With the excitement of the QE3 announcement wearing off in the fourth quarter, market participants refocused on the less-than-stellar earnings season in the U.S. and uncertainties surrounding the U.S. presidential election and impending fiscal cliff, while the negative impact of Hurricane Sandy further dampened investor sentiment. Despite a double-dip recession in the eurozone, there was some progress on the European policy front and China's economy continued to show signs of stabilizing, which helped international stocks outperform their U.S. counterparts. For the quarter, the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices returned -0.38%, 0.12%, 1.85%, 6.60%, and 5.61%, respectively. Value stocks outperformed growth stocks during the quarter, in a reversal of a multi-year trend, with the Russell 1000 Value Index returning 1.52% and the Russell 1000 Growth Index declining 1.32%.
Within the Russell 1000 Index, Financials, Industrials, and Materials were the top-performing sectors in the fourth quarter, while Telecommunication Services, Information Technology, and Energy sectors lagged.
U.S. Corporate Earnings Unable to Boost Equity Markets
As we anticipated, the U.S. earnings season proved to be less than stellar and unable to provide a sufficient boost to equity markets that could help sustain the momentum created by the announcement of QE3 by the U.S. Federal Reserve in September. Reported earnings of S&P 500 companies were down 1% on a year-over-year basis and revenues were down 2.3%. Large U.S. companies, in particular, continued to face headwinds in their profits linked to the eurozone and some of the largest emerging-market economies, like China and Brazil.
Economic Recovery in the U.S. Continues Despite Hurricane Sandy
The labor market continued to show signs of improvement in the fourth quarter as the unemployment rate dropped to 7.7%, the lowest in four years. Vehicle sales remained strong and, with inflation staying low, the U.S. service sector recovery, along with better-than-expected trade data, helped real GDP increase at a revised 3.1% annualized rate in the third quarter. Unfortunately, we believe that the impact of Hurricane Sandy on economic activity will rear its ugly head in the months to come, though the positive multiplier effect of reconstruction could lift GDP later in 2013.
After already being weakened by the global economic slowdown, the U.S. manufacturing sector, particularly in the Northeast, received an additional blow from Hurricane Sandy; however, other U.S. macro data reported during the quarter were slightly more positive. Construction spending has been increasing for several months, and exports from the U.S. reached a record high as demand from emerging markets more than offset weakness in Europe. The ISM National Manufacturing Index also rebounded more than anticipated in December, indicating manufacturing activity in the U.S. expanded in the final month of the year.
Strong signs of recovery in the U.S. housing market, the slowly improving employment picture, and good performance in the equity markets year-to-date seemed to be making a positive impact on American consumers. Consumer confidence reached its highest level in five years while consumer spending has also been improving, giving us confidence that U.S. equity markets can continue to perform well in the long run.
U.S. Housing Market Recovery
As we commented for the past several quarters, we believe the U.S. housing market can provide a significant positive catalyst for U.S. economic growth and help offset some of the softness in the manufacturing sector. Our contention in the second half of 2011 that the U.S. housing sector had started to recover is now supported by multiple data points, including sales of new and existing homes, which continued to increase throughout the fourth quarter of 2012. At the same time, the inventory of homes for sale has been tightening, which has helped push home prices higher. The decision by the U.S. Federal Reserve to purchase $40 billion of mortgage-backed securities each month in an effort to lower long-term interest rates also seemed to be working as mortgage rates dropped to new record lows during the quarter.
Congress Avoids Fiscal Cliff but Budget and Debt Ceiling Battles Loom
The fiscal cliff became a major source of concern for investors as the year-end deadline approached. Despite initial positive rhetoric from policymakers, negotiations were visibly contentious before Congress reached a last-minute deal that allowed the payroll tax cut to expire and postponed most spending cuts for two months. Though the initial response by market participants to the deal was positive, a tough road lies ahead for policymakers with debt ceiling negotiations picking up and entitlement reforms yet to be addressed.
