Asset Management

More signs of economic growth support rising markets

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

January 18, 2013

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Strong U.S. and Chinese economic data, along with a generally encouraging start to fourth-quarter corporate earnings season, supported U.S. and global equity markets during the past week. In the U.S., increased risk appetites were evident, as small- and mid-cap stocks outperformed large caps, and value beat growth, based on respective Russell indexes, for both the week and month to date through January 17. For the month-to-date period, the S&P 500 Index was up nearly 4% and reached its highest level since December 2007. Meanwhile, foreign developed- and emerging-market equities also gained. Asian markets were particularly strong late in the week on China’s fourth-quarter growth numbers and confidence that the Bank of Japan will enact further monetary stimulus.

Article Highlights

  • Equities and high-yield bonds gain on favorable economic news.
  • U.S. Treasury yields remain in a tight trading range.
  • Housing starts surge and first-time jobless claims drop, reinforcing positive trends.
  • China’s GDP growth and other economic data surprise on the upside.
  • Looming U.S. debt ceiling remains the “elephant in the room.”

In fixed-income markets, high-yield bonds also benefited from the week’s positive economic news. Continued robust demand helped drive high-yield bond prices up and their yields down to uncharted low territory. For the month to date through January 17, high-yield bonds, global emerging-market bonds and commercial mortgage-backed securities (CMBS) outperformed U.S. Treasuries and other high-quality investment-grade sectors, whose returns were flat to slightly negative in an environment in which investors were comfortable seeking out risk.

Positive flows into emerging-market bond funds remained supportive of that sector, but yields on the highest-quality CMBS rose during the week for the first time in nine months, following an exceptionally long rally. The yield on the bellwether 10-year Treasury wavered slightly early in the week, but on January 17 closed at the same 1.89% level at which it ended the previous week. It was trending slightly lower by mid-day on January 18. Meanwhile, the 30-year yield traded in a tight range of about 5 basis points (0.05%) above the key 3% threshold.

U.S. housing starts and retail sales climb, while first-time unemployment claims drop

The past week brought a number of positive U.S. economic releases that reinforced recent trends of improving growth, with little evidence of inflationary pressures.

  • In December, housing starts surged 12.1% to their highest level in more than four years, reaching a much-stronger-than-forecast annualized rate of 954,000.
  • Retail sales rose 0.5% in December (versus expectations of about 0.2%), while sales for October and November were revised higher.
  • First-time unemployment claims dropped to their lowest level since 2008, although the numbers should be taken with a grain of salt, as the data at this time of year tend to be volatile and subject to seasonal quirks and anomalies.

These favorable numbers follow other recent evidence suggesting the U.S. recovery is gaining some momentum, including expansionary (50+) readings for the Purchasing Managers Index (PMI, a measure of manufacturing sector health); home prices that have rebounded to their highest levels since 2006; and rising leading economic indicators published by a number of sources, including the OECD and the Economic Cycle Research Institute.

In addition, the recovery so far has been moderate enough to avoid potential overheating, which carries the risk of higher inflation. As measured by the Consumer Price Index, inflation in December remained tame on both a month-to-month and year-over-year basis, helped in part by steadily declining prices at the gas pump.

As welcome as generally positive economic news is, we would note that some reports are beginning to lose their element of surprise, as forecasts and expectations have also risen. With better anticipated economic performance beginning to be priced into the equity markets, the potential for strong upward market moves in response to the data may diminish. The Citigroup Economic Surprise Index, which measures the extent to which economic data releases diverge from consensus forecasts, has started to turn down. This downturn is underscored by the latest Empire State manufacturing and Philly Fed regional surveys, which were lower than expected, reflecting corporate managers’ concerns about higher taxes, the uncertain impact of the new healthcare law and the fiscal stalemate in Washington.

