Asset Management

2012 Third Quarter Equity Market Review

William Riegel, Head of Equity Investments

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Equity markets produced positive returns during the third quarter of 2012, reversing the fear-driven declines that dominated the second quarter. The markets’ rebound was largely in response to a variety of monetary easing and stimulus measures implemented by the Federal Reserve, European Central Bank (ECB) and China’s central bank, combined with some better-than-expected growth indicators in the U.S.

In late July, ECB president Mario Draghi reassured markets that his institution would do “whatever it takes” to support the European Union (EU) — a pledge later backed up with a plan for direct, unlimited ECB purchases of bonds issued by fiscally strapped eurozone governments. The ECB’s plan calmed unsettled markets by lowering the “tail risk” of a financial collapse in Europe (i.e., caused by the breakup of the EU).

Article Highlights

  • Equity markets posted positive returns due to monetary easing and stimulus measures as well as growth indicators in the U.S.
  • Sectors such as energy, consumer discretionary and information technology saw robust gains, while utilities and consumer staples lagged.
  • Foreign developed and emerging-market equities also performed well, despite mixed economic news from Europe and China.
  • Markets could move higher through year-end, but a number of economic and geopolitical risks could make the markets volatile for the remainder of 2012 and into 2013.

Aggressive action by the Federal Reserve followed in mid-September, with an eagerly anticipated announcement of open-ended quantitative easing. The so-called QE3 program calls for the Fed to purchase $40 billion per month of mortgage-backed securities in an effort to drive interest rates lower and stimulate growth.

Global economy faces both headwinds and tailwinds
In the U.S., evidence of a healing housing market continued to mount during the quarter, with substantial improvements in housing starts, building permits, new and existing home sales, and home prices. Other positive indicators included surging auto sales and rising consumer confidence. Meanwhile, weekly first-time jobless claims stayed in a narrow range, and although job creation was positive, it was not robust enough to signal strong GDP growth, which was revised down from 1.7% to 1.3% for the second quarter.

The economic landscape in Europe remained subdued. Key manufacturing gauges contracted, and even relatively healthy economies such as Germany and France showed signs of substantial weakening during the quarter. In China, manufacturing indexes were mostly weaker in the quarter, and the still-slowing economy continued to wait for additional meaningful policy stimulus beyond central bank easing.

With risk back in favor, economically sensitive sectors lead the rally
In general, equity investors increased their risk appetites in the third quarter, reversing the risk-averse environment that prevailed in the second quarter. The S&P 500 Index rose 6.35%, with robust gains in economically sensitive sectors such as energy (+10.14%), consumer discretionary (+7.45%) and information technology (+7.45%), among others. Returns generally lagged in defensive sectors, including utilities (-0.53%) and consumer staples (+3.84%). Based on specific Russell indexes, large caps (+6.31%) topped both mid caps (+5.59%) and small caps (+5.25%), while value (+6.44%) slightly outperformed growth (+6.01%).

Foreign developed and emerging-market equities also performed well, despite mixed economic news from Europe and China. The MSCI EAFE Index and MSCI Emerging Markets Index gained 6.92% and 7.74%, respectively. The MSCI Europe Index was up 8.7%, as markets such as Spain (+11.12%) outperformed on increased optimism about ECB policy actions. In Asia, Japan (-0.84%) was a notable laggard, while Pacific markets aside from Japan (+10.99%) surged.

The third quarter’s decline in macro-driven market volatility offered a more favorable investment environment for active fund managers than the previous quarter. Intra-market correlations fell, meaning individual stocks were more likely to rise or fall based on unique, company-specific drivers of performance and less prone than to move in lockstep with other stocks. TIAA-CREF’s equity portfolios, which emphasize stock selection based on bottom-up, fundamental company research, generally performed well due to good stock picking. Approximately 63% of our active equity funds and accounts exceeded their respective Morningstar peer group categories in the third quarter, and 94% have done so for the year to date through September 30, 2012. For the one-, five- and 10-year periods ended September 30, 2012, the percentage of funds outperforming their peers was 80%, 64% and 80%, respectively.

Outlook: continued slow growth, cautious optimism
The near-term macroeconomic outlook remains mixed. U.S. economic activity is improving somewhat, toward the slow-growth trend we saw earlier this year. As of mid-October, consensus forecasts of third-quarter GDP growth in the U.S. were slightly below 2%. Meanwhile, global growth forecasts continue to hover around 3.3% for 2012 as a whole and 3.6% for 2013. Weakness in Europe, and to a lesser extent China, is offset by hopes of reacceleration driven by continued monetary easing by the world’s central banks.

Mixed third-quarter earnings reports reflect weakness in these key regions, combined with minimal corporate confidence in the U.S. government’s ability to balance its books. Companies, particularly those with exposure to Europe and China, have lowered their forward-looking guidance. Uncertainty over earnings has triggered a market correction entering the fourth quarter — an encouraging sign, given our view that sentiment had recently approached overly bullish levels. Despite volatility, we remain optimistic that markets can move higher through year-end, carried by increased consumer spending and strong demand for housing in the U.S., along with improving conditions in China.

That said, a number of economic and geopolitical risks could make the markets volatile for the remainder of 2012 and into 2013. A bullish market view is clearly jeopardized by the looming threat of the U.S. “fiscal cliff,” the combination of drastic spending cuts and tax increases that will take effect in January unless a political compromise is reached. Although this issue will remain front and center after the November elections, we believe that some measure of pragmatism can prevail, making the cliff more of a navigable slope.

Against this backdrop, we remain committed to identifying fundamentally strong companies for our portfolios, balancing the search for superior returns with vigilant risk management, in keeping with our disciplined, long-term investment approach.