Market Roundup - September 2012
A September to remember?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
By John Manley, CFA, Chief Equity Strategist
By James Kochan, Chief Fixed-Income Strategist
Whoever said “Talk is cheap” never listened to central bankers. Whether they were comments from European Central Bank (ECB) President Mario Draghi or Federal Reserve (Fed) Chairman Ben Bernanke, they moved markets during the past month. September will likely see more words moving markets. Not only was there the ECB policy meeting on September 6, but there is also the Federal Open Market Committee (FOMC) meeting on September 12 and 13.However, September isn’t all about the bankers. There is an important election in Holland on September 12, the German Constitutional Court is expected to rule on the constitutionality of the eurozone’s permanent bailout facility (the European Stability Mechanism), and we could receive a status update on the Greek austerity program at some point during the month. If you take all of these events and mix in the U.S. Employment Situation Report on September 7 (which could sway the FOMC one way or the other on more stimulus) and the continued drip of data on the slowdown in China, September really could be a month to remember.
The economyBy Brian Jacobsen
Markets seemed to hang on every word from central bankers’ mouths. ECB President Draghi pledged to do “Whatever it takes.” The FOMC promised to “Act as needed.” These are strong words. In September, we’ll probably hear more strong words, though we don’t expect to see a lot of action.
In Europe, the ECB decided on a plan to support the short-term government debt market for countries asking for funds from the European Financial Stability Facility (EFSF) or its permanent successor, the European Stability Mechanism (ESM). The ECB only announced the outlines of the plan because the life of the ESM hangs in the hands of the German Constitutional Court, which will rule on its constitutionality by September 12.
The Dutch elections on September 12 may usher in a coalition government that supports relaxing some of the austerity conditions imposed on Greece as a condition of the Greek bailout. The political sentiment seems to be shifting from hard and fast reform to one of more soft and slow reform. The additional monetary stimulus from the ECB and the softer and slower pace of fiscal adjustment could prove to be a turning point in the eurozone debt saga.
In the U.S., the FOMC has been sending a clear signal to investors that it will provide more monetary stimulus to the economy if needed. The FOMC’s behavior in presidential election years has not been any different than in non-election years, so it will likely do what it wants, when it wants, even if that is right before the presidential election. However, the form and timing of FOMC easing will depend on the economic data. One poor employment report (perhaps a reading of non-farm payroll gains of below 100,000) could trigger a new open-end bond buying program by the Fed. We expect that the September meeting would be too soon to engage in more bond-buying, but the FOMC might want to get itself out of the corner it painted itself in when it gave a date for how long it expects economic conditions to warrant exceptionally low rates. It could do this by stating that it will keep rates exceptionally low until the unemployment rate falls below 7%, provided inflation stays below 4%. That type of change would make its commitment conditional on the data rather than the date, giving the Fed significantly more flexibility in conducting monetary policy.
The natural follow-up policy, which would only be triggered if there were poor employment reports in September and October, would be for the FOMC to commit to not only keeping rates low, but also buying $100 billion per month of agency or mortgage-backed securities or longer-dated Treasury securities until the unemployment rate dips below 7%, and as long as inflation stays below 4%. The FOMC is likely to include additional language that will give it flexibility to adjust the size and timing of the purchases as economic conditions warrant.
Whether it’s the ECB or the FOMC, monetary policymakers are getting anxious to act, while fiscal policymakers seem to be dragging their feet.The slowdown in Europe is having a cascading effect on global growth. This is most evident in the slowdown in China. However, we think it’s important to note that China’s slowdown seems to be proceeding at a manageable pace, avoiding what some people have called a “hard landing.” Also, an easing of austerity in Europe should help. The Chinese government is going through a transitional phase. In 2011, the National People’s Congress endorsed the 12th Five-Year Plan, which focuses on promoting domestic consumption instead of relying heavily on export-led growth. In addition, the Chinese Communist Party’s Central Committee is going through a once-in-a-decade power change. The passing of the baton of power will not be completed for a few more months, which is likely stalling any new stimulus programs.
EquitiesBy John Manley
Despite the conventional wisdom of the dog days of summer, the weather in August usually starts off hot and then cools as Labor Day approaches. It appeared that way this year, and the U.S. stock market seemed to take its cue from the thermostat.
The S&P 500 Composite Index rose 2.0% in August but put more than 100% of that gain in place before the middle of the month. Performance was sharply divided, not only by time, but also by sector. Almost every sector with economic exposure outperformed, while almost all of the “safe havens” slipped in absolute terms. The mega-cap Dow Jones Industrial Average (DJIA) rose 0.6% in the period, with a front-end load and an end-of-month 90-point pop that saved it from a posting a flat month. The DJIA has lagged the S&P 500 Index for most of 2012.
