Asset Management

GDP growth better than expected, but Q3 earnings underwhelm

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

October 26, 2012

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After a relatively encouraging start, U.S. corporate earnings releases turned negative during the past week. A number of high-profile companies missed expectations and guided down forecasts, citing poor foreign activity and fear of the looming “fiscal cliff” at home. This less-than-rosy earnings picture helped drive the S&P 500 Index down 1.4% for the week through Thursday, October 25. Friday morning’s release of better-than-expected GDP growth failed to offer much cheer to the markets, at least in the early hours of trading. International stock markets also had a difficult week, with the MSCI EAFE Index declining by about 1.5% through Thursday.

In fixed-income markets, the long-running rally in “spread sectors” (representing a range of higher-yielding, non-U.S. Treasury products) paused for breath, as recent stock market declines caught up with debt markets. Yields on investment-grade corporate bonds and high-quality structured notes widened relative to U.S. Treasury yields. However, much of this spread widening occurred on light trading volume and was concentrated in select categories of recently issued, higher-risk securities. Nonetheless, nearly all spread sectors have seen yields widen somewhat.

Article Highlights

  • Third-quarter GDP growth comes in at 2%, ahead of forecasts.
  • Consumers spending more, but businesses continue to hold back.
  • U.S. equity markets remain unimpressed by Q3 corporate earnings.
  • Pause in fixed-income “spread sector” rally is no surprise.
  • Speculation over November elections, fiscal cliff intensifies.

This heightened volatility is to be expected following the strength and duration of the spread product rally. With quantitative easing (QE3) and other positives now largely priced in, these fixed-income sectors are forced to react to news flow and earnings reports. Meanwhile, the yield on the bellwether 10-year Treasury, which had closed as high as 1.86% in recent sessions, was at 1.77% on Friday morning.

GDP growth of 2% reflects confident consumers, cautious businesses
The government’s initial estimate of third-quarter GDP growth came in at 2%, ahead of consensus forecasts of about 1.7% and encouragingly higher than the 1.3% growth recorded in the second quarter. In the third quarter, growth was lifted by gains in consumer spending and stronger homebuilding activity. Business spending, however, was disappointing, as companies held onto cash instead of making outlays for equipment and software—reflecting, in part, worries over the potential impact of the U.S. fiscal cliff.

The past week brought additional evidence of rising consumer confidence and support of the U.S. recovery.

Higher earnings for consumer-related stocks: More than 70% of S&P 500 companies in the Consumer Discretionary sector that have already reported third-quarter earnings have beaten analysts’ forecasts, versus an average of only 62% for all sectors.

Consumer sentiment at a five-year high: The University of Michigan/Thomson Reuters Consumer Sentiment Index reached its highest level since September 2007.

Rising home sales: Low mortgage rates, an improving job market, and increased optimism about the direction of the economy have led more consumers back to the housing market, with September new home sales at their highest level in two years.

The week’s other favorable economic releases included gains in durable goods orders, a drop in weekly first-time unemployment claims, and an uptick in manufacturing activity as measured by the “flash” (initial) Purchasing Managers Index, or PMI.

Divergent data on Europe and China
Outside the U.S., economic releases were mixed. European data continued to disappoint, while the pace of deceleration in China appeared to have slowed.

  • In the eurozone, the composite PMI of manufacturing and nonmanufacturing activity fell to 46.1 in October, a 40-month low. Any reading under 50 indicates a contraction, and there are worries that activity could weaken even further over the next few quarters.
  • Job losses continued to mount in Europe, highlighted by a jump in Spain’s unemployment rate to above 25%, a record high.
  • China’s manufacturing PMI improved to 49.1 in October, a three-month high. While still under the 50 threshold separating contraction from expansion, the latest reading offers evidence that the slowdown in China’s economy may be bottoming.
  • The Shanghai Stock Exchange “A Share” Index has continued to edge higher, confirming more positive readings on the Chinese economy.

U.S. growth heading in right direction, while investors focus on election, fiscal cliff
The latest GDP number is encouraging. Although the economy is not yet where it needs to be, it is moving in the right direction, driven by a more confident U.S. consumer. There’s a disconnect between business spending and consumer spending, so we will be watching this relationship closely. Overall, we expect to see slightly stronger growth indicators as we move through the next few months. Assuming no external shocks to the system and a rational approach to resolving the fiscal cliff, we expect GDP growth to approach 2.5%-plus by the late spring or early summer 2013.

With businesses holding back, corporate cash levels have continued to build. We expect this money to be put to use, either for acquisitions or increased capital spending, once the November election is behind us and fiscal cliff issues are being addressed. Increased business spending could prove particularly beneficial for technology companies, which so far have been the primary victims of third-quarter earnings disappointments.

In the meantime, the S&P 500 Index, which hit a 2012 peak of 1465 in mid-September, has fallen below a key support level of 1422. Despite that breach, we believe the market should be able to hold at various other support levels before working higher into the New Year. This is more likely given that market sentiment has sharply reversed from very bullish levels.

Although the U.S. equity market is currently at levels that some find expensive or at least fairly valued, the relative value of stocks versus bonds remains extremely attractive. For example, S&P 500 stocks are trading at about 13 to 14 times forward earnings estimates, while a comparable calculation for high-yield bonds shows a “price-to-earnings” (P/E) ratio of 15.4. This is only the second time since 1980 that high-yield bond multiples have exceeded that for equities.

Markets ponder the potential impact of Election Day
Interestingly, some equity strategists have speculated that the recent pullback in stocks is actually connected to the increased odds of a Romney victory in November. The thinking, which may be premature, is that Governor Romney, if elected, would likely appoint a much more hawkish Federal Reserve Board in 2014, thereby eliminating the massive liquidity being provided by open-ended QE3.

In fixed-income markets, the spread-sector rally is likely to resume after the elections, albeit at a more subdued pace, as the Fed’s continuing asset purchases create further shortages of the most sought-after securities. Although some pundits have suggested that a Romney win would be better for such assets in the short term, we believe these sectors will rally regardless of the election outcome—especially if the winner commits to resolving the fiscal cliff issues during the “lame duck” sessions of Congress.