Asset Management

Market rally continues on positive earnings and economic tailwinds

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

January 25, 2013

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U.S. equity markets remained upbeat during the past week, benefiting from further evidence of an improving economy, generally positive corporate earnings reports, and a temporary reprieve from the fiscal showdown in Washington, as the House of Representatives voted to raise the debt ceiling for approximately three months. For the year to date through January 24, the S&P 500 Index is up nearly 5%, breaching the 1,500 threshold for the first time since 2007. As of mid-week, more than 90% of the S&P 500’s constituents were above their 50-day moving price averages, a phenomenon that has happened only 14 times in the last 22 years.

Article Highlights

  • Congress approves temporary debt ceiling increase, taking pressure off markets.
  • Equities and higher-yielding fixed-income securities extend winning streak.
  • Despite one-month drop in new home sales, U.S. housing fundamentals continue to strengthen.
  • European markets gain on banks’ early repayment of ECB loans.
  • Global outlook: Europe stabilizing, China accelerating, U.S. “steady as she goes.”

The market’s advance has confounded the many observers who have been predicting a correction. Although current levels suggest that the U.S. market may be “overbought,” the trading pattern over the past few weeks underscores the improving economic growth picture and indicates that there is much liquidity looking for opportunities to gain exposure to this growth.  Meanwhile, foreign developed- and emerging-market equities have also gained, with the MSCI EAFE and MSCI Emerging Markets indexes up about 4% and 2%, respectively, since the beginning of the year.

In fixed-income markets, fund flows into various categories were positive, indicating that the asset class remains in favor. Investment-grade corporate bonds, emerging-market bonds, and high-yield debt funds took in well over $4 billion in the most recent week. Higher-yielding, non-U.S. Treasury “spread” products have been outperforming Treasuries and investment-grade bonds, partly because of concerns about rising interest rates, and partly because demand for higher-rated securities has not been able to absorb significant new supply. Yields on 10-year and 30-year Treasury yields edged higher during the week, reflecting stronger U.S. and global economic prospects and thus decreased demand for safe-haven assets.

Steady U.S. growth trajectory continues

Data released during the week confirmed the steady pace of the U.S. economic recovery and offered hints of stronger growth to come in 2013.

  • The Index of Leading Economic Indicators published by The Conference Board rose 0.5% in December—slightly ahead of expectations and the strongest reading since last September.
  • U.S. manufacturing activity increased in January, according to the “flash” (preliminary) Purchasing Managers Index, or PMI, published by Markit Economics. At 56.1, the latest PMI reading was the best since March 2011. (Any level of above 50 signals expansion.)
  • Weekly first-time unemployment claims dropped to 330,000, a five-year low. This improvement is another welcome step in the right direction, but we are still looking for the four-week moving average to drop even more, to 325,000 or below, before we are fully confident of a sustained recovery in labor markets.

Despite a drop in new home sales in December (versus an upwardly revised November figure), the longer-term trend in the U.S. housing market is one of continued strengthening. Compared with a year ago, new home sales jumped nearly 9%, while median prices rose about 14%.

Encouraging developments in Europe, accelerating growth in China

Although the eurozone remains in recession, there were some additional signs that the economic picture is stabilizing.

  • The Markit flash composite PMI for the region, while still contracting, improved from 47.2 in December to 48.2 in January—a 10-month high. Readings varied by individual country, with Germany showing the most improvement and France weakening considerably, but overall the pace of Europe’s economic downturn eased as 2013 began.
  • Late in the week, the European Central Bank (ECB) announced that banks would start early repayment of three-year loans provided through the ECB’s Long-Term Refinancing Operation (LTRO) in 2011.This is a positive sign for the European banking system, as it suggests liquidity has improved and banks are better able to meet their funding needs—which in turn could spark an increase in consumer lending and potentially stronger growth.
  • Germany’s closely watched business climate index, published by the Ifo Institute, rose sharply in January, supporting optimism that fourth-quarter slippage in German economic activity may be ending.

ECB President Mario Draghi added to the favorable tone at the World Economic Forum in Davos, publicly stating that Europe is stabilizing and predicting a recovery in the second half of the year. European equity markets have responded: For the year to date through January 24, the MSCI Europe Index is up nearly 5%.

In Asia, China’s reaccelerating economy was evident again, with the Markit flash manufacturing PMI climbing to a two-year high of 51.9 in January, from 51.5 in December. Meanwhile, Japan’s negative inflation rate in December underscored the fundamental weakness in the Japanese economy, as well as the challenges the nation will face in stimulating economic growth and meeting the Bank of Japan’s new 2% target inflation rate.

U.S. housing a key to market direction and sustained recovery

While fourth-quarter U.S. GDP growth will come in significantly weaker than the 3.1% figure we saw in the third quarter, that slowdown is largely attributable to the impact of fiscal cliff uncertainty, which dented consumer confidence and inhibited business spending. GDP growth in the first quarter should rebound, both on an easing (perhaps temporary) of cliff-related fears and because we expect continued strength in the U.S. housing market to remain a powerful stimulant. Rising home prices can help lead the recovery by driving increases in:

  • Consumer net worth
  • Consumer discretionary spending
  • Bank lending activity on improved balance sheets
  • Construction by homebuilders
  • Home sales, as “fence-sitters” move to beat further price increases

Among the potential headwinds the economy and financial markets face are a resumption of high-stakes political brinksmanship regarding fiscal policy and the U.S. debt ceiling, rising oil prices (up 14% from November 2011 lows), and consumer confidence that, while generally trending up over the past several months, remains volatile.

In addition, equity and fixed-income markets have largely priced in good news and, as such, may waver if the good news does not materialize, or does not occur relatively quickly. The risk of disappointment in this regard is highlighted by the Citigroup Economic Surprise Index, which has started to turn lower, indicating that economic strength—although real—is no longer better than expected.

Market prospects balance uncertainty with optimism

Equity markets continue to rise, inspired in part by good fourth-quarter S&P 500 earnings releases. Two-thirds of the 90 companies reporting so far have exceeded analysts’ expectations (which admittedly had been scaled back). Among the positive revenue surprises were those from large companies such as General Electric, IBM and Google, while Apple Inc. fell short.

Short-term bulls point to other technical market indicators, including a sharp rise by the Dow Jones Transportation index, which recently hit a new high above 2011’s peak. Dow theorists view this as an extremely bullish indicator that buttresses the case for a stronger economy and a rising market for the full year.

Although this view has some historical credence, and the frequently predicted market correction of January 2013 has yet to materialize, there are reasons to temper such bullishness. One is that the VIX index, a measure of implied volatility in the S&P 500 that is popularly perceived as a gauge of investor fear, has slipped to 13—a level low enough to spark concern that an imminent reversal may be inevitable. In addition, other technical analysis shows bullish sentiment has reached levels that in the past have been followed by sharp corrections. Given this history, we would not be surprised to see a modest pullback in stock prices.