Asset Management

Improving economic signals keep markets on upward climb

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

February 1, 2013

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U.S. equity markets climbed higher during the past week and for the month of January, driven primarily by improving economic activity and generally favorable corporate earnings releases. January’s market advance was led by mid caps (+6.8%) and small caps (+6.3%), and by a continued preference for value (+6.5%) over growth (+4.5%), as measured by the respective Russell indexes. The S&P 500 Index gained 5.2% for the month, getting the year off to a very strong start. Foreign developed- and emerging-market equities also rose in January, with the MSCI EAFE and MSCI Emerging Markets indexes up 5.3% and 1.4%, respectively.

Article Highlights

  • Despite blips in GDP growth and unemployment rate, U.S. economy remains on track.
  • Equities post healthy gains in January, marking a strong start to the New Year.
  • Bond markets worry that economic improvements could lead to early end of Fed’s QE3.
  • Europe and China show further signs of progress in their respective economies.
  • We continue to forecast U.S. GDP growth of 2.5%, on average, for 2013.

Fixed-income markets, however, grew increasingly concerned that a more rapid economic recovery in the U.S. could cause the Federal Reserve to end its quantitative easing (QE3) program sooner than previously anticipated, causing a potentially accelerated rise in interest rates. The Barclays U.S. Aggregate Bond Index posted a slightly negative return (-0.7%) in January, weighed down by longer-term U.S. Treasuries (-3.9%). As Treasury prices fell, their yields rose. During the past week, the closing yield on the bellwether 10-year Treasury breached the 2% threshold for the first time since April 2012, while the 30-year yield rose above 3.2%. Meanwhile, high-yield bonds have continued to outperform, returning 1.3% in January as increased demand drove their prices higher and yields lower.

Despite mixed headlines, U.S. economy remains on growth trajectory

At first blush, some of the key U.S. economic data released during the past week appeared somewhat discouraging:

  • GDP growth. Following 3.1% real GDP growth in the third quarter of 2012, the advance estimate of fourth-quarter growth was surprisingly negative (-0.1%). However, this headline number was driven by a sharp decline in government spending (including a 22% drop in defense outlays) and a marked slowdown in business inventory growth, areas of the economy that were disproportionately affected by fiscal cliff concerns. Other components of GDP growth were strong, in some cases exceptionally so. With increases in consumer spending, housing investment and business investment, the private-sector economy expanded by about 1.8%. Looking ahead, we expect GDP growth to begin moving slowly back toward its underlying rate, which we continue to forecast at 2.5%, on average, for the year.
  • Unemployment. The national unemployment rate ticked up one-tenth of a percentage point, to 7.9%, in January, but mostly for a positive reason: the labor pool has expanded. More people are beginning to look for work, the average and median length of time unemployed is starting to come down slowly, and the “underemployment rate” — which includes discouraged workers and people looking for full-time employment who have had to settle for part-time work — has finally started to budge.

Many other U.S. economic indicators were positive:

  • Total nonfarm payrolls grew by 157,000 in January. Although this number was somewhat less than expected, previous monthly totals for 2011 and 2012 were revised upward based on more complete data, with a particularly sharp increase for the fourth quarter of 2012.
  • Manufacturing activity as measured by the Institute for Supply Management (ISM) rose to 53.1 in January, from 50.2 in December. This was a stronger reading than expected and the highest level for the ISM index since April 2012. (Readings above 50 indicate expansion.)
  • Orders for capital goods (excluding defense and aircraft) increased for the third straight month in December, signaling a likely stronger-than-expected rise in manufacturing in the first quarter of 2013. Durable goods orders also rose in December.
  • Home prices were 5.5% higher in November 2012 than they were a year earlier, based on the S&P/Case-Shiller 20-City composite home price index. We expect this number to hold for December and for the price index to increase between 5% and 7% in 2013.
  • Although pending home sales slipped in December (-4.3%), they were still up 4.9% for the year.
  • U.S. auto sales jumped by double digits in January—traditionally a weak month for carmakers. It appears that total auto sales could come in at an annualized rate of 15.4 million, which would be an exceptionally strong reading for January.
  • Consumer sentiment as measured by the University of Michigan-Thomson Reuters index, rose from 72.9 in December to 73.8 in January, a more optimistic view than that conveyed by The Conference Board’s Consumer Confidence Index, which fell sharply.

On balance, U.S. data releases confirmed that the underlying private economy is healthier than some headlines would suggest. That said, U.S. economic reports are no longer “surprising” to the upside relative to consensus forecasts, as evidenced by a downturn in the Citigroup Economic Surprise Index over the past several weeks.

More of the same from Europe and China

The past week brought more signs of stabilizing conditions in Europe and stronger growth in China.

  • Manufacturing in the eurozone continued to contract, but at a slowing rate. The Markit Purchasing Managers’ Index (PMI) of manufacturing activity for the region edged up, from 46.1 in December to 47.9 in January—its best showing in 11 months.
  • The Citigroup Economic Surprise Index for Europe hit a new high, which means that indicators are increasingly beginning to beat expectations, albeit in the context of a still-shrinking economy.
  • In China, economic activity has also improved, confirmed by a bullish breakout in the Shanghai Stock Exchange “A Share” Index.

Globally, the manufacturing sector expanded to a 10-month high of 51.5 in January, as measured by the JP Morgan Global PMI. Significant contributions came from the U.S., Mexico, China, Brazil, and other emerging markets. Of concern is that improving global economic momentum has led to rising commodity prices. Oil in particular has advanced sharply from its most recent lows, putting an added burden on consumers, who are paying 30 cents more per gallon at the gas pump than they were two months ago.

Other risks that could drag on the markets include a rekindling of European fears (Italian elections are set for late February), the ongoing U.S. fiscal debate, and increasing noise about currency “wars,” as seen with Japan’s recent focus to weaken the yen in order to fuel export growth.

Outlook

The most recent data releases continue to point to strengthening fundamental demand in the U.S. economy, tempered by a degree of uncertainty. Against this backdrop, U.S. equities remain relatively cheap in our view, although short-term trading sentiment has arguably reached overly optimistic levels — which could in turn set the stage for a period of market weakness or at least a sideways pattern.

However, because fear of such a correction has become widespread, a true market “surprise” would be a continuation of the recent advance or a sideways pattern that supports reasonable returns from individual stock selection. A favorable sign is that intra-stock correlations in the U.S. have fallen sharply, which means returns have become less subject to broad market moves and more tied to earnings and other company fundamentals.

In fixed-income markets, flows continue to be positive for investment-grade and high-yield debt funds, but we increasingly see greater momentum for flows into equity and floating-rate loan funds. A further pick-up in equity flows, and/or a substantial rise in longer-term Treasury yields, has the potential to spark a significant flight from high-quality corporate funds to equities.

Overall, the bond market is taking its cues from economic releases more so than it has in recent years, as each data point may offer a glimmer of insight as to when and if the economy reaches a level of employment growth that will cause the Fed to reduce its extraordinary stimulus measures. While the probability of a sharp rate spike is currently low, a few months of robust employment growth could raise the odds of that outcome.

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