The smaller, more aggressive stocks performed better in August, which can be inferred from the 3.5% rise posted by the Valueline Composite (Arithmetic) in the month. Clearly, investors were willing to take on more risk as central bankers in the U.S. and Europe seemed increasingly willing to inject funds into their respective economies and, through them, equity markets. However, growth seemed to outdraw value as the Russell 3000® Growth Index returned 3.5% in the month, while the Russell 3000® Value Index returned 3.0%. That both of these indexes bested the S&P 500 Index is testimony to the participation of smaller companies in the rally. Also of note was the 4.3% gain posted by the Nasdaq Composite. As an index dominated by information technology (IT) and biotech names, it seemed to be a perfect host for investors’ greater appetite for risk.
Economically sensitive sectors clearly dominated the American equity market last month. IT (which we favor) gained 4.8% in August as the market digested generally favorable second-quarter results and looked forward to 2013 prospects. The consumer discretionary sector followed closely behind with a 4.2% rise. The housing market seems suddenly more stable and less heavy, and American consumers seem as resilient as ever.
The financials sector also outperformed in August, with a 3.0% gain. While we still believe that this sector has asset-quality and earnings-power issues before it, we must admit that a more stable housing market in the U.S. and a more pragmatic political environment in Europe have lifted it to outperformance in the past three months. We still believe that it is too early to emphasize the area or to believe that the market will rise above its current trading range.
Investors did not seem too concerned with safety or certainty in August. The consumer staples group dipped 0.6%, while the telecommunication services sector dropped 2.5% and the utilities sector fell 4.8%. While we believe that consumer staples may offer a temporary, lower-risk way to gain exposure to emerging markets, we think it could be time to look for direct exposure to emerging market consumers.
Outside the U.S., equity markets were mixed. Emerging markets slipped or at least lagged the S&P 500 Index. Resource markets generally kept pace or slightly bettered the U.S. equity market. On balance, Europe outperformed, but safe and stable countries were slight laggards, and the “problem children” posted significant gains. That latter fact may mark significant progress on the immense problems facing the continent.
In the emerging markets space, Mexico, China, and Hong Kong were under pressure, with respective local currency declines of 3.2%, 2.7%, and 1.6%. (Currency fluctuations reduced China’s and Mexico’s losses by 20 to 30 basis points in U.S. dollar terms.) China continued to deal with slowing industrial production and a reticence to aggressively expand monetary policy. India, which gained 1.1% in August, recently has shown resilience in its manufacturing sector. All of our monitored emerging markets are down significantly for the past year, and all but Brazil (in U.S. dollar terms) continued to lag the U.S. last month. We have not been aggressive buyers here, preferring to gain exposure selectively and through large-capitalization, multinational consumer staples companies.The developed markets are of greater interest. All of these markets have lagged the U.S. over the past year, with Spain, Italy, and Greece posting double-digit losses. Recently, however, the markets have begun to rebound and outperform the S&P 500 Index. While much remains to be done both politically and economically, we sense that the ECB’s more aggressive policies and rhetoric may be placing a floor under these markets and actually setting the stage for a longer period of superior performance. We know Europe’s problems, Europe knows Europe’s problems, and, most important, the markets are forcing European decision-makers to begin to stabilize volatile situations and make needed structural changes. In some respects, this places Europe ahead of the U.S. in the long process of reducing or eliminating the excesses of the last several decades. That this is happening with the U.S. equity market up and Europe’s down appears to be a compelling opportunity.
BondsBy James Kochan
Bond market performance in 2012 has been skewed toward the weaker credit categories, and that pattern was extended during August. The high-yield corporate market outperformed in August by a wide margin, and the CCC and weaker category returned approximately 50 basis points more than the BB credits. Investment-grade corporate bonds outperformed Treasuries and mortgages, and the BBB sector was the best-performing credit sector. These performance differentials are especially significant year to date (YTD). Within the high-yield market, the CCC and weaker index has outperformed the BB index by 365 basis points (100 basis points equal 1.00%), and the BBB index is 225 basis points better than the AA index in the investment-grade sector YTD.
Table 1: Year-to-date bond market total returns (%)
A similar pattern of returns is evident in the municipal market. The A/BBB sectors returned 0.30% in August, versus a return of 0.11% for the AAA/AA sectors. Thus far in 2012, the performance differential is 310 basis points in favor of the A/BBB credits. The BBB sector has outperformed the AAA sector by 500 basis points thus far in 2012.
