The start of the year witnessed a continuation of many of the dominant economic themes from 2017, including firming fundamentals, a flattening Treasury yield curve, ongoing labor market improvement, a weakening U.S. dollar, and increasing inflation expectations. Across the major asset categories, risk
Early February market activity has exhibited unusually high levels of volatility, both in the equity and fixed income markets. While most signs point to idiosyncratic causes, such as large unwinding of short-volatility positions, markets have been quick to punish nearly every corner of the (liquid) investible universe. The recent shift upward in Treasury rates, a change of leadership at the Federal Reserve, and early warning signs of a potential shift in inflationary sentiment appear to have overshadowed positive fundamental developments—both domestically and abroad—leading to swift adjustments in the risk postures of global capital allocators.
Our Research Review normally highlights solely the activity of the prior month, but February's correction is meaningful, and thus, in this
Treasury Rates Spike to Near Taper Tantrum Levels, Sending Ripples Through the Markets
After concluding 2017 virtually unchanged for the calendar year, the yield on the 10-Year Treasury Note spiked significantly in January, concluding the month at 2.71%. The yield represented a monthly increase of 30 basis points (bps), the ascension of which went seemingly unperturbed through early-February trading activity. For example, as of February 7, the 10-Year Treasury Note Yield stood at 2.84% and was closing-in on May 2013 Taper Tantrum levels.
The secular trend of declining nominal Treasury rates, which has occurred from 1982 until
Regardless of whether or not the more than
To summarize, U.S. interest rates increased materially at the beginning of the year, leading to elevated downside volatility across rate-sensitive asset classes and sectors, such as long duration bonds, REITs, utilities, and, more recently, equities as a whole. The prospect of higher domestic inflation rates has likely served as a driving force behind this increase. Traditional fundamental underpinnings of the broader economy appear sound at the current time, with metrics such as payrolls growth, GDP growth, leading economic indicators, and PMI gauges witnessing solid improvement in recent months.
Global markets continued their ascent during January. A notable driver of returns for January was U.S. Treasury Secretary Steve Mnuchin’s comment about a weak U.S. dollar being good for the economy, which some construed as potentially abandoning the historically strong dollar policy that has been in place in the U.S. since the 1990s.
January improved upon the strong returns investors saw during 2017. The S&P 500 posted 14 days of new highs out of 21 trading days, resulting in the largest gain to start the new year since 1997.
The first week of February brought some of the most volatile swings in equity prices in recent years. The Dow Jones Industrial Average fell by more than 1,179 points from February 2nd through the 6th—the largest sell-off in point-terms in history. Potential causes of the increased volatility include the fear of rising U.S. inflation based on a higher-than-expected wage report, increased use of algorithmic trading, and overreactions to declining markets.
During January, the House and Senate failed to pass a spending bill, which resulted in a partial government shutdown lasting three days. As indicated by the S&P 500, the market appeared unphased by this event and closed at record highs on Friday, January 19th, the day of the government shutdown. The S&P closed at another record high on the following Monday when Democrats and Republicans came to an agreement for a short-term funding bill.
euro zonecontinued recovering in January, contributing to equity returns as the euro continued its trend of appreciating. When evaluated in trade-weighted terms, the appreciation of the euro has been modest, resulting in an increasedshare prices for exporters.
During the January 25th meeting, Mario Draghi highlighted the potential risk that inflation in Europe would not return to the European Central Bank’s target in what appeared to be a counter to the recent rise in the euro.
Emerging markets returns were also supported by currency movement during the month of January. After strong returns in 2017, emerging market equities have garnered more investor attention from around the globe.
The Treasury curve steepened over the month, as 10-year rates rose more than two-year rates for the first time since July 2017.
Conversely, the spike in volatility in early February led to an intermittent flight-to-quality as investors rushed to Treasuries, resulting in a short-term increase in prices and causing a decrease in Treasury yields.
The U.S. dollar experienced a sharp decline in late January relative to other developed and emerging market currencies, contributing to the underperformance of dollar-denominated debt in comparison to that of locally-denominated debt.
Treasury yields spiked in mid-January, likely driven by renewed inflationary sentiment, solid economic fundamentals, and the initiation of tax stimulus in the U.S., leading to broadly negative fixed income returns.
High yield (HY) spreads continued to tighten in January, hitting a new cycle low of 323 bps at the end of the month, as HY yields remained stable, providing one area of positive performance in the fixed income markets.
U.S. REITs stumbled in January amid expectations of stronger economic growth and the potential for rising interest rates. Infrastructure REITs were one of the few bright spots, gaining 3% on anticipation that the Federal government will roll out new plans to increase infrastructure spending in 2018.
Oil prices had the strongest January in five years, driven in large part by the weakening U.S. dollar. A falling dollar makes it cheaper for non-U.S. investors to buy crude.
Despite generally bullish sentiment, analysts say the market had been dented by rising output in North America. U.S. crude production has grown to over 9.8 million barrels per day and output may break through 10 million barrels per day in the next few months.
Natural gas prices received a jolt from the wave of extreme cold weather sweeping over the Eastern half of the U.S. The effect has been twofold: on the supply side, the frigid temperatures have curtailed production in places like the North Dakota Bakken; on the demand side, the U.S. is burning through significantly more gas due to the extreme cold snap.
Commodity prices rose across the board in January, led by energy prices. A weaker dollar and improved economic growth helped boost raw material prices, in particular. Rising inflation is expected to feed back into the outlook for commodity prices.
Global macro managers—both discretionary and systematic—generated strong returns to begin the year. Discretionary managers benefitted from the rise in global interest rates, as many were positioned for monetary policy tightening. Systematic managers continued their performance rebound as bullish trends in equities, energy, and currencies (vs. the U.S. dollar) persisted.
Event-driven idiosyncratic situations generated mixed results. Some notable merger arbitrage positions were profitable, whereas equity special situation trades—including Altaba and Naspers—were among the top detractors.
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