Fixed-income markets are increasingly likely to react to individual economic releases, as several months of strong data could encourage the Federal Reserve to slow or stop its asset purchases before the end of the year. As we saw during the past week, there are a number of dissenters on the Fed board who are uncomfortable with continuing quantitative easing (QE3) throughout 2013, based on the economy’s current trajectory. It remains to be seen whether the 2% payroll tax increase (part of the fiscal cliff deal) will create enough of a headwind to temper consecutively strong economic releases, at least until sometime in the second half of the year.

China revs up while Europe seeks to shift from reverse to neutral

China, whose closely-watched economic fortunes play a key role in driving both global growth rates and global financial market performance, released stronger-than-forecast data on January 18.

  • China’s GDP grew 7.9% in the fourth quarter compared with the same quarter a year ago—the first increase following seven consecutive quarters of slower growth.
  • Chinese retail sales surged 15.2% in December versus a year ago, an improvement over November’s 14.9% increase.
  • Industrial output in China rose 10.3% in December from the year-ago period, outpacing November’s 10.1% gain.

After a soft patch that spooked markets in mid-2012, more recent indicators suggest the Chinese economy has managed to avoid a “hard” landing. This improvement, along with increased confidence that China’s new leaders will pursue further stimulus policies, has been reflected in rising Chinese stock prices. The Shanghai Stock Exchange “A Share” Index, for example, climbed more than 3% in the week ended January 18. An unwelcome byproduct of more rapid growth, however, has been rising inflation, driven by food prices. There is concern that this could lead the government to tighten monetary policy as a way to keep growth and inflation manageable.

Europe’s economy remains weak. On January 15, Germany reported that its GDP shrank approximately 0.5% in the fourth quarter of 2012, compared with the third quarter. Data released earlier in January showed the December Composite PMI for the eurozone (measuring both manufacturing- and service-sector activity in all 17 member nations) coming in below the 50 threshold that separates contraction from expansion. Although this marked the eleventh consecutive month of below-50 readings, there was some modest improvement over the previous month, offering hope that the regional economy may be poised to start a slow, gradual shift from reverse to neutral. This case is also supported by continued healing in the region’s sovereign debt markets. Spain completed a successful bond auction on January 17, while Portugal is exploring a return to the bond markets with a 5-year issue.

Outlook: Upside potential, but debt ceiling still looms large

Strong economic data and corporate earnings reports continue to support U.S. equity markets. The extended rally has raised the possibility of a correction, although this has been avoided thus far. A number of factors currently offer encouragement to those with a bullish view:

  • Historically, when equity returns are positive for the first three trading days of the year, the market finishes the full year higher 70% of the time, according to JP Morgan research. The S&P 500 gained nearly 3% in the first three days of 2013.
  • It is still early in the earnings season, but almost 70% of companies reporting to date have beaten expectations.
  • Price/earnings (P/E) ratios are below their 50-year average, suggesting there is room for expansion.

Such data might be more encouraging were it not for a very big elephant in the room—the impending deadline to lift the U.S. debt ceiling, along with automatic spending cuts that would be triggered by budget sequestration if no compromise is reached. While the spending cuts would be a negative for the economy, producing an estimated 0.5% to 0.7% net drag on GDP growth, failure to raise the debt ceiling would have far more serious consequences, both for the economy and U.S. financial markets. On January 18, Congressional Republicans announced that they would vote on a proposal to raise the debt ceiling for three months, extending the deadline for a long-term agreement to mid-April. Although this is far from a done deal, the newly expressed willingness to allow the ceiling to rise, even temporarily, could help mitigate the economic impact of the next “cliff”-like event.

That said, lower-rated fixed-income assets would likely sell off if the negotiations go poorly or the nation’s credit rating becomes subject to further downgrade. In general, fixed-income flows will merit watching in 2013, as we have already seen a surge of flows into equity funds, which are broadly perceived as cheaper relative to bond funds in the prevailing environment. Meanwhile, equity risk premiums remain wide as investors await further cues from Washington.