Among mortgage categories, while agency-backed mortgages have returned 2.6% YTD, the commercial mortgage-backed securities (CMBS) market has returned 9.9%.
The Treasury market struggled during most of August, primarily because the markets in Europe were quiet. Treasuries have performed best when the European markets were in disarray. While there is the potential for renewed turmoil in the weeks ahead, it now appears that a consensus is developing among eurozone leaders over strategies for preventing yet another market crisis. It is possible, therefore, that the Treasury market might not enjoy the strength of demand from foreign investors that was so important during the first half of this year.The strong performance records of the corporate and municipal markets thus far in 2012 reflect a quest for income by domestic investors. Flows into high-yield and investment-grade corporate bond mutual funds have been strong all year. In the face of this demand, corporations have been able to issue record amounts of bonds at the most favorable terms in modern times. Flows into municipal mutual funds have been steady, and that has been sufficient to keep yields relatively low because the volume of issuance in the municipal market has been less than the amount of bonds maturing thus far in 2012. Those who worry about bubbles in those two markets are concerned about what might happen if those mutual fund flows were to turn negative. But, until the fixed-income markets offer attractive alternatives to the income offered by corporates and municipals, that is probably not a serious risk.
Asset allocationBy Brian Jacobsen
Investment horizonsFor investors with an investment horizon of three years or longer, we recommend a strategic overweight to equities relative to fixed income. Short-term, over the next two months, unusually high market volatility should bias a portfolio toward higher-yielding safe-haven assets that can be deployed quickly when the market drops.
EquitiesWithin the equity portion of a portfolio, long-term, we prefer a barbell strategy focused on U.S. assets and select emerging markets assets. This results in a relatively unbiased portfolio in terms of the equity allocation between developed and emerging markets but a portfolio heavily biased toward U.S. assets and away from non-U.S. developed assets. We are looking for opportunities in Europe. As the U.S. markets reach the upper end of our projected trading range for the year (1,450 on the S&P 500 Index), we like trimming the U.S. and adding to multinational, export-oriented European equities.
Value versus growthBased on the relatively equal valuations given to growth and value stocks and our belief that the U.S. economy is not going to dip into a recession within the next six months, we prefer growth over value. Further, value indexes tend to be dominated by financials. While we think financials will survive, they might not thrive in the current regulatory environment. That could change if there is a Republican takeover of the Senate. Prospects of regulatory forbearance for financials could be a boon to bank stocks. As a result, we recommend a heavy overweight toward growth and a corresponding underweight to value, although we do like the value space, provided you don’t try to hug a benchmark in that area.
Large caps versus small capsWhen dividing the equity universe between large-cap and small-cap stocks, we think large-cap companies are better positioned to maintain profit margins and revenue growth. Input prices are extremely volatile, and credit markets are still not back to normal—although they are returning to normal in the U.S. Small-cap stocks also appear to be trading at slightly higher valuations compared with large-cap stocks. While we prefer large-cap stocks, we do not recommend a heavy overweight because there are many selective opportunities in the small-cap space. The large companies with huge amounts of cash on hand will likely look to expand market share or penetrate new markets through strategic acquisitions. As evidenced by some recent acquisitions, executives at large-cap companies may be willing to pay premium prices for acquisitions. For this reason, it will be important to be selective and invest in companies making prudent acquisitions.
Fixed incomeBased on our economic outlook, we believe that interest rates are likely to remain low for the next two years. This presents an opportunity for investors to take on additional duration and credit risk. Provided the economy does not dip into a recession, default rates should not increase, meaning the increased yields on higher-yielding debt may provide better income to investors than the lower-credit-risk issues.
Asset allocation summary table1The blue bar on each diagram below represents our recommended tactical positioning for investors looking to make adjustments to their portfolios based on current market conditions. The green bar represents our recommended strategic positioning for investors with a time horizon of three years or more.
The bottom lineSeptember could be a volatile month, but we think that volatility could present some excellent opportunities for investors to pivot to European equities and into riskier assets, like growth-oriented equities. The easing of austerity requirements in Europe and the addition of monetary easing could make for a proverbial “risk on” period in Europe. In the U.S., we still have the looming fiscal cliff to contend with, though we think it will be successfully deferred to 2013. The bigger concern is whether the economic data in the U.S. proves to be too good, rather than too bad. Bad data could spur the Fed to act while good data could keep the Fed in a holding pattern. To the extent that the gains of August were attributable to the expectation of more Fed easing, the Fed may disappoint.