November 30, 2012
Heading into the final day of November, U.S. and global equity markets appeared to be on track for a full recovery from their early-month swoon. For the month to date through November 29, the S&P 500 Index was up 0.6%, while the MSCI All Country Index (excluding the U.S.) was up 1.8%. During the past week, and throughout the month, intense interest in U.S. fiscal cliff negotiations generally trumped economic data and corporate earnings releases as a primary market driver. Any positive comments out of Washington tended to lead stocks higher, while pessimistic statements had the opposite effect.
In fixed-income markets, U.S. Treasuries benefited from fiscal cliff uncertainty. With no deal apparently imminent, many investors added Treasuries to their portfolios as a safety measure. Higher demand for Treasuries drove their prices higher and their yields lower. The yield on the bellwether 10-year Treasury security closed at 1.62% on November 29, down from 1.75% at the beginning of the month.
Meanwhile, fiscal cliff concerns have not deterred corporations from issuing record levels of bonds. These new issues are being absorbed, in part by dealers adding to their inventories. Bond fund flows have remained largely positive in recent weeks, although many accounts have either bought their fill for the year or are waiting for clearer direction on the fiscal cliff before committing to further purchases. Over the past week, spreads on investment-grade and high-yield corporate bonds relative to Treasuries remained stable to slightly tighter, even as Treasury yields drifted lower.
Evidence shows continued modest expansion in U.S. economy
A raft of economic data released during the past week confirmed that the U.S. recovery is proceeding at a moderate pace, with some upside surprises tempered by cautionary signs.
GDP and consumer spending: Estimated third-quarter GDP growth was revised upward, from 2.0% to a higher-than-expected 2.7%. The bulk of the revision reflects a build-up in business inventories, as companies slowly ramped up production in recognition of increased consumer spending. That said, consumers didn’t spend as much as we initially thought in the third quarter, as personal consumption expenditures (PCE) were revised down, from 2.0% to 1.4%, for the period. Moreover, PCE dipped 0.2% in October, the first monthly decline since May.
Housing: Housing continues to provide an economic tailwind. Home-price increases have been stronger than anticipated, as measured by the S&P/Case Shiller 20-City Composite Index (+3.0% year-over-year in September, the largest annual percentage gain since July 2010) and the expanded-data FHFA House Price Index (+3.3% over the four quarters ended September 30). In addition, pending home sales jumped 5.2% in October and were 13.2% higher than in 2011—the 18th consecutive month of annual gains.
Industry: Regional surveys were mixed, which suggests activity is slowing a bit in the fourth quarter. Manufacturing surveys in the Federal Reserve’s Dallas and Kansas City districts were down, while Richmond’s was up. In addition, the Chicago Fed’s Midwest Manufacturing Index fell 1.2% in October, while the Chicago Purchasing Managers Index (PMI), published by the Institute for Supply Management, barely inched into expansionary territory in November. Nationally, orders for durable goods were flat in October. Excluding the volatile defense and transportation sectors, however, orders were up 1.7%—a sign that the slowdown in capital expenditures is not as pronounced as it seems at first blush.
Labor markets: Weekly jobless claims fell sharply for the second consecutive week, after spiking well above 400,000 in the immediate wake of Hurricane Sandy. Sandy’s impact will continue to skew the weekly data for some time; we expect that volatility in the number of claims will start to subside in the middle of the first quarter of 2013.
Consumer confidence: Readings of consumer confidence were mixed. The Conference Board’s index rose slightly in October, to its highest level since February 2008, while the Thomson-Reuters/University of Michigan index gained less than expected after being revised downward from its initial reading.
Economic surprise index and leading indicators: The Citigroup Economic Surprise Index, which measures the extent to which economic data releases diverge from consensus forecasts, ticked down. We believe this is more likely a residual effect of Hurricane Sandy than the start of another deceleration in the economy. Supporting this view is The Conference Board’s index of leading economic indicators, which edged up 0.2% in October, to 96—its highest level since June 2008.
In Europe, some improvement at the margins—but unemployment hits another record high
Although Europe’s economy remains troubled, there have been signs of modest improvement in some data, as well as hopeful developments in addressing the eurozone debt crisis.
