been applied. The index, which is in a long-term slump, hit a new low on August 29.

As summer winds down, anticipation ratchets up
The closing days of August and the first week of September will bring a series of potentially critical policy events, any or all of which could trigger significant moves in the financial markets.

QE3: Now or later? Fed chairman Ben Bernanke’s August 31 speech at the annual Jackson Hole summit could foreshadow a third round of quantitative easing (QE3) designed to jump-start persistently sluggish economic growth. However, investors’ heightened expectations may go unrewarded if no new policy specifics are announced. In fact, approaching Labor Day weekend, many market participants believe that a final decision on QE3 will depend on the August employment report (to be released on Friday, September 7) or even be delayed until the fourth quarter, when anxiety about the U.S. “fiscal cliff” could intensify amid election-season political gridlock.

European bond purchases. Following the European Central Bank (ECB) meeting on September 6, markets will look to ECB president Mario Draghi to outline the bank’s bond buying program for the southern tier of Europe (Spain and Italy), further loosen collateral requirements for banks, and lower interest rates by another 0.25%. The specifics of the bond buying program in particular may dictate whether the summer rally in European equity markets will be sustained. Among the key variables will be when and under what circumstances bond purchases occur, whether those purchases will have co-equal or senior status relative to debt held by existing bondholders, and where on the yield curve (that is, in which maturities) the purchases will be focused. There is disagreement about how much detail the ECB will be willing to share at this stage, although Draghi’s cancellation of a scheduled September 1 appearance at the Jackson Hole summit signals to some that next week’s ECB meeting will yield specifics.

Constitutionality of Europe’s bailout fund. Although approved by German lawmakers, the European Stability Mechanism (ESM)—the permanent bailout fund created to help fiscally strapped eurozone governments meet their financing needs—has run into constitutional challenges within Germany. On September 12, Germany’s federal Constitutional Court is scheduled to rule on the legality of the ESM. A positive result is needed to make the ESM operational, while a negative ruling would be a serious blow to European and global credit markets.

Equity market volatility, which recently has been relatively low, has now begun to rise, perhaps in anticipation of the many upcoming events on the global policy calendar. Additionally, history shows that September has tended to be a seasonally weak month for equities. For example, the average monthly return of the S&P 500 Index over the past 40 Septembers (1972-2011) was –0.67%, including double-digit declines in 1974 and 2002. There is no guarantee that this historical tendency will repeat itself in 2012, but caution is warranted. Also of potential concern is that U.S. equity investor sentiment has moved clearly into a bullish zone, which could set the stage for a market correction.

In fixed-income markets, spread sectors have been expecting that meaningful QE3 will, in fact, occur and that genuine progress will be made in addressing Europe’s debt crisis this fall. This optimism is priced into yield spreads, which narrowed relative to Treasuries over the summer. However, if the Fed and ECB underwhelm with their imminent policy moves, there is significant potential for spread products to reverse their summer rally and underperform in the weeks and months ahead.