During the first quarter of 2012, the S&P 500® was up nearly 13% on a total return basis. Most other stock markets around the world also advanced. Nevertheless, a number of domestic and global issues continue to hamper sustainable economic growth both in the U.S. and around the world. Thomas Dillman, President of Mutual of America Capital Management Corporation, provides insights on these issues and also examines the potential impact that the upcoming elections in the U.S. could have on the financial markets.
Increasing Investor Confidence Bolsters Markets
During the first quarter of 2012, most stock markets around the world staged strong rallies except in the debt leveraged nations of Europe (Spain down 5%, Portugal down 1%). The S&P 500 advanced almost 13% for the quarter, adding to a 15% rally through year-end 2011 that began in early October, 2011. These rallies were in response to the trend of improving U.S. economic data, most importantly in terms of jobless claims (declining) and new hires (increasing). In general, most data from early October and going forward began to show incremental improvement. Investors became more confident that a self-sustaining recovery was in the making, and that the U.S. would become the engine for global growth over the next year or two as Europe sorted out its problems.
In fact, as 2011 neared its conclusion, a number of actions taken by European policymakers to deal with the sovereign debt crisis added to investor confidence. In addition to purchases by the European Central Bank (ECB) of European sovereign debt in the secondary markets, a second Greek bailout was finalized in December. This was accompanied by a number of programs to establish funds for potential future bailout efforts for other countries, and most significantly, a plan by which the ECB would provide three-year loans at very low interest rates to European banks to help avoid a banking crisis. Other liquidity measures outside of the European Union further contributed to an expanding global liquidity pool serving as a bulwark against another potential global financial crisis. These included a 75 billion pound monetary stimulus program in the United Kingdom, a Japanese injection of funds to buy foreign currency to weaken the yen, rate reductions by the Chinese monetary authority, and the ongoing 0% interest rate policy and quantitative easing programs previously implemented in the United States. Also, early in 2012, the ECB lowered its official bank lending rate by 25 basis points to 1.00%.
These factors helped convince investors that the worst case scenario, a global financial meltdown and recession, had been avoided for the time being, and that taking on risk in the form of equities, corporate debt, and commodities would be rewarded over the short to medium term. Thus, stock prices continued their advance in the new year, while bond prices tumbled and yields rose on the prospect of stronger growth—the typical expectation of accompanying inflation, and by inference the prospect for an earlier than announced rise in official interest rates.
Domestic Economic Data Mixed
However, in early April 2012, the Change in Nonfarm Payrolls report for March missed expectations by 100,000 workers, 50% less than consensus estimates, after having shown steady improvement during the previous six months. The jobs data is arguably the most important information regarding the strength and durability of economic recovery. This latest report raised serious doubts among the bulls, who had been driving stock prices higher. Stocks declined and bond prices rose in response to the possibility that positive data reported over the prior four months was about to wane, as had happened in the previous two Aprils. Sure enough, subsequent economic data began coming in on the soft side, including reports related to initial jobless claims, imports and exports, some regional manufacturing surveys, and most recently, housing starts. Not all the news has been bad, however. Retail sales (especially the auto industry), confidence indexes (both consumer and business), and most manufacturing indexes have remained firm. Overall, though, the data on the domestic front have become decidedly more mixed.
Global Growth More Problematic
On the global front, economic growth remains a serious concern. China announced 1st quarter of 2012 growth of 8.1%—strong by most standards, but below consensus expectations of 8.4%—raising concerns that China's growth might continue to slow further, weakening another important prop to global growth. Meanwhile, Europe is barely limping along, as austerity programs designed to address and resolve the sovereign debt crisis are undermining growth. Over the past few weeks, interest rates on Spanish and Italian sovereign debt have begun to rise once again to levels deemed too high to permit refinancing longer term if they persist.
Impact of Market Trading and Corporate Earnings
Since reaching its closing high for the year of about 1,420 on April 2, the S&P 500 has declined a modest 3.5%, although some commentators are beginning to anticipate a deeper correction. Market technicals, which are measures to assess the strength or weakness of the market's internal dynamics, have been cautionary for some time. Volume of trading has been anemic and some leaders of the recent rally are breaking trend lines on the downside. While such indicators are not necessarily helpful in assessing economic and corporate fundamentals, they do provide insight into the current health of the market. After an advance of nearly 30% since last October, it would be customary to expect a pullback, and we seem to be getting that.
