Equities started the year strong as global inflation remained tame, and aggressive, accommodative monetary policy by central banks around the globe helped equity markets rally hard off their lows posted in the fall of 2011. Continuously improving U.S. economic data, strong corporate earnings, and policy steps toward mitigation of the sovereign debt crisis in Europe also provided support for the equity markets worldwide. Despite the eurozone entering a double-dip recession, a material slowdown in the emerging markets, particularly in China, and the intensifying policy stalemate in the U.S., the Standard and Poor's (S&P) 500, Russell 1000, Russell 2000, MSCI EAFE, and MSCI Emerging Markets Indices were all up for the year, returning 16.00%, 16.42%, 16.35%, 17.90%, and 18.63%, respectively.
In a reversal of a multi-year trend, value stocks outperformed growth stocks with the Russell 1000 Value Index returning 17.51% while the Russell 1000 Growth Index returned 15.26%. Within the Russell 1000 Index, Financials, Consumer Discretionary, and Health Care were the top-performing sectors in 2012, while the Utilities, Energy, and Consumer Staples sectors lagged.
Gradual Economic Recovery in the U.S. Boosted by the Housing Market
Recession in Europe and the global economic slowdown have been deemphasizing the contribution of exports to U.S. GDP, diminishing the manufacturing sector's ability to be the main driver of U.S. economic growth. Conveniently, improvements in the U.S. consumer sector, helped by the recovery in the housing sector, filled in the gap and became a more important factor for a self-sustained U.S. economic recovery.
The U.S. labor market, while still weak, showed very encouraging signs of improvement during the year as the unemployment rate dropped to 7.8%, the lowest in four years. Construction spending increased throughout the year, vehicle sales remained strong, and the U.S. service sector also continued to show signs of recovery. An improving consumer balance sheet allowed banks to increase lending, and consumer confidence showed signs of improvement while consumer spending patterns remained promising. The U.S. housing market continued to bottom out and recover during the year as historically low mortgage rates and low home prices supported housing activity.
Accommodative Policy by the Fed as Global Easing Cycle Continues
For much of the year, the Federal Open Market Committee (FOMC) maintained that it was ready to act should economic conditions in the U.S. deteriorate and warrant further action. This so-called "Bernanke put" provided support for U.S. equity markets throughout the year with investors believing the Fed would provide future liquidity injections in the event the economy faltered. In June, the FOMC announced an extension of "Operation Twist" through the end of 2012, and later announced a third round of quantitative easing (QE3), making an open-ended commitment to purchase $40 billion of mortgage-backed securities each month until substantial improvements in the labor market could be seen. Outside of the U.S., the global easing cycle continued as policymakers around the globe continued their efforts toward easing monetary policies.
Good Corporate Earnings Support Equity Markets
Markets also found support in a string of good corporate earnings reports throughout the year, which helped drive improvements in investor sentiment. Improvements in the top-line numbers driven by the economic recovery were encouraging; however, large U.S. companies in particular began to face headwinds in their profits linked to the eurozone and some of the largest emerging-market economies, like China and Brazil.
"Fiscal Cliff" Fears Drive Investor Uncertainty
Despite positive macroeconomic data in the U.S., 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.
Double-Dip Recession in Eurozone
Europe continued to provide a negative backdrop to investor confidence and was a drag on the global economy throughout the year. Unemployment in the euro region reached a record high of 11.7% while manufacturing PMI remained mired deep in contraction territory, and with GDP contracting in the third quarter, the eurozone officially entered a recession for the second time in four years.
There was some progress on the policy front, however. The LTRO (long term refinancing operation) helped the eurozone sovereign bond markets by driving down short-end yields and reducing investor perception of the probability of a tail risk event. A broad agreement to create a single bank supervisory body for the eurozone was also a positive policy development. There were some notable improvements on the European sovereign debt side as yields on government debt of peripheral eurozone countries, including Spain, Italy, Portugal, Ireland, and Greece, declined after the ECB made an open-ended commitment to purchase sovereign debt of countries under severe fiscal stress.
Economic Growth Slows in China
The Chinese economy decelerated in 2012 as foreign direct investment (FDI), one of the major drivers of economic growth in China, declined throughout the year. With export revenues deteriorating and a slumping real estate sector, investors feared a "hard landing" for the Chinese economy. However, a slower inflation trend allowed the Chinese government to reposition its economic and monetary policy from contractionary for most of 2011 to stimulative, and more recent data has suggested that China's economic slowdown may be stabilizing.
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. We believe that if the housing market continues to recover and gather momentum the way it did in 2012, an additional positive multiplier effect could be felt throughout the U.S. economy as consumer confidence and spending improve. At the same time, we see the eurozone's problems continuing to drag on and negatively impacting global economic growth, though we believe that it is unlikely to derail the U.S. economic recovery.
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 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.
This commentary represents the opinions of the author as of 1/16/13 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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