The U.S. economy cooled modestly in the fourth quarter of 2018, as February’s release of gross domestic product (GDP) showed the economy grew at an inflation-adjusted annualized pace of 2.6%, compared to a 3.4% third quarter rate and an even stronger 4.2% pace witnessed in the second quarter. Despite moderating growth, an ongoing divergence between domestic and international fundamentals continued to serve as a dominant global macro theme through February, with mounting expectations that central monetary authorities would follow a shallower-than-previously-expected near-term policy path. In addition, strong positive momentum across global risk sectors witnessed in January spilled over into February, supporting global equity returns, particularly domestic. Fixed income markets also participated in the risk-on market environment that has characterized the first two months of 2019, with solid returns generated in credit-related sectors such as high yield and bank loans. Real assets continued to post strong performance during the month, with commodities, energy infrastructure, and REITs each enjoying double-digit year-to-date total returns.
U.S. Economic Growth Pulling Away from Rest of the World
The transmission of tax stimulus into the economy and a roll-back of certain regulations helped drive a wedge between domestic and international fundamentals in 2018, with most broad measures of U.S. economic activity pointing to an expansionary bias, as conditions appear to have moderated abroad, particularly in Europe and Japan. Recent updates to late-2018 growth dynamics help highlight this divergence, as U.S. real GDP growth ascended to a three-and-a-half-year high of 3.1%, while euro zone growth slowed to 1.2%, a five-year low, and Japanese growth declined to 0.0%, the weakest pace since first quarter 2015.
Since most economic data provides a lagged-view of business cycle conditions, extrapolating this ongoing deviation into a future set of assumptions would undoubtedly serve as an imprudent endeavor. Indeed, estimates of first quarter 2019 GDP, such as the Atlanta Fed’s GDPNow™ model, have evolved to reflect a much shallower growth trajectory, with the model’s most recent update from March 6th indicating a 0.5% growth rate. The latest partial government shutdown, however, may have exerted inorganic weakness into late-2018/early-2019 economic data.
The expansion of the federal budget deficit as a means to finance the most recent tax package has the potential to complicate policy makers’ ability to combat future business cycle downturns, since recent deficit growth has outpaced growth in GDP, driving the budget-balance-as-a-percentage-of-GDP ratio deeper into deficit territory. In fact, through year-end 2018, the ratio stood at -4.5%. Absent restrictive near-term fiscal policy and/or a significant growth spurt, the U.S. economy may enter the next downturn with one of the worst fiscal standings in recent memory.
Of course, proponents of the growing Modern Monetary Theory movement, which calls on the Federal Reserve (Fed) to utilize its balance sheet as a debt monetization tool to fund expansionary social programs, would likely find little concern with the U.S.’s deteriorating fiscal position. Aside from a potentially destabilizing loss of confidence in the U.S. dollar as a global reserve currency, the allure of expansionary fiscal policy sourced by simultaneous expansionary monetary policy is sure to gather momentum in the coming years.
To summarize, the U.S. remains one of the few remaining bright spots amid a weakening global economic backdrop, as U.S. GDP growth has accelerated to a three-and-a-half-year high, while the growth trajectory of many key trading partners has headed in the opposite direction. As fiscal stimulus tailwinds begin to fade, the likelihood of this divergence continuing presumably remains limited, forcing policy makers to reach deeper into their toolkits in search of creative ways to keep the economic engine chugging along.
Following a rebound in January, developed equity markets continued to rally in February. The U.S. equity market led global markets with the end of the U.S. government partial shutdown, the continued dovish stance of the Fed, and the progression towards a trade deal between the U.S. and China.
Micro cap stocks surged during the month, outperforming both small and large cap stocks. The surge was primarily attributed to standout performers in the Russell Microcap Index, specifically within the financials and health care sectors. Growth continued to outperform value, but the performance disparity reduced.
Momentum in Europe continued to weaken with a contraction in manufacturing activity and political changes in Spain and Italy.
The sterling appreciated against the dollar, with expectations of the UK and the European Union reaching an agreement as opposed to a “no-deal” Brexit.
The rally in emerging markets stalled, as currencies weakened against the dollar. Latin America experienced heightened volatility due to on-going political and economic tensions in Venezuela.
While the recent Chinese stimulus package and trade negotiation progression supported Chinese equities, economic data overall remained soft outside the U.S.
High yield bond spreads to Treasuries tightened with the resurgence of risk tolerance, while the performance of higher quality bond sectors was lackluster, suggesting that markets continue to have a constructive outlook on the U.S. economy.
In the Fed’s Semiannual Monetary Policy Report to Congress in late February, Fed Chair Jerome Powell reiterated the Fed’s intention to remain patient amid a generally favorable U.S. economic outlook, with conflicting signals—disappointing retail numbers in contrast with steady hiring, wage growth, and low unemployment.
Additionally, Powell indicated that the Fed plans to stop shrinking its balance sheet by the end of 2019, thus maintaining a considerably larger balance sheet in the long run, in contrast with pre-2008 levels. Further details regarding the plan to end “quantitative tightening” are expected to be announced in the coming months.
As of February 28th, Fed fund futures projected neither a rate hike nor a rate cut in 2019, but did indicate a potential rate cut in 2020.
U.S. REITs, as measured by the FTSE NAREIT Equity TR Index, rose marginally by 0.5% in February, lagging the strong gains seen in January (+11.6%). Tepid returns can be partially attributed to a continuation of downward pressure on capitalization rates (cap rates). Cap rates for most property types continue to trend downward through 2019, mainly due to rich property valuations. However, in certain sectors, such as commercial real estate, increases in property prices have been supported by rising net operating income, explaining resilient year-to-date returns.
Crude oil (WTI) rose over 6% in February, reaching a high of $57.4/barrel during the month on the positive outlook for OPEC-led supply cuts and the announcement of a higher-than-expected cut by Saudi Arabia. The cuts come alongside involuntary production headwinds resulting from U.S. sanctions on Venezuelan and Iranian crude oil. While U.S. oil production is on the rise, risk remains with the outcome of the U.S.-China trade agreement and concerns over a slowdown in global growth.
Commodity benchmark returns were led by the performance of energy and industrial metals. Industrial metals’ returns have mainly come from recovering emerging markets and China's Purchasing Managers Index. Despite overall global uncertainty regarding the U.S.-China trade agreement, industrial metals began to recover on the news of historically low PMI levels in China, as the market began to price in potential mean-reversion.
Event-driven strategies were generally positive during the month. Average merger arbitrage spreads tightened, more likely due to reduced supply rather than deal-specific catalysts. Distressed investing was broadly supported by high yield spread tightening and a lack of negative idiosyncratic situations, which tend to drive the returns of process-driven investments.
Trend-followers experienced mixed results across asset classes. While equity markets continued their strong rebound in February, following a tumultuous fourth quarter, agricultural commodities such as wheat and coffee drew down further in the month, benefitting those managers positioned for weakness. Trends across developed market bonds generally reversed course in February, catching managers off guard. Finally, U.S. dollar price action was choppy throughout the month, resulting in additional losses.
Volatility investors largely benefitted from risk-on positioning, while some profited from relative value arbitrage trades, as prices continued to mean revert in February. Defensive, or long volatility, positions were punished by decreasing implied volatilities across a wide array of global risk assets.
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