Greece: After the previous week’s delay, the International Monetary Fund (IMF) and eurozone finance ministers approved a plan that will allow Greece to receive its next installment of bailout funds, while providing additional flexibility for hitting longer-term fiscal targets. The agreement calmed financial markets, even though it was widely expected.
Germany: Consumer sentiment and labor utilization in Germany have improved, as have German and eurozone composite PMI readings. Equity markets have also improved. In particular, cyclical companies with greater exposure to emerging markets appear attractive and have begun to outperform more defensive, Europe-oriented stocks.
Bond yields: Spanish and Italian bond yields, which earlier in the course of the sovereign debt crisis spiked to unsustainable levels, have fallen dramatically. This likely represents not just improved sentiment but substantial bond purchases even by previously reluctant investors, such as Germany. For Spain, falling bond yields have made it possible for Prime Minister Mariano Rajoy to continue to delay a formal bailout request from the European Central Bank (ECB).
Unemployment: The jobless rate for the 17-member eurozone region climbed to a new record high of 11.7% in October. There were huge discrepancies among member nations: In Spain, for example, unemployment was nearly five times higher (26.2%) than in Germany (5.4%). Despite daunting unemployment and fiscal austerity measures, ECB president Mario Draghi predicted the region will return to growth in the second half of 2013.
China: economic gains not reflected in equity market performance
China continues to be a puzzle. Economic data looks better, anecdotal evidence has been favorable, and the 10-year bond rate is rising. Yet despite these signs of expansion, the Shanghai Stock Exchange “A Share” Index—which we see as the ultimate test of Chinese economic health—has fallen to a three-year low. A partial explanation for this decline may be the dramatic growth of wealth management in China, with some wealth managers offering tremendous yields on certain debt products, making them more attractive than equities. Yields on these instruments have now fallen to a point where the Shanghai A market may again appeal to the retail investor.
While the Shanghai A market has declined, the Hong Kong market has risen. In many cases, individual companies listed on both exchanges have seen their stock prices appreciate more in Hong Kong than in Shanghai. Such divergences have happened before, reflecting the restricted nature of the A Share market, in which only Chinese nationals can invest (non-Chinese can only do so via a small qualified pool).
Despite the recent poor performance of the A Share market, we believe the underlying fundamentals for the Chinese economy are improving. However, it will take some time for them to become evident on a broader scale. This is largely due to uncertainty and volatility that may occur during China’s leadership transition—a process lasting several months.
Outlook: slower U.S. growth in the fourth quarter
Our forecast for fourth-quarter GDP growth currently stands at 1.5% to 2%, a slower pace than we saw in the third quarter. This reflects lower-than-expected capital goods orders and reduced consumer spending in October. We expect housing to provide a boost to GDP growth as rebuilding slowly picks up. If the weather stays warm, we would expect the housing tailwind to increase markedly in the first quarter of 2013. A cold winter, however, would likely delay the positive impact until the second quarter.
On balance, the outlook for equity markets is favorable:
In the meantime, watching the fiscal cliff remains the order of the day. Despite very clear differences between the White House and Congressional negotiators, there have been rumblings that a framework for compromise may slowly be emerging, which might be why the markets shrugged off some of the more discouraging public comments made during the past week. Given the size of the risk premium we already see in the markets, we think any drive off the cliff may result in limited downward movement. Certainly any positive news may lead to a sharply higher move, both in the markets and for the economy.
In fixed-income markets, the fiscal cliff is absolutely the key to market sentiment at the moment. Some investors think the best hope is for a delay of 6 to 9 months, which would not impress the U.S. government’s many global creditors (or rating agencies) but would likely avoid a near-term economic shock. Interestingly, despite the fiscal cliff concerns, high-yield spreads have actually narrowed a bit. This is in contrast to last year, when high-yield spreads widened heading into the failed deficit talks that ultimately set the stage for the fiscal cliff. Of course, given the uncertainties involved, we could still see wider spreads ahead of any negotiated resolution.
The information provided herein is as of November 30, 2012.
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