Asset Management

Markets eye further gains as economy holds steady

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

February 15, 2013

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Despite concerns that overly bullish sentiment could lead to an imminent market correction, the upward trend in U.S. equities continued for much of the past week, as U.S. economic signals remained generally benign. The Wilshire 5000 Total Market Index, one of the broadest measures of the U.S. stock market, moved above its 2007 peak, while the S&P 500 again closed in on its all-time high. Of the more than 80% of S&P 500 companies that have reported fourth-quarter earnings, roughly 60% have beaten expectations for revenues and earnings per share. For the year to date through February 14, the S&P 500 is up 7%.

Article Highlights

  • U.S. equity benchmarks look to reclaim five-year highs.
  • Investment-grade corporate bond markets are unnerved by recent leveraged buyouts.
  • Eurozone GDP declines, but leading indicators improve.
  • China remains on track, while Japan’s reinflation efforts may take longer than markets expect.
  • Rising gas prices, higher payroll taxes and the looming “sequester” are potential headwinds.

Fixed-income markets continued to seek direction. “Spread” products (higher-yielding, non-U.S. Treasury securities) traded within a tight range, while Treasuries weakened slightly, with the yield on the bellwether 10-year Treasury edging back up above the 2% level. The investment-grade corporate sector was rattled by news of the leveraged buyout (LBO) of food giant Heinz, coming on the heels of a recent LBO announcement involving computer maker Dell. Because adding debt through an LBO can dramatically reduce the value of an investment-grade security, bonds of companies whose business characteristics and/or equity price make them a potential LBO candidate generally suffered during the week.

No game-changers in U.S. economic data

U.S. economic news generally moved sideways to slightly weaker during the past week, consistent with our expectation that 2013 will start slower and pick up steam as the year progresses. The overall tone remained modestly positive.

  • Lower unemployment claims. First-time unemployment claims fell sharply (-27,000) from an upwardly revised figure for the previous week, translating to a stable four-week moving average—an encouraging sign for labor market developments for the year.
  • Flat retail sales. Consumers bought more retail goods in January but at a decidedly slower pace (+0.1%) than in December, probably reflecting the 2% payroll tax increase and rising oil prices.
  • Rising consumer sentiment. The University of Michigan-Thomson Reuters index of consumer sentiment rose more than many economists expected in February, to 76.3— the highest level since last November.

Meanwhile, manufacturing output signals were somewhat mixed. Although U.S. industrial production dipped 0.1% in January, the New York Fed’s Empire State Index of manufacturing activity surged in February.

Europe’s recession continues, but there are hopeful signs

Recent European data has been mixed.

  • The eurozone economy shrank 0.6% in the fourth quarter of 2012 (versus the prior quarter) and 0.9% compared with a year ago.
  • Eurozone industrial production was up 0.7% in December 2012 versus November, but down 2.4% year-over-year.
  • The Conference Board’s Leading Economic Index for the euro area rose 0.4% in December, after climbing 0.6% in November.

The focus in Europe remains on Italy’s February 23 election. While a win by controversial former Prime Minister Silvio Berlusconi is relatively unlikely, such a scenario would be a major negative, causing Italian bond yields to spike and euro breakup fears to resurface. In the meantime, Italy successfully issued long-dated bonds on February 13, a sign that financial markets remain confident in the country’s overall prospects.

Currency rates are another concern for Europe. As the Japanese yen has depreciated, the euro has strengthened. This poses an obstacle to the eventual recovery of the eurozone economy, which now appears to be bottoming, as a stronger euro hurts European exports. The weak yen will be a primary topic at the meeting of G20 leaders this week. It is likely that further yen depreciation will be met with increasingly stiff resistance from other countries.

China marches on as Japan seeks firmer footing

In Asia, China’s economy signaled ongoing strength, evidenced in part by the Shanghai Stock Exchange “A Share” Index (available only to Chinese investors), which has continued to advance. Although food price inflation remains a concern, many experts believe this is a temporary phenomenon, and that prices will revert to longer-term averages following the end of Chinese New Year celebrations in late February.

Japanese GDP contracted for the third consecutive quarter, indicating that the beneficial effects of a weaker yen and rising equity prices have not yet led to improved economic performance. Japan appears intent on introducing inflation as the only credible way to deal with the country’s debt problems and long-stagnant economy. However, when a similar program was tried in 2002-2004, the government balked after a slight increase in the consumer price index.

So far, the Japanese market seems convinced that this time will be different. Measured in yen terms, the MSCI Japan Index is up nearly 12% for the year to date through February 14. We think the market may be ahead of the reality, as the potential difficulties inherent in full-blown quantitative easing will likely result in much slower progress than is currently priced in by investors.


The U.S. economy remains on a positive track, assisted by a number of tailwinds—particularly in housing. Other favorable indicators include increased bank lending, higher monthly job creation, rising state-tax receipts, improving trade data, and a drop in the federal budget deficit to 6% of GDP from 10%. We think that 2013 can be the year in which the economy is able to rely somewhat less on the Fed’s monetary stimulus and somewhat more on organic growth resulting from business expansion, household formation and stronger consumer spending based on a heightened sense of confidence about the future.

Additionally, there appears to be a growing sense of resignation that the looming budget sequester will not be averted, resulting in deep, automatic spending cuts. That said, the impact of higher payroll taxes and gasoline prices may present potential headwinds for the economy and the market. Assuming no political compromise is reached to avoid or mitigate the impact of these cuts, U.S. growth forecasts will be lowered, though still positive.

In the meantime, technical trading patterns continue to suggest that the stock market advance has legs, and that the threat of slower growth is not yet a concern. In fixed-income markets, we have seen relative strength in the financial sector, as banks are not subject to LBO risk due to regulatory and operational reasons. Overall, the potential for increased LBO activity reflects a more stable environment for financing, reduced equity volatility and an undervaluation of equities generally. For investment-grade corporate bonds, headwinds include not just more LBOs but the risk that flows will move out of fixed-income funds and into equity funds, further reducing demand and causing yields to rise.