Nearly every major sub-asset category suffered steep declines in October, with the most pronounced downside volatility experienced in U.S. small cap growth equity. While it is difficult to isolate the primary culprit behind the selloff, a number of forces were likely to blame for the poor monthly performance, with examples including a continued rise in U.S. Treasury interest rates, diverging global economic fundamentals, growing U.S.-China trade war tensions, and a lack of clarity around the next chapter of Brexit. Across global equity, the poor year-to-date momentum behind international equities gathered pace in October, with domestic markets suffering less substantial declines. Despite the weak performance in nearly every major risky asset category, those investors seeking the perceived safety of fixed income were likely underwhelmed during the month, with both rate-sensitive (e.g., core bonds) and credit-sensitive (e.g., high yield bonds) posting negative performance. Real assets were also not spared, with sizable losses across energy, infrastructure, real estate-related assets, and commodities.
U.S. Treasury Interest Rates Ascend to Seven-Year Highs
A dominant theme throughout 2018 has been the gradual rise in U.S. Treasury interest rates, the ascent of which has been fueled by accelerating inflation, strengthening economic growth, and ongoing Federal Reserve (Fed) rate hikes. In October, the yield on the 10-Year U.S. Treasury Note touched 3.23% and represented the highest interest rate since April 2011. Higher interest rates may serve as a welcomed trend for those that rely on interest income. The U.S. housing market, however, which accounts for an estimated 15-18% of gross domestic product according to the National Association of Home Builders, has not been supportive of the increase.
Treasury interest rates and mortgage rates have increased to seven-year highs, with the 30-year fixed-rate mortgage national average nearing 5% through October. This increase in lending rates helped slow the pace of home sales growth rates. The chart below juxtaposes an equal-weighted composite of existing, pending, and new home sales annual growth rates against the 30-year fixed rate mortgage national average.
With both Treasury and mortgage rates at a seven-year high, it is likely no coincidence that home sales growth rates, on average, are at their slowest pace since 2011. Additionally, steadily increasing home prices, modest wage pressures, and swelling lending rates have hampered home affordability, with the National Association of Realtors’ Home Affordability Composite reflecting the least-affordable housing backdrop since 2008.
Interestingly, the gradual slowdown taking place in the housing market occurred during a period of strengthening domestic economic growth, leading to the question—just how weak would the housing market be if broader economic conditions were not as robust? Or conversely, just how strong would GDP growth be if the housing market were better equipped to handle the increase in borrowing costs?
The answers to these questions are unknowable, but the end result is the same; rising Treasury rates have driven mortgage rates higher, in turn slowing the housing market, which accounts for a material portion of overall GDP. Thankfully, other critical areas of the economy remain on solid footing, including an extremely tight labor market, solid consumption growth, and a rebounding industrial sector, among others. The slowdown in the housing market, while a trend worth monitoring, does not appear to be slowing the broader economy at the present time.
In summary, October was a painfully difficult month for those investors with exposure to nearly any asset category outside of cash, with key drivers including rising interest rates, persistent trade war tensions, and increasing signs of a slowdown abroad. With both Treasury and mortgage rates at a seven-year high, the U.S. housing market appears to be in the midst of a slowdown, the magnitude of which does not appear overly worrisome at this point in time.
- Volatility defined the month of October for the global stock market. The S&P 500 rose or fell more than 1% in a single day on ten occasions during the month. To put this in perspective, the S&P 500 had eight 1% swings during the entire year of 2017.
- Equity returns across the globe were negative during October. The S&P 500 was down almost 7%, while the MSCI Emerging Markets and MSCI EAFE indices were down only slightly more.
- During October, value began outperforming growth stocks across all capitalization (cap) spectrums and regions; however, both styles returned negative absolute values during the month. When comparing returns for the year-to-date periods, growth is still outperforming value across all market caps with the exception of micro-cap.
- Trade concerns hindered the Chinese economy, coupled with fears of a broader slowdown, as the year-over-year Chinese GDP growth report was lower than expectations. However, Chinese authorities announced a stimulus package consisting of policy measures, including potential tax cuts, to help prevent a wider slowdown of their economy.
- The minutes from the Fed's September 25-26th meeting were released in mid-October, which touched on the Fed’s continued commitment to tightening monetary policy through gradual increases of the federal funds rate.
- While volatility in the equity markets dominated headlines over the month, credit spreads widened, and higher quality credit outperformed lower quality issues.
- The 10-year Treasury yield touched a high of 3.23% in October, largely due to real yields moving higher and less so due rising inflation.
- Internationally, German government bonds rallied amid investor speculation that the European Central Bank (ECB) would extend its bond buying program, while Italian bond yields rose, due in part to the country’s ongoing budget dispute.
REITs declined in October, with investor concerns regarding technology companies hitting the data center sector hardest. Additionally, slowing global growth weighed on the hotel sector despite the U.S. posting relatively strong GDP growth. Within the FTSE NAREIT Equity REITs Index, data centers (-11.5%) posted the lowest returns, followed by hotels (-10.0%) and office (-5.1%).
In Asia, retail and office REITs delivered performance in line with expectations, with office REITs reporting negative rental reversions. Overall, REITs in Asia had to rely on organic growth and delivered weak distribution per unit.
Overall, commodities were under pressure during the month due to macroeconomic risks which came from continued fears of an escalating trade war between the U.S. and China.
The energy complex declined from recent highs, with the WTI futures falling more than 10 percent over the month, mainly attributable to evolving expectations surrounding the sanctions against Iran's oil exports.
The industrial metals space was also negatively impacted in October, as copper continued to be a focus amid concerns surrounding a Chinese slowdown. Other base metals sharply declined, including nickel, which experienced positive tail winds on expectations of growth in demand for electric vehicles.
Hedge funds focused on volatility trading had mixed results, as long volatility exposure was profitable but short volatility faced headwinds. Realized volatility in global equity markets was unmatched by moves in other risk assets, leading to attractive cross asset volatility trades.
Systematic macro strategies had a challenging month due to trend reversals. Some discretionary strategies benefitted from trading in the stressed emerging markets as well as long U.S. dollar positioning.
Event-driven strategies lost money, as merger arbitrage, distressed, and special situation equities all experienced losses. An uptick in merger activity, combined with increased market volatility, did provide opportunity for spread and volatility trading. Also weighing on the space was uncertainty surrounding deals seeking regulatory approval from China.
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All data is as of October 31, 2018 unless otherwise noted.
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