William Riegel, Head of Equity Investments
Lisa Black, Head of Global Public Fixed-Income Markets
March 29, 2013
U.S. equity markets moved higher in a trading week shortened by the Good Friday holiday, with both the S&P 500 Index and Dow Jones Industrials Average closing at record highs. Gains for the week came despite concerns about the banking crisis in Cyprus and a batch of softer-than-expected U.S. economic data. The S&P 500 rose 3.8% in the month of March and 10.6% for the full first quarter. Foreign developed equity markets underperformed, with the MSCI EAFE Index returning 0.8% for the month (through March 28) and 5.2% for the quarter, while emerging markets were down nearly 2% for both the month and quarter.
The tone in fixed-income markets continued to grow more cautious. Amid global macro concerns, particularly in the eurozone, emerging-market debt has weakened along with emerging-market equities. Many investors have flocked to the safety of U.S. Treasuries, boosting their prices and lowering their yields. Since its recent peak of 2.07% on March 11, the closing yield on the bellwether 10-year Treasury has fallen by 20 basis points (0.2%), to 1.87%. As a result, yield spreads between Treasury securities and most corporate bond sectors have widened. For the month and quarter, however, total returns for high-yield corporate bonds (+1.0% and +2.9%, respectively) remained ahead of the flat to slightly negative results for investment-grade bonds.
Cyprus remains in focus, keeping markets on edge
Fear that fallout from the bank crisis in Cyprus would spread to other eurozone nations was a dominant theme during the past week. The agreed-upon “bail in” of Cypriot bank depositors and debt holders turned out to be less egregious than originally proposed, but it still sets a precedent that increases funding costs for weaker banks in southern Europe, further constricts liquidity in the region and could undermine economic growth. We will be watching for deposit withdrawal rates in other European countries to determine whether there are signs of a contagion effect. Ultimately, as in the case of Greece, the final resolution of the Cyprus crisis will likely play out over a number of years, with more money required to support the tiny nation’s membership in the European Union.
Also in Europe, and of more immediate concern, Italy remains without a government, and manufacturing activity across the eurozone has been extremely disappointing, as measured by Purchasing Manager Indexes (PMIs). This lack of growth is distressing, particularly for France. If credit spreads begin to widen for French debt, the European Central Bank (ECB) will be hard pressed to support the country’s financing needs.
China still seems to be running in place
After a sharp rise last week, the Shanghai Stock Exchange “A” Share Index—which we consider a reliable gauge of the health of the Chinese economy—retraced that move and declined sharply in response to further government efforts to rein in wealth management products offered by banks. These policies come on the heels of recent steps aimed at cooling a potentially overheating real estate market. Although we remain optimistic that China will continue to grow, the pace of that expansion is debatable. If China’s growth comes in at the lower end of expectations, then emerging markets, Europe, and the materials sectors are likely to struggle further.
A mixed week for U.S. data releases, but trends appear on track
Following a raft of strong U.S. data the week before, economic headlines were a bit more muted in the final week of March.
We are keeping a close eye on the trajectory of U.S. growth. The first quarter was clearly strong, as consumers spent, corporate production ramped up, and capital spending surged. We are concerned, however, that the healthy pace of growth in the first quarter may decelerate in the second quarter, as happened in 2012.
Consumers spent freely in the first quarter, as incomes rose on better employment numbers, and higher home and equity prices created a wealth effect. However, these gains were offset by higher payroll taxes and gas prices, and were insufficient to fully support the pace of first-quarter spending. As a result, savings were drawn down. The risk is that the pace of spending will ebb as confidence dips and the full impact of the sequester and payroll tax increase is felt.
Similarly, while businesses boosted production, this reflected inventory rebuilding after last year’s pre-fiscal-cliff preparations. A potential deceleration in growth may already be unfolding, warranting close scrutiny of company surveys and the past week’s uptick in first-time jobless claims. If expectations of slower growth materialize, the equity market may be vulnerable to a correction.
In fixed-income markets, there is a continuing sense that risk-averse sentiment will prevail for a while, following the exceptional rally by lower-rated, higher-yielding sectors in the fourth quarter of 2012 into January of 2013. Although fixed-income markets were “due” for a correction, in our view it is not likely to be severe, as many backstops—such as the ECB’s liquidity and bond purchase programs and the Fed’s continued quantitative easing program—remain in place. Ironically, as the eurozone situation becomes more worrisome, the likelihood of the Fed continuing to buy assets for a longer period increases, thereby supporting riskier assets. While this puts a floor on asset price volatility, eventually the U.S. and global economies (and their bond markets) will need to operate without such extraordinary measures. The longer we go without self-sufficiency, the more difficult the transition will be.
The information provided herein is as of March 29, 2013.
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