Asset Management

Strong jobs report boosts optimism in week dominated by Hurricane Sandy

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

November 2, 2012

Click here for a downloadable version (PDF)

October was a down month for stocks, as equity markets corrected from strong third-quarter performance. The S&P 500 Index lost 1.85% for the month, while the MSCI All Country World Index dropped 0.67%. In the U.S., poorer-than-expected corporate earnings results and guidance led to the partial retrenchment of market indexes. Uncertainty over the November elections and the looming “fiscal cliff” exerted a powerful restraint on corporate expectations, while Hurricane Sandy forced a rare two-day shutdown of U.S. financial markets as October drew to a close.

The first day of November provided a positive jolt to equities, however, as a spate of favorable economic data fueled a gain of more than 1% in the S&P 500. A much-better-than-expected employment report the following morning reinforced the brightening economic outlook.

Article Highlights

  • Historic storm shuts down U.S. financial markets for two days.
  • U.S. economy adds 171,000 jobs in October, far more than forecast.
  • After market correction in October, stocks have room to rise.
  • Fixed-income markets seek direction ahead of Election Day.
  • Hurricane rebuilding efforts will provide lift to GDP, offsetting shorter-term negative impact.

Fixed-income markets drifted in October, seeking direction ahead of the U.S. elections. The long-running rally in “spread” products (higher-yielding, non-Treasury securities) appeared to run out of steam in late October, although these sectors still outperformed U.S. Treasuries for the month as a whole.

  • The Barclays U.S. Aggregate Bond Index returned 0.20% for October, with U.S. corporate bonds (+1.29%) outperforming Treasuries (-0.17%).
  • U.S. corporate high-yield (+0.88%) and global emerging-market bonds (+1.27%) also outperformed, as did commercial mortgage-backed securities (+0.55%).
  • Over the course of the month, the yield on the 10-year Treasury climbed from 1.64% to close at 1.72% on October 31. The yield was modestly higher immediately following the release of Friday’s robust employment report.

Employment gains bolster evidence of a strengthening U.S. recovery
Following the previous week’s estimate of third-quarter GDP growth (above expectations at 2%), the week ending November 2 brought a string of more data releases that indicate continued strengthening of U.S. economic fundamentals. News on the employment front was particularly encouraging:

  • Weekly first-time unemployment claims dropped by 9,000, to 363,000.
  • The Labor Department’s October payrolls figure (171,000 net jobs added) far exceeded consensus expectations of approximately 120,000.
  • Job creation totals for September and August were upwardly revised by a combined 84,000.
  • The monthly ADP employment report, which measures private-sector job growth only, showed an increase of 158,000 jobs in October, versus a revised 114,000 in the previous month. Historically, the ADP has been a relatively weak indicator; however, a new methodology, introduced with October’s report, suggests that this monthly figure may warrant closer attention.

Gains in manufacturing, consumer confidence, and home prices
Beyond employment, the week’s other upbeat news included:

  • The Purchasing Managers’ Index (PMI) published by the Institute for Supply Management (ISM) increased to 51.7 in October, from 51.5 the prior month, evidence that manufacturing momentum remains positive. (Any reading above 50 indicates expansion.)
  • Consumers are more optimistic than at any time since February 2008, as measured by the Conference Board’s Consumer Confidence Index.
  • Home prices continued to rise, with the S&P/Case-Shiller 20-city composite index indicating 2% year-over-year growth in August.

One relative soft spot in the latest U.S. data was auto sales, which slipped a bit last month, although Chrysler and General Motors still reported their best October in five years. There are some indications that sales in the Northeast were clipped by Hurricane Sandy in the closing days of October.

Europe remains weak, with data generally in line with expectations
Downbeat economic news from Europe supports our assessment that the region as a whole will find itself in a mild recession this quarter.