One potential offset is corporate earnings. While the rate of growth in corporate earnings is expected to slow substantially from the double digit rates witnessed in most quarters since late 2009, earnings are still expected to advance in the single digits for the current quarter and the year as a whole. The key, as usual, will be the degree to which reported earnings surprise positively or negatively. With only about 25% of the S&P 500 companies having reported so far for the 1st quarter of 2012, the positive surprise ratio is 81%, not a bad start to the earnings season. Growth expectations at the beginning of the quarter were 2% versus last year's comparable quarter, but, if past patterns prevail, should come in a bit stronger than that. Supporting this belief is the fact that the year-over-year growth rate reported so far by the companies which have reported is about 10%.
Stimulus Measures Still Under Consideration
Another potential offset would be further monetary stimulus measures from the U.S. Federal Reserve, the European Union, and/or even China. The Fed has said it will not begin to consider raising interest rates until 2014, and it has already conducted two large Quantitative Easing programs. The issue of whether or not it would initiate a third such program, "QE3," is one of the most debated issues among global policymakers, economists, investors, and most intensely, among the members of the Federal Reserve Board itself. That said, the Fed is on record as saying that future action by the Board will be "data dependent." Given that the Fed has employed liquidity injections as its main response to any threat of recession over the past three-and-a-half years, it would seem likely that any such real threat to achieving a self-sustaining economic recovery in the United States would likely elicit a similar response, at least while Mr. Bernanke is chairman. The only potential impediment to such action would be signs that inflation is escalating. While not as low as the Fed would prefer on a long term basis, inflation remains tame enough, at least on the basis of the statistics, to permit additional easing.
Similarly, in Europe, policymakers eventually accepted the need for massive quantitative easing as the only way to delay an implosion of the European financial, economic and political system. Delay is the key word, not just for Europe, but for any monetary stimulus measure. Liquidity injections are intended to protect from immediate disaster so that economic and financial institutions have the time to heal through debt reduction and capital rebuilding. They do not solve the underlying problems. We have made the observation repeatedly that the problems created leading up to the financial crisis of 2008 will take many years to work through. In the meantime, the economic data will continue to move between modestly improving to modestly deteriorating—hopefully on a long-term upward trajectory—until the global system reestablishes a new equilibrium. Markets will reflect these ebbs and flows, but on a leveraged basis. Thus, we will at times experience extreme volatility, and at other times, a period of calm, such as we've just been through.
Economic Outlook Remains Uncertain
In fact, markets are likely to be roiled over the remainder of the year as investors face a series of unknowns. One is the outcome of the U.S. Presidential and Congressional elections in November. Those results will bear significantly on how the country deals with two huge interrelated challenges. The first is addressing the continuing large annual deficits and consequent growth of our national debt. The second is what actions will be taken when the Bush tax cuts and the payroll tax reduction expire at the end of this year, while new taxes under the Affordable Care Act and the Congressional budget deal's automatic sequestrations for defense and discretionary spending go into effect. It is estimated that these events collectively will yield "fiscal drag," essentially a subtraction from the spending stream that fuels economic growth, worth 3.5% to 5.0% of Gross Domestic Product. Given that GDP is struggling to surpass 2.0% on an annual basis, something is going to have to give. This is essentially the same problem facing Europe, left by the legacy of the debt bubble that burst in 2008. And, as suggested above, continued monetary stimulus measures may well continue to be needed to prevent a slide into recession or worse. While some commentators have raised the specter of runaway inflation as a result of the massive global liquidity injections over the past several years, the obstacles to growth remain staggering.
That said, if positive economic and earnings growth can be sustained, even at sub-normal levels, markets could continue to rally, especially if further stimulus is applied. At some point, however, investors are going to insist that economies run on their own steam, not on policy props. When that occurs is anybody's guess, but when it does, markets will not fare well.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
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