Progress on the Policy Front, but Eurozone in Double-Dip Recession
Eurozone GDP contracted at an annualized rate of 0.1% in the third quarter on a quarter-over-quarter basis and 0.6% on a year-over-year basis, officially pushing the euro area into a recession for the second time in four years. With unemployment in the euro region reaching a record high of 11.7% during the quarter and manufacturing PMI mired deep in contraction territory, the fiscal drag in the eurozone continued to be worse than anticipated (a scenario that we expected for some time now despite more optimistic consensus forecasts). The European Central Bank (ECB) revised its 2013 GDP forecast from 0.5% expansion to 0.3% contraction.
There were some notable improvements on the European sovereign debt side, however. Yields on government debt of peripheral eurozone countries, including Spain, Italy, Portugal, Ireland, and Greece, continued to drop during the quarter as the European Central Bank's pledge to buy the sovereign debt of countries under severe fiscal stress helped restore some investor confidence in the eurozone bond market. Meanwhile, Greece reached a deal with its international creditors that will allow for the release of the next tranche of bailout funds, while market participants responded favorably to the proposed Greek bond buy-back program.
Signs of China's Economic Slowdown Stabilizing
Data released during the quarter suggested China's economic slowdown may be stabilizing as the growth-boosting measures enacted by the Chinese government seemed to be having the desired effect without stoking inflation fears. China's manufacturing PMI finished the quarter in expansion territory and year-to-date industrial profits were up, contributing to a rally in Chinese stocks to close the year. However, although economic growth appeared to be stabilizing, the Chinese economy is not out of the woods yet. China's transition from an export-driven economy to a more consumer-driven economy will likely face significant challenges. Having said that, continued economic growth in the U.S. will likely help make up for some of the lost exports, which could provide a significant positive boost for the Chinese economy.
We are looking for continued uncertainty surrounding the looming debt-ceiling debate and budget negotiations in the U.S. We remain hopeful, however, that reason will prevail and policymakers will be able to reach a compromise. At the moment, there seems to be little focus in the marketplace on the potential negative impact that the dysfunctional U.S. political process around fiscal cliff and budget ceiling negotiations could have on the outlook for the credit rating of the United States and resulting actions by credit rating agencies, which could once again significantly upset investor sentiment.
We believe, however, that if the housing market continues to recover and gather momentum the way it did in 2012, a positive multiplier effect could be felt throughout the U.S. economy as consumer confidence and spending improve. We continue to think that the housing market can provide a substantial positive impact for the U.S. economy in the next 12 to 18 months and, quite likely, beyond. At the same time, we see the eurozone's problems continuing to drag on and negatively impacting global economic growth. This would particularly affect larger-cap stocks in the developed markets, including the United States, as well as stocks in China and other emerging-market economies. This dynamic could prove positive for active managers of equities.
Overall, we believe 2013 could be another good year for equity markets despite the political dysfunction in Washington. This time, however, in addition to attractive, positive returns in equities, we may also see positive asset flows into equities as retail and institutional investors gain further confidence in the U.S. economic recovery and improvements in the labor and housing markets, reversing a multi-year trend of outflows from equity funds. Unfortunately, the new flows may be reallocations from other asset classes and not necessarily come from investors' cash positions, as risk aversion is still relatively high among investors. In fact, if we see an inflection point in fixed-income performance in 2013, causing bond returns to turn negative, investors may be less willing to reallocate cash to risky assets; however, we think equities may still attract incremental flows.
With the global macro picture becoming less treacherous, value discipline gaining traction in the marketplace after a multi-year hiatus, and small cap stocks picking up in performance, we believe that active managers will be in a better position to add value in 2013, reversing a painful multi-year trend of underperformance by active managers. We expect the consumer and pro-cyclical sectors to continue to drive the recovery in the U.S. in 2013, while the manufacturing sector could regain its strength in the second half of the year.
This commentary represents the opinions of the author as of 1/10/13 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
Accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
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