Asset Management

Markets’ weekly gain threatened as earnings and home sales disappoint

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

October 19, 2012

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U.S. and foreign equity markets posted solid gains during much of the past week, but by Friday morning the mood had begun to sour amid some high-profile corporate earnings disappointments and an unexpected drop in the pace of existing home sales. Through October 18, the S&P 500 was up 2% for the week, while foreign developed- and emerging-market stocks had gained 3.4% and 1.7%, respectively, based on MSCI indexes.

Although markets responded negatively to individual companies’ earnings misses, on balance the third-quarter earnings picture appears to be better than some analysts had feared. Over 60% of releases so far have been ahead of expectations.

Article Highlights

  • Equity markets rally before hitting Friday-morning speed bump.
  • U.S. housing starts surge, but existing home sales are below forecast.
  • Worries over corporate earnings temper optimism on economy.
  • Treasury yields rise to one-month high before wavering.
  • Europe remains calm, while China’s economy shows signs of improvement.

Higher-yielding, non-Treasury fixed-income securities (“spread products”) also rallied, reflecting increased risk appetites and a continued demand for yield. Fund flows into investment-grade corporate bonds funds continued at a strong pace, as did demand from foreign central banks seeking alternatives to mortgages. Such alternatives remain in short supply, in part because the Federal Reserve’s substantial purchases of mortgage-backed securities (MBS) have taken a large share of available MBS supply off the market.

Meanwhile, U.S. Treasuries underperformed for much of the week. The yield on the 10-year note closed at 1.86% on October 18, versus 1.69% at the end of the previous week. In addition, the 30-year yield rose above the psychologically important 3% level, up from 2.83%. On Friday morning, yields began to decline amid earnings and home-sales data.

U.S. economic releases skew toward the positive
Despite Friday’s below-forecast reading on September’s existing home sales, a number of U.S. economic releases have come in better than expected, as reflected in the Citigroup Economic Surprise Index, which moved higher in the U.S. Among the key positive releases:

  • Retail sales jumped 1.1% in September, ahead of forecast, while July and August sales were revised upward.
  • Housing starts surged by 15% in September, the fastest pace in four years, while building permits spiked 11.6%. In addition, the homebuilder confidence index edged up a point to its highest level since June 2006.
  • The median sales price of an existing home posted its largest annual gain since November 2005.
  • Industrial output rebounded following a weak August, beating consensus forecasts.

The rise in housing starts represents a significant improvement that appears to be exclusively demand-based, rather than weather-related. With the bulk of housing indicators pointing to sustained positive momentum, we see favorable implications for job growth, bank earnings and discretionary consumer spending.

The U.S. consumer is also benefiting from a healing job market and a substantial rise in net consumer wealth, which has risen by more than $5 trillion from a 2009 low, as home prices and equities appreciate.

In addition, lower oil prices have contributed to a recent drop in the price consumers pay at the pump, while wholesale prices currently suggest another 20-cent decrease is likely.

Europe remains calm as Spain avoids a downgrade and EU summit concludes
The markets’ long-running fixation on Europe took a back seat in the past week, reflecting a relative lull in developments surrounding the eurozone debt crisis. Importantly, there were no major shocks to the system that could have derailed the slowly improving prospects for further meaningful policy action.

  • Spain avoided a credit rating downgrade by Moody’s Investors Service, relieving fears that Spanish sovereign debt would be cut to “junk” status.
  • A two-day summit of EU leaders concluded on October 19 with no breakthroughs—but with no calamities, either.
  • Although overall economic activity remains weak in the eurozone, the Citigroup Economic Surprise Index for Europe has ticked up, reflecting some better-than-expected data releases.

Against this backdrop, yields on Spanish government bonds have continued to fall and are running approximately 200 basis points (2%) below their mid-summer peak of about 7.6%. At the same time, the MSCI Europe Index gained 3.5% in the past week through October 18.

Improving Chinese data hint that economic cooling may have bottomed
China’s economic slowdown, which has been a source of concern over the past several months because of its potential impact on the trajectory of global growth, showed signs of easing:

  • Industrial production and retail sales for September accelerated, while iron ore inventories have declined, suggesting increased activity.
  • Leading economic indicators, while still in contraction mode, finally turned upward, as calculated by the OECD (Organization for Economic Cooperation and Development).
  • China’s GDP grew 7.4% in the third quarter versus a year ago, in line with expectations.

Meanwhile, comments by Chinese officials suggest that growth may accelerate in the fourth quarter. If this occurs, then 2013 may turn out to be a better year for growth than many forecasts currently imply.

Fears of U.S. “fiscal cliff” continue
Uncertainty about the looming fiscal cliff remains a dominant theme, given the potential for a substantial blow to the U.S. economy. Estimates range from a 4% to 5% reduction in GDP if no action is taken to avert the automatic tax increases and spending cuts. In our view, the probability of this outcome is 10% or lower. More likely is a temporary delay in December, followed by a deal that stretches out fiscal rebalancing over time, with an aggregate “hit” to GDP of 1% to 2% in 2013. Even under this less draconian scenario, it may require a period of market volatility in December and beyond to force policy action and reach an agreement.

In the meantime, equity market sentiment has backed off recent levels that we believed were overly optimistic. Friday’s sharp decline in equity prices reveals a bearishness that could help set the stage for equity markets to move higher. In fixed-income markets, mortgages appear to reflect the full benefit of QE3, while other asset classes—such as commercial mortgage-backed securities and higher-quality emerging-market sovereign and corporate securities—may have further room to rally. That said, we expect these and other “spread sectors” to become increasingly sensitive to corporate earnings releases and other headline news (e.g., the presidential election and fiscal cliff). This means volatility will likely increase from now until year-end, albeit tempered by the Fed’s ongoing asset-buying program.