William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
October 5, 2012
The third quarter of 2012 wound down with U.S. equity markets meandering, as investors digested the latest batch of economic data and major policy announcements by the Federal Reserve and European Central Bank (ECB). Markets grew more confident during the first week of October, however, with the S&P 500 Index rising 1.5% through October 4 on signs of improving economic activity.
Non-U.S. equities also climbed: the MSCI EAFE and MSCI Europe Indexes rose 1.2% and 2.3%, respectively, through October 4. Markets appeared poised to build on these gains following the surprising news that the U.S. unemployment rate dropped to 7.8% in September—the first time in 44 months that it has been below 8%.
In fixed-income markets, many “spread products” (higher-yielding, non-Treasury securities) benefited from the week’s positive economic news and from strong demand for an increasingly scarce supply of higher-yielding investments in the market. Commercial mortgage-backed securities and investment-grade corporate bonds were among the chief beneficiaries during the week, as fixed-income investors proved willing to accept higher levels of risk. Investment-grade corporate bond funds, for example, saw inflows of $1.2 billion during the week.
Meanwhile, falling demand for safe-haven assets hurt U.S. Treasury markets, where prices declined and yields rose. The yield on the bellwether 10-year Treasury security closed at 1.7% on October 4 and was ticking upward in the immediate wake of September’s employment report.
Employment numbers cap a week of improving economic momentum
U.S. and global economic momentum was generally positive during the week, which was capped by the release of September’s unexpectedly favorable U.S. employment data. The economy added 114,000 jobs in September—in line with or slightly above consensus forecasts—while payrolls for July and August were revised higher, to 181,000 and 142,000, respectively. Additionally, the decline in the unemployment rate was driven by increased job creation and not by more people leaving the workforce.
Among the other favorable U.S. economic indicators released in the past week:
Europe seen as down but not out, with glimmers of optimism for 2013
In Europe, manufacturing is still contracting. Recent PMI levels have been above expectations, however, indicating some improvement. Additionally, some economic forecasts for Europe have been revised upward for 2013 on expectations that fiscal cuts by eurozone governments may not be as deep as originally thought, and that ECB policies may enhance the flow of credit.
During the past week, ECB president Mario Draghi continued to reassure financial markets, whose primary concern is whether and when Spain will request a formal bailout. Such a bailout, which would come with strict fiscal conditions, is considered essential to preventing a shock to the system as Spain’s debt woes continue. However, the likelihood that Spanish Prime Minister Mariano Rajoy will make the request soon has been diminished by recent social unrest and the political need for the government to get through regional elections on October 21.
Asian economies continue to decelerate but may be reaching inflection point
Asia remains very much in contraction mode, but manufacturing weakness in the region may be reaching an inflection point. The decline in manufacturing PMIs shows that manufacturers, facing weak domestic demand, are substantially reducing their inventories. However, inventory levels may now be down past the point of “normal,” which could set the stage for a sharp reversal.
In China, where both the economy and the stock market have been disappointing, there are hopeful signs. For example, the Shanghai Stock Exchange “A” Share Index has rebounded nicely off recent lows. If that trend continues, it may indicate that policymakers’ heightened focus on economic stimulus will be successful in improving domestic demand.
Cautious optimism tempered by recognition of real risks
In the U.S., evidence continues to suggest that the Federal Reserve’s ongoing efforts to stimulate the economy may be bearing fruit. Meanwhile, global economic activity appears to be slowly improving, helped by central bank policies designed to provide massive amounts of liquidity into the financial system. Although some of these actions may carry some risk for higher inflation, equity valuations remain relatively cheap. The equity market rally that began in early June is now the fourth-longest since 2002 without a correction of at least 5%.
Looking ahead, we believe markets have the potential to continue trending higher in the fourth quarter, but we caution against overconfidence. A bullish market view is clearly jeopardized by the looming threat of the U.S. “fiscal cliff.” However, there are increasing rumblings of political efforts that might turn the cliff into a “slope,” with potential spending cuts and other measures delayed or phased in gradually. Such a development could prove to be another positive catalyst for markets heading into 2013.
The information provided herein is as of October 5, 2012.
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