by Natalie Trunow, Senior Vice President, Head of Equities
July 28, 2009
The second quarter of 2009 saw a substantial rebound in the equity
markets, bringing returns of major indexes for the calendar year through
June 30, 2009 into positive territory. Investors’ optimistic outlook for
an impending economic recovery fueled the rebound, which started in early
March. The rally continued until mid-June, at which point mixed economic
news and downbeat earnings projections brought expectations for an early
recovery more in line with reality. The vigorous rally left its mark on
equity markets--the Standard & Poor’s 500 Index (S&P 500) returned
15.93% for quarter and the Russell 1000 Index gained 16.50%.
Rally Fueled by Perceived “Green Shoots”
Eighteen months into the recession, equity markets reacted to the signs
of perceived “green shoots” in the economy. While the economic picture
in the United States remained weak during the quarter, reports of a slower
rate of economic deterioration were the little encouragement battered
investors needed to trigger a rally early in the quarter. Eager for signs of
stabilization and recovery, investors interpreted marginal improvements in
the leading economic indicators, slowing declines in real estate prices, and
better-than-expected reports on job losses as the “green shoots” of
recovery.
This optimistic market sentiment triggered a sharp run-up in equity
markets around the globe that began on March 9 and continued through June 12
with higher-risk, high-beta assets posting some of the highest gains. During
this time period, the S&P 500, Russell 1000 Index, Russell 2000 Index,
MSCI EAFE Index, and MSCI Emerging Markets Index rose 40.8%, 41.6%, 54.2%,
50.5%, and 64.4%, respectively. The beaten down Financials and Consumer
Discretionary sectors were up 49.1% and 33.6%, respectively.
Commodity-related securities also rallied through the quarter on
expectations of economic recovery.
Markets Bounce Back
For the calendar quarter, the Russell 2000 Index gained 20.7% and the
Russell Midcap Index gained 20.8%. Growth and value stocks performed about
the same, except in small-caps, where the higher-beta Russell 2000 Growth
Index returned 23.4% and the Russell 2000 Value Index gained 18.0%. Within
the Russell 1000 Index, the Financials sector led performance for the
quarter with a return of 31.84%. The Telecommunication Services and
regulation-impacted Health Care sectors lagged, returning 3.89% and 9.67%,
respectively.
Geographically, international equity markets outperformed the U.S. during
the quarter, with the MSCI EAFE Index gaining 25.4% in U.S. dollar terms.
The MSCI Emerging Markets Index rose 34.7%, with the previously battered
markets in Hungary, India, and Turkey returning 69.6%, 59.8%, and 56.6%,
respectively.
Economic Activity Remains Weak, But the Pace of
Deterioration Slowed
Early in the second quarter, the Commerce Department released its advance
estimate of the first quarter’s gross domestic product (GDP) growth, which
showed a significantly worse-than- anticipated 6.1% decline. Subsequent
reports revised real GDP growth for the first quarter to -5.5%. Over the
past two quarters, the U.S. economy has contracted at an annual rate of
5.9%, which is the worst two-quarter performance for the U.S. economy in
fifty years.
Early in the quarter, the unemployment picture appeared to improve
somewhat, as May’s unemployment report was better than expected and the
economy lost jobs at a rate that was slower than in April. Although new
temporary jobs accounted for a large part of the difference between
expectations and the reported numbers, markets reacted strongly to this
report. However, the jobs picture deteriorated later in the quarter—the
June report, which was released just after the close of the quarter, saw the
U.S. unemployment rate rise to 9.5%, the highest level since August 1983.
Real Estate Still Mixed, Autos Troubled
News was mixed on the real estate front. In April, home price
deterioration slowed as home sales stabilized, which sent real-estate
development stocks up 62% for the month. Housing price declines appeared
less severe, as the U.S. Treasury’s efforts to depress mortgage rates
through purchases of Treasury securities and agency paper saw some success.
In June, however, mortgage delinquencies continued to rise and, with
foreclosure rates at recent highs, building activity continued to slump as
builders were unable to compete with the low prices of foreclosed
properties.
Troubles in the automotive sector intensified as Chrysler and General
Motors filed for bankruptcy. Chrysler was eventually sold to Fiat and
General Motors received a total of $50 billion in funding commitments from
the government. Bondholders and car dealers chafed at the terms of the
bankruptcy filings, but both moved forward.
Conditions Improve for Banks
Financial stocks were the most dynamic sector in the second quarter.
Financials in the Russell 1000 Index were up more than 30% during the
quarter, and Financials in the MSCI EAFE Index rose more than 40%. During
the quarter, the Financial Accounting Standards Board (FASB) changed its
mark-to-market accounting rules to allow banks to mark their distressed
assets to internal models rather than to fair value. That change, along with
better-than-expected earnings data, boosted shares of financial companies
that had been weighed down by steep losses on mortgage-backed securities in
their portfolios. The FASB’s rule changes, which lessened the threat of
nationalization of U.S. banks, will also limit transparency for investors
and may result in banks being more reluctant to sell their distressed assets
into the Treasury Department’s Public-Private Investment Program at
market-clearing prices.
Credit market participants expressed more confidence in the soundness of
banks with Treasury-Eurodollar (TED) spreads narrowing and the London
Interbank Offered Rate (LIBOR) continuing to fall, reaching pre-crisis,
long-term lows. This was a welcome sign which indicated normalization in
bank-to-bank and short-term lending—an important step in opening up credit
markets.
Even in the midst of improving credit markets, the Treasury Department
warned that banks had reported “significant declines” in commercial and
industrial lending and in consumer loans, including credit card debt. During
the course of their “stress tests” designed to assess the funding needed
by the nation’s 19 largest banks in the event of further economic
deterioration, Federal banking agencies increasingly focused on the quality
of bank loans, and the wide variations in underwriting standards, in
determining the health of the banks under review.
In May, the government announced the results of the stress tests. The
results indicated that 10 of these banks will need to raise a total of $74.6
billion in new assets. The government also estimated that some 1,000
additional banks would likely fail in the next two to three years. However,
given that no major institutions were cited as having severe immediate
problems, investors greeted these government announcements with a sigh of
relief.
In June, Standard & Poor’s cut its ratings for 18 banks, signaling
that banks were not out of the woods yet. At the same time, the Treasury
Department made an effort to decrease its involvement in the banking
industry by granting financial institutions permission to buy back the
government’s shares and to propose fair market values for the warrants
held by the government.
Investment Outlook
Over the past few months, companies have been aggressively cutting costs
and slashing inventories, which should make for healthier margins and better
productivity once economic recovery takes hold. While top-line revenues have
come in below expectations, second-quarter reported earnings were better
than expected due to aggressive cost cutting. Going forward, any improvement
in the top line should be a big positive for leaner companies. However, if
the top line remains anemic and companies run out of opportunities to slash
costs further, earnings comparisons in the coming quarter or two could be
disappointing.
In the third quarter, we foresee that conflicting economic data will
continue to generate volatility in the equity markets. In the longer term,
however, the markets should begin to recover when investors get a firmer
confirmation of improvement in economic and earnings data. So far, inflation
seems to remain at bay, which should help support corporate recovery.
With the steep stock-market rally in the second quarter, markets seemed
to be forecasting a sharper, v-shaped recovery. However, judging by
fundamentals, this rise came too far, too soon, and we were due for the
pause in the rally experienced in June. Overall, we are still placing a
higher probability on a slower-paced recovery with high potential for
renewed volatility in markets.
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