Asset Management

Markets hold onto previous weeks’ gains while lacking decisive direction

William Riegel, Head of Equity Investments
Joseph Higgins, Portfolio Manager, Global Public Fixed-Income Markets

September 21, 2012

Click here for a downloadable version (PDF) 

U.S. equity markets maintained the high levels achieved by last week’s rally, which was triggered by the Federal Reserve’s announced third round of quantitative easing (“QE3”). Market activity was characterized by light trading and somewhat muted responses to developments that included additional easing from the Bank of Japan, concerns over Spain’s reluctance to request a bailout, and mixed economic news in the U.S.

Defensive sectors led the markets, with consumer staples and utilities outperforming more economically sensitive sectors such as industrials, financials and energy. Domestic stocks, while down slightly for the week as of September 20th, outperformed international stocks, which realized steeper declines based on global growth concerns. These concerns continue to be a primary focus in developed and emerging international markets.

Article Highlights

  • Markets hold onto previous weeks’ gains based on light, low-conviction trading.
  • U.S. housing shows signs of strength while manufacturing and employment disappoint.
  • Positive momentum in Europe perhaps disrupted by looming concerns.
  • Bank of Japan announces easing plan while China struggles to combat slowing growth.
  • We foresee prospects for a short-term correction, while keeping an eye on long-term value in Europe.

Fixed-income markets reflected a shift to more defensive positioning, as yields required for riskier credits increased while yields on safer U.S. Treasuries declined throughout the week. Part of this movement reflected a modest retraction of last week’s strong gains in mortgage-backed securities, which had fully priced in the Fed’s ongoing QE3-related purchases in that sector. High-quality corporate bonds did very well under prevailing conditions, as did Treasuries, as the 10-year Treasury yield declined from 1.88% to 1.79% as of September 20th.

Focus in U.S. remains on direction of economy
While signals remain mixed in the U.S., overall indications point to a rebound from the 1.7% GDP growth registered in the second quarter back to 2%-plus trend-line growth.

Positive indications include:

  • The National Association of Home Builders Index reached the highest level in six years, exceeding expected levels and reflecting increased optimism among home builders.
  • Although August housing starts were less than expected, sales of existing homes jumped nearly 8% and new housing permit issuance improved, indicating very strong housing activity.
  • The ECRI index of leading indicators again moved higher, as did economic surprise indices.
  • The Philadelphia Fed Index, a measure of regional manufacturing growth, declined by less than expected.

Negative indications include:

  • The Empire State Index indicated a sharp slowing in manufacturing activity in New York State, marking its lowest reading since 2010 and possibly foreshadowing declines in other states.
  • Weekly jobless claims came in above consensus at 382,000, pushing up the four-week average and indicating lackluster job creation.

Although improved housing activity indicates that housing markets are continuing their recovery, this nascent strength has not yet appeared in employment numbers. The Fed’s hope is that lower interest rates will lead to more refinancing, home sales and home-related expenditures, which could boost employment over time. Additionally, higher home prices, which have increased by 10% on a year-to-date basis, are expected to bolster consumer confidence via the "wealth effect." This can lead households to become more willing to use savings for discretionary purchases, thereby boosting GDP. As the turnaround in housing prices and additional stimulus measures are recent developments, the anticipated effects will take time to filter through to broader measures of consumer activity and economic growth.

Economic headwinds and upcoming budget announcements loom for Europe
Prospects for improvement in Europe have been bolstered in recent weeks by several developments, including:

  • the European Central Bank bond-buying program;
  • a favorable ruling by German courts on the establishment of a permanent bailout fund (known as the European Stability Mechanism, or ESM; and
  • a Dutch election that supported a euro-centric government.

Despite these positive developments, Spain’s reluctance to request a bailout, as well as renewed uncertainty over the implementation of a single supervisory mechanism for eurozone banks have emerged as items of concern. Additionally, declining measures of business confidence and a strengthening euro represent additional headwinds for the eurozone economy.

Anticipated developments in Europe next week could represent potential triggers that may lead to a short-term correction in European markets and beyond, including:

  • The Greek government is set to formulate a revised plan to close a €13.5B ($17.6 billion) deficit, followed by a meeting between the Greek Prime Minister and Troika officials (leaders of the European Commission, International Monetary Fund, and the European Central Bank) to assess the feasibility of a budget deal.
  • The Spanish government will determine provisions of the 2013 budget and is likely to release the results of its bank stress tests, which will indicate how much European support will be needed for the sector.
  • The French government will lay out an attempt to reach European fiscal targets, with a significant chance of labor unrest in the weeks that follow.

Bank of Japan announces stimulus and China struggles to improve growth
The Bank of Japan surprised markets during the week with quantitative easing measures intended to stimulate the country’s sluggish economy. These measures will likely lead to depreciation in the value of the yen, thereby increasing the competitiveness of Japan’s exports. As a result of quantitative easing programs now in effect in Europe, Japan and the U.S., capital is likely to flow to emerging markets that offer higher interest rates. This will likely place pressure on emerging markets to limit appreciation of their currencies, which is often accompanied by a reduction in exports.

Along with other Asian economies, China continues to struggle to implement effective measures to boost growth. A preliminary survey of manufacturing activity for September indicates continued contraction, as has been the case for 11 straight months. New measures announced to reverse slowing will likely be accompanied by the release of stimulus funds that were previously held up by government transition issues, which may allow activity to reaccelerate meaningfully in the first half of 2013. Investors in Chinese markets remain unmoved by that prospect for the time being, as evidenced by steep declines realized by the Shanghai Composite during the week.

Based on the strong run-up in markets in recent weeks, the S&P 500 has moved to within 7% of its 2007 peak, reflecting high levels of optimism and a strongly bullish sentiment that may leave U.S. equity markets vulnerable to a short-term correction. By comparison, the MSCI Europe Index has advanced a world- beating 24% since hitting a June 1st low, but still remain 72% below the 2007 peak. Despite the very strong move by European equities, they remain relatively cheap and have, in our opinion, significant upside potential assuming the EU holds together and growth resumes.

Within fixed-income markets, we consider conditions to be supportive of spread sector credits, which may outperform in a continued slow-growth environment. Moreover, we remain encouraged that improvements in housing market activity, against a backdrop of stepped-up stimulus in the U.S. and abroad, will result in improving global growth conditions into next year.