May 9, 2013
U.S. markets climb as feared correction fails to materialize during the quarter
Global equity markets produced broadly positive results in the first quarter, with the U.S. and Japan outperforming most other developed markets. After trading sideways in the fourth quarter of 2012, U.S. equity markets climbed to record highs in the first three months of 2013, boosted by a particularly strong start in January. The S&P 500 Index advanced 10.61% for the quarter, while the broader Russell 3000 Index was up more than 11%. The positive U.S. market environment reflected better economic data driven by the housing sector and corporate inventory restocking after the year-end resolution of the “fiscal cliff.” With the cliff averted, U.S. consumers and businesses breathed a bit easier and increased their spending, prompting accelerated economic activity. Investor optimism was also lifted by signals that the Federal Reserve’s monetary policy will remain accommodative until stronger economic trends emerge.
Japanese equities surged 11.63% in the quarter, based on the MSCI Japan Index, primarily on the government’s aggressive new monetary easing measures, designed to weaken the yen and reinflate the nation’s long-moribund economy. Overall, non-U.S. equities were mixed, with European markets generally underperforming. Germany (+0.18%) and France (+0.55%) were essentially flat, but well ahead of Italy (-9.77%) and Spain (-5.58%), two countries whose economic and fiscal woes remained in the spotlight. Foreign developed markets as a whole rose 5.13% (MSCI EAFE Index), while emerging markets fell 1.62% (MSCI Emerging Markets Index) due to the strengthening of the dollar, lower commodity prices, and China’s mixed economic landscape.
Although U.S. equity performance was strong for the quarter, market volatility increased in March, largely on signs of a potential U.S. economic slowdown and renewed anxiety about Europe, where Italian elections failed to resolve political uncertainty and the “bail-in” of bank depositors in Cyprus brought the eurozone debt crisis back into focus. In addition, the S&P 500’s extended rally — bolstered by extremely bullish sentiment levels — raised fears that a market correction was both inevitable and imminent. Such a correction failed to materialize by quarter-end, however, and the market locked in year-to-date gains that were near levels we would have expected for the entire year.
Defensive sectors lead the market higher
In mid-February, we began to see a sharp rotation away from economically sensitive cyclical sectors of the S&P 500 and toward traditionally defensive sectors. For the quarter as a whole, defensive categories such as Healthcare (+15.64%), Consumer Staples (+14.34%), and Utilities (+12.67%) outperformed. Meanwhile, returns for economically sensitive sectors varied considerably: Consumer Discretionary (+12.03%) and Energy (+9.99%) produced strong gains, while Information Technology (+4.15%) and Materials (+5.06%) were relative laggards. Based on specific Russell market-cap and style indexes, small caps (+12.39%) and mid caps (+12.96%) topped large caps (+10.96%), while value (+12.26%) outperformed growth (+9.82%).
The outlook for equities
Looking ahead, the global economy remains in relatively slow-growth mode. In the U.S., the government’s advance estimate of first-quarter GDP growth came in at 2.5%, at the low end of projections. A primary concern is that we may see a pattern similar to the one experienced in each of the past two years — significant weakening over the summer, followed by improved growth heading into year-end. A potential slowdown in growth may already be unfolding, partly due to the effects of the federal budget sequester kicking in. While this warrants close scrutiny of company surveys and employment levels, the risk of deceleration may be mitigated by continued strengthening of the U.S. housing market. In February, for example, home prices posted their largest year-over-year gain (+9.3%) since May 2006.
Europe remains in recession, with lingering sovereign debt and fiscal problems, although the political uncertainty in Italy that rattled markets in the first quarter has abated with the recent formation of a new coalition government. China’s growth outlook is positive but blurred by mixed economic signals, including a below-forecast reading on first-quarter GDP growth (+7.7% versus an expected 8.1%). In Japan, it is too early to tell if the central bank’s efforts to revive the economy will deliver long-lasting results, but so far optimism has held sway over the markets, with Japanese equities up nearly 8% in the month of April alone and over 20% year-to-date.
Against this backdrop, we believe that 2013 will likely be another positive year for equities, but with the potential for volatile and sideways trading along the way. If we do see an equity correction in the U.S., we expect it will prove to be shallow. From a sector perspective, we have begun to see movement back into cyclical sectors, such as Information Technology, which lagged in the first quarter. This rotation is explained partly by weaker-than-expected earnings for a number of defensive stocks such as bellwether AT&T. In general, first-quarter corporate earnings reports have been much weaker because of revenue shortfalls, with muted demand and the stronger dollar resulting in fewer upside surprises. Moreover, U.S. corporate margins look as if they have peaked, while valuations and short-term trading sentiment remains extended.
U.S. profit margins may be retreating from elevated levels, but that does not necessarily foreshadow a sharp decline. For one thing, falling commodity prices may lend support to corporate margins as the cost of goods declines. Furthermore, the 1990s proved that margins can remain at high levels for many years. Another lesson from the 1990s, however, is that flat-to-down profit margins generally favor large-cap and growth stocks. In recent weeks, large caps have outpaced small caps, and growth has beaten value, based on the respective Russell indexes — in both cases, a reversal of first-quarter trends. U.S. equity markets now appear to be moving beyond an “early economic recovery” rally and into a period of expectations for stable growth, a phase that will need to be confirmed by corporate profits and positive economic data points.
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TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no guarantee of future results.