William Riegel, Head of Equity Investments
After a volatile year in 2011, equity markets grew more confident in the first quarter of 2012. Evidence of improving economic activity in the United States and reduced fears about European bank and sovereign debt problems fueled an increase in investors’ appetite for risk, leading to strong equity market returns across geographic regions, market capitalizations and investment styles. Most equity benchmark indexes posted double-digit gains for the quarter.
While the pace of U.S. economic growth remained moderate, there were encouraging signs that the recovery had become self-sustaining. Trends in employment, manufacturing, consumer spending and housing were generally favorable. The pickup in activity, along with rising crude oil and gasoline prices, led to expectations of higher inflation, although the core inflation rate, as measured by the Consumer Price Index (CPI) less food and energy costs, remained relatively benign (+0.2% in March).
Similar performance across market segments masks rotation into large caps
The S&P 500 Index gained 12.6% for the quarter, while the broader Russell 3000 Index returned 12.9%. Foreign developed and emerging-market equities also posted double-digit gains, with the MSCI EAFE and MSCI Emerging Markets Indexes rising 10.9% and 14.1%, respectively.
Reflecting the favorable growth outlook for the U.S. economy, S&P 500 performance was led by the financials (+22.1%), technology (+21.5%), and consumer discretionary (+16.0%) sectors, while more defensive sectors such as utilities (-1.6%) and consumer staples (+5.5%) underperformed. Based on Russell market-cap and investment-style indexes, returns were similar for large cap stocks (+12.9%), mid caps (+12.9%), and small caps (+12.4%), while growth stocks (+14.6%) outperformed value stocks (+11.2%).
The similarity of returns for varying market segments masked a clear rotation into high-quality, large-cap companies, beginning on February 15. This mid-quarter shift was an early sign of unease among investors: With an eye on potential storm clouds in Europe and a cooling Chinese economy, they began moving into equity market segments that tend to be less volatile. As an example, the S&P 100 Index — representing the 100 largest firms in the S&P 500 — was up 3.6% in March, while the MSCI Emerging Market Index was down 3.3%.
In terms of style, investors preferred the relative stability of growth stocks over “riskier” value stocks throughout the entire quarter. This marked a change from the previous quarter, when growth lagged value in a strong up market.
Better environment for active stock pickers
The first-quarter investment environment afforded greater opportunities for active equity fund managers to outperform. In 2011, equity markets were fixated on daily headlines and global macro developments, leading to higher-than-normal correlations, with stocks tending to move in lockstep, regardless of company fundamentals. In the first quarter of 2012, markets were less volatile than in 2011, and correlations among individual stocks fell dramatically. As a result, active managers were generally rewarded.
Outlook: Constructive but cautious, as a “fiscal cliff” looms
As the first quarter ended and the second began, we began to see some weakening in U.S. employment and other indicators that had been picking up steam in the first quarter. After two months in which net new monthly payrolls exceeded 200,000, employers added only 120,000 jobs in March, far below consensus forecasts. The unemployment rate dipped one-tenth of a percentage point, to 8.2%, but this was due to more people leaving the workforce and not expanded hiring. Meanwhile, first-time claims for unemployment benefits also ticked up in the first weeks of April. In addition, housing starts and existing home sales for March fell short of expectations, and homebuilder confidence in April slipped for the first time in seven months.
Somewhat tempering these concerns were robust retail sales figures for March, an uptick in The Conference Board’s index of leading economic indicators, increases in steel production and bank loans, and lower commodity prices. Moreover, while fewer than half of all S&P 500 companies have released first-quarter earnings thus far, early results have been promising. Nearly 80% of firms to date have reported upside surprises, albeit relative to lowered expectations. For companies that have already reported, margins were higher than in the fourth quarter of 2011 and versus the year-ago period. On balance, we think the odds favor another upward move in U.S. equity markets as summer approaches, punctuated by inevitable fits and starts, with U.S. growth continuing on a slow trajectory.
Our chief concern for the U.S. is the looming “fiscal cliff” the economy and financial markets will have to climb if public-policy gridlock in Washington persists. There would be a significant impact on GDP in 2013 in the event that the debt ceiling is not lifted in November and automatic budget cuts are triggered, tax cuts are allowed to expire and unemployment insurance is not extended. Equity markets are not yet focused on this possibility, but as we move through the year, investors will become more attuned to the potential toll these fiscal hits could take on economic growth, corporate profits, and stock prices.
Outside of the U.S., investors continue to fear an economic slowdown in China. Recent contraction in Chinese manufacturing activity, as well as lower-than-forecast first-quarter GDP growth of 8.1% (versus 8.9% in the fourth quarter of 2011), have been particularly worrisome. At the same time, deepening pessimism about Europe’s economy and debt crisis, most notably in Spain, has contributed to increased market volatility.
Lastly, we are acutely aware that in both 2010 and 2011, April marked a pivot point for economic weakness and subsequent stock market declines, so we continue to monitor developments closely, mindful of potential downside triggers. Although we do not anticipate the degree of economic sluggishness that triggered market pullbacks in the past two summers, we believe the recent slowing of momentum at the macro level will provide a basis for a continued rotation into large-cap and growth-oriented stocks, as the market tends to gravitate to these categories when the economy appears more vulnerable to downside risks.
Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Please note that equity investing involves risk.
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).