William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
March 1, 2013
Equity market volatility continued in the last week of February, amid unexpected political headlines out of Italy, a slew of mostly positive U.S. economic data, and the inevitable onset of the federal budget sequester. (Read more about the sequester here.) For the full month of February, equity performance was mixed: the S&P 500 Index was up 1.4%, while foreign developed and emerging markets declined 1.0% and 1.3%, respectively, based on MSCI indexes.
Fixed-income markets also bounced around during the week as investors digested the rapid news flow. The net effect of the week’s developments was to create a bullish tailwind of continued central bank support, both from the Federal Reserve and in Europe, combined with a steadily improving U.S. economy. Overall, the month of February was broadly if modestly positive for fixed income, with U.S. Treasuries and high-yield bonds alike returning about 0.5%. The yield on the bellwether 10-year Treasury began the month at 2.04% and closed at 1.89% on February 28.
Economic data and Fed reassurances outweigh sequester fears
In the U.S., major data releases continued to support our view of a strengthening economy, particularly in the housing market:
Although these sales figures may partially reflect a rebound from Hurricane Sandy (i.e., the replacement of destroyed homes), the highest rate of sales growth occurred in Western states (+45% from December to January).
Other favorable economic readings included:
On the manufacturing front, key gauges of activity, such as the Institute for Supply Management (ISM) index and the Markit Purchasing Managers’ Index (PMI), posted healthy readings well above the 50 threshold separating contraction from expansion. Meanwhile, first-time unemployment claims fell by 22,000, and the four-week moving average also declined, further evidence of improvement in the labor market. In addition, fourth-quarter GDP growth was revised upward, from slightly negative (-0.1%) in the government’s preliminary estimate to +0.1% in its second estimate, which is based on more complete data.
Beyond the favorable data, markets were also assuaged by Federal Reserve Chairman Ben Bernanke’s public statements signaling that the Fed’s quantitative easing program will not be ending any time soon. Moreover, the Fed indicated that it is considering holding on to balance sheet assets to maturity, rather than selling them off as previously indicated. This would have the practical effect of extending the Fed’s easing cycle, a welcome development for the markets.
Accordingly, markets were largely inclined to discount fears of a major disruption caused by the budget sequester. While the sequester’s automatic spending cuts are an unwelcome negative at a point when the economy is seeking to gain momentum, estimates of the net drag on GDP growth are low (-0.5% to -0.7%) and will be felt gradually.
Europe unsettled by Italian elections and continued weakness in manufacturing
The election in Italy, which produced much stronger-than-expected finishes by controversial former prime minister Silvio Berlusconi and a euro-skeptic third party, showed that there is little enthusiasm among voters for continued austerity policies. While the election results initially drove global equity markets sharply lower on resurgent fears about sovereign debt problems and a potential breakup of the eurozone, tentative moves to form a coalition government (which may or may not include Berlusconi in some limited role) helped markets retrace their lost ground. In addition, despite election- driven anxiety, Italy was able to sell government bonds at auction this week.
Most of the week’s major economic releases in Europe were generally in line with previous readings. Consumer and business sentiment indexes trended flat in most countries, as did inflation. Manufacturing PMIs remained weak (below 50) in all eurozone nations except Ireland (51.5) and Germany (50.3). Meanwhile, European Central Bank (ECB) president Mario Draghi said the ECB intends to continue offering support to eurozone member nations.
Whether equity markets globally can resume their 2013 advance is an open question in the face of the macro headwinds we see. Beyond the U.S. sequester, we are focused on a number of macro issues. In Europe, Italy must form a credible government and make a commitment not to backtrack on austerity measures that have already been enacted. Looking ahead, we would not be surprised to see a slower pace of reform in Italy, leading to a more gradual recovery from recession.
In China, food price inflation has thankfully cooled following the New Year, which has lessened fears of fiscal tightening. However, falling food prices have been accompanied by a weakening pattern in industrial metals prices, especially copper. This may signal a far more gradual pattern of growth than in previous cycles. In addition, China’s manufacturing PMI for February dipped to 50.1, from 50.4 in January—barely in expansionary territory. On the positive side, the Shanghai Stock Exchange “A Share” Index begun to move higher again, after a period of weakness.
The recent market correction, while not a macro factor, also gives us pause. Although the downturn was sharp, on a technical basis it was not a “typical” move. The CBOE Volatility Index (the VIX, or so-called “fear index,” which measures the implied volatility of the S&P 500) spiked in February but fell shy of 20—a level which, if exceeded, generally signals true panic. In addition, short-term trading sentiment, while correcting from elevated optimistic levels, remains short of neutral. These are signs that we may yet see further market weakness.
In fixed-income markets, flows into most types of bond funds remain positive, with the exception of some high-yield asset categories. In the past week, U.S. loan funds reported their second-largest inflows ever, just two weeks after setting a record high. A sustained rotation out of bonds and into equities will likely not occur until we see a significant rise in Treasury rates, perhaps to the 2.5%-3% range on the 10-year security. We believe those are plausible levels for the second half of the year or as we head into 2014.
The information provided herein is as of March 1, 2013.
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