  • The unemployment rate in the eurozone hit a record-high 11.6% in September.
  • Spain, in particular, released worsening unemployment figures (25.8%), declining retail sales (-12.6%), elevated inflation (+3.5%), and negative third-quarter GDP growth (-1.3% year-over-year).
  • Other major economies (Germany, France and Italy) released little data to indicate a shift in the slowing trajectory, with the exception of retail sales in Germany (+1.5%)—a significant upside surprise.

China’s economy improving, South Korea remains strong
In Asia, China continues to exhibit marginal strength. In the past week, China’s leading index and manufacturing PMI both improved slightly compared with the previous reading. These recent releases, along with anecdotal information from our research analysts on the ground there, point to a “U” shaped recovery (an inflection point in the growth trend line, rather than a “soft landing”). Tempering these signs of progress are retail sales in Hong Kong, which slowed slightly on the month.

South Korea, the region’s strongest performer of late, continued to show strength with healthy industrial production and export growth. However, the manufacturing survey cooled slightly, and inflation numbers ticked up to 2.1% from 2%.

Outlook: further strengthening in U.S. and Asia, more weakness in Europe
The global economy continues to muddle along, with slightly improving economies in the U.S. and across Asia and slightly deteriorating economies across Europe. We expect Europe to fall into a mild recession this quarter, and that the downturn could steepen in coming quarters as the Spanish economy begins to weigh more heavily against the regional average. Germany is still holding strong but will likely begin to slow in coming quarters as well. Asian economies will improve modestly as China bounces off of the lows seen in the third quarter.

In the U.S., it is clear that fundamental demand in the economy is increasing. We expect GDP growth to track close to 2.3% to 2.5% by late spring or early summer 2013—a level of demand that should provide support to corporate earnings and stock prices, ultimately bringing equity market performance more in line with the economic growth rate.

In the near term, we think the odds favor a seasonal fourth-quarter rally in the equity markets for a variety of reasons: Globally, central banks continue to provide ample liquidity, the relative valuation of stocks versus bonds remains compelling, and short-term trading sentiment has again become cautious—a contrarian signal. (Hedge funds, for example, have lowered their net exposure to equities over the past two weeks.)

Moreover, while analysts’ expectations for earnings may yet prove high, the market tends to be more sensitive to rising inflation. Increasing inflation expectations have historically signaled higher price-to-earnings (P/E) ratios, and the price indexes embedded in the recent third-quarter GDP estimate were stronger than expected.

In fixed-income markets, U.S. economic strength could help reignite a rally in spread sectors. However, with bond investors fixated on the November elections, we think it unlikely that markets will move strongly in any direction until the election results are known. Depending on the outcome, the impact on various industry and company issuers may vary. We believe the overall market is likely to rally in any event, particularly if there are no hurricane-related delays in the voting process or disputed outcomes such as occurred in 2000. Following the election, the markets will be looking for signs that a lame duck session of Congress can get ahead of “fiscal cliff” issues.

The impact of Hurricane Sandy
It is still too early to measure the true economic impact of Hurricane Sandy. However, we can begin thinking about the shock wave and how it will flow through the economy over the coming quarters. The media and Wall Street will focus primarily on the storm’s impact on GDP. In our estimation, Sandy will subtract about 0.1% from GDP due to lost activity over a short period of time, but this will be negated by a gain of roughly 0.2% in the fourth quarter of this year. Thus, we expect a marginal 0.1% net increase in GDP this quarter attributable to rebuilding efforts. Rebuilding is likely to begin more quickly than after a typical storm, due to impending winter weather that will inevitably slow construction in the Northeast.

Although rebuilding will add to GDP, there will be a negative impact on the economy due to lost spending that otherwise would have occurred. Examples include lost airline revenues and reduced auto and retail sales. In some cases, we could see an uptick in manufacturing activity as companies work to rebuild low inventory levels to compensate for increased demand as we rebuild. Finally, although the most recent employment report bodes well for the trajectory of economic growth, we should expect to see a degree of volatility around job numbers during the next few months because of disruptions in data reporting caused by Sandy. Data could be somewhat less reliable until the reporting process smoothes out again.