Asset Management

Markets remain volatile as fiscal cliff talks begin

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

November 16, 2012

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Global equity markets extended their losing streak and finished the first half of November down more than 3%, based on the MSCI All Country World Index. U.S. stocks underperformed their international counterparts, with the S&P 500 Index falling 4% month-to-date through November 15, versus declines of 2.7% and 2.0%, respectively, for the MSCI EAFE and MSCI Emerging Markets indexes.

As in the previous week, heightened fear of the imminent U.S. “fiscal cliff” was the primary market driver. Adding to the sense of gloom was confirmation that the eurozone had indeed fallen back into recession during the third quarter. While not unexpected, this news underscored the tenuous state of global aggregate growth. Meanwhile, evidence of Hurricane Sandy’s economic impact began to show up in some key U.S. data releases.

Article Highlights

  • Equity markets extend losses heading into final trading day.
  • Risk avoidance helps Treasuries, hurts fixed-income “spread sectors.”
  • Weekly jobless claims soar in Hurricane Sandy’s wake.
  • Europe slips into recession, China has new leadership.
  • Volatility to continue as fiscal cliff negotiations get underway.

Fixed-income markets were also unsettled. In the current risk-averse environment, lower demand for “spread” products (higher-yielding, non-Treasury securities) has caused the prices of these assets to fall and their yields to rise. Among those shying away from spread products are securities dealers reluctant to add significant inventory to their balance sheets ahead of year-end. In contrast, the U.S. Treasury market has benefited from its safe-haven status: Yields on both the 10-year and 30-year Treasury have fallen by 20 bps (0.20%) since Election Day. As a result, yield spreads between certain spread products and Treasury securities have widened, particularly in the case of high-yield and investment-grade corporate bonds.

U.S. economy begins to feel short-term effects of Sandy

Economic releases during the past week were generally muted. Among the notable releases were indicators showing Hurricane Sandy’s short-term impact on economic activity:

  • First-time claims for unemployment surged by 78,000, to 439,000—an 18-month high. Before Sandy, weekly claims had been staying within a narrow range between 350,000 and 400,000. Under normal (i.e., non-hurricane) conditions, 400,000 claims is a threshold that, if breached, could indicate a significant deterioration in labor market conditions.
  • U.S. industrial production declined 0.4% in October, with Sandy reducing total output by 1%, according to Federal Reserve estimates.
  • Two gauges of regional manufacturing activity, the Empire State Index and the Philly Fed Index, reflected Sandy’s disruptive impact in New York and New Jersey during November.

Markets generally took these negative indicators in stride, as the effects were anticipated and should be short-lived.

Recession and debt concerns weigh on Europe

In Europe, the release of GDP data showed the region’s economy contracting 0.1% in the third quarter, supporting what many observers had considered a foregone conclusion: The 17-member eurozone has entered a double-dip recession.

  • Eurozone GDP growth has now been negative in every quarter of 2012. (Two successive quarterly declines in GDP growth typically signal a recession.)
  • Europe emerged from the global financial crisis and “Great Recession” in the third quarter of 2009 and managed to sustain quarterly positive growth until late 2011. Since then, fiscal decline and the burgeoning sovereign debt crisis have taken their toll.

In the past week, progress toward resolving Europe’s debt crisis stalled. The Spanish government remained unwilling to request a formal bailout from the European Central Bank (ECB), while agreement on the timing and conditions for Greece to receive its next installment of bailout funds hit a roadblock. Meanwhile, the recent passage of further austerity measures in Greece prompted more anti-government protests.

China offers mixed bag of data and sentiment as new leaders are named

Recent readings on China’s economy have shown some improvement, but forward indicators are mixed. During the week, Chinese economic data were overshadowed by the ruling party’s announcement of its new leaders. Initial market reaction was downbeat, as the new lineup turned out to be more conservative than expected, and thus less likely to enact needed political and economic reforms. The Shanghai Stock Exchange “A Share” Index fell 1.2% on November 15 in the wake of the leadership news, and another 0.8% on November 16.

Outlook: Fiscal cliff negotiations will continue to set the tone in the short term

U.S. equity markets began to rally late Friday morning amid encouraging comments made by Congressional leaders engaged in the first round of fiscal cliff talks. We expect to see further volatility in the short term as negotiations continue and markets react to each hint of progress or gridlock. This is consistent with a split-personality market, one that fears the cliff but is drawn to slowly improving economic fundamentals, brightening prospects for corporate earnings, and the extremely attractive relative value of stocks versus bonds.

On balance, we think the odds still favor a rising U.S. equity market heading into 2013, although we cannot discount the risk that such an increase is from lower, “cliff-driven” levels. In the meantime, short-term trading sentiment has again become very bearish, a contrarian indicator that could set the stage for a potential rally. Another positive sign is that correlations between and among stocks have dropped, which means the market is moving less in lockstep and may reward individual stock picking based on company fundamentals.

Outside the U.S., Japan has begun to look more interesting; Japanese equities have been cheap for some time, and with the economy slipping back toward recession, the likelihood that the Bank of Japan will initiate quantitative easing has increased. In response, the yen has weakened considerably, losing about 4% of its value against the dollar since the beginning of the fourth quarter. This has begun to bolster Japanese stocks, particularly exporters, with the Nikkei Index outperforming other Asian markets late in the week. Prime Minister Yoshihiko Noda’s decision to dissolve parliament and call for fresh elections in December is also seen as positive step toward reviving Japan’s economy, which contracted 3.5% in the most recent quarter.

More broadly, foreign developed- and emerging-market stocks have begun to improve, and in our view remain attractive on a tactical basis relative to U.S. equities. Quarter-to-date through November 15, the MSCI EAFE and MSCI Emerging Markets indexes have declined 1.9% and 2.6%, respectively, holding up better than the S&P 500, which is down 5.8%, and the Russell 2000 Index (U.S. small caps), which is down 8.0%, during the same period.

In fixed-income markets, we believe investors will reassess relative value as the fiscal cliff eventually moves toward complete or partial resolution, and that yields on spread products may well start to tighten from recent wider levels. The fact is, the Fed was purchasing bonds a month ago, and it will be purchasing bonds a month from now. With interest rates remaining at historic lows, the hunt for yield will ultimately continue, even if some market participants have invested their fill as we approach year-end.