Following a first quarter spike in volatility, global market participants faced a multitude of risks in the second quarter. Central to these risks were heightened concerns of global trade wars, strong appreciation of the U.S. dollar (particularly versus emerging market currencies), diverging economic health between the U.S. and its largest trading partners, and continued efforts by developed market central banks to normalize monetary policy.
International equities declined during the quarter, with developed markets cooling modestly and emerging markets witnessing a sizable move lower. Worries of a trade-related slowdown and sentiment for tighter Fed policy applied pressure to both emerging market currencies and risk assets.
After witnessing elevated volatility in the first quarter, most fixed income sectors experienced modest performance in the second quarter. Below-investment grade credit, such as high yield bonds, outperformed higher quality sectors, which likely reflected an ongoing expansionary bias.
Following a slump in the first quarter, energy infrastructure posted a solid rally for the second quarter, including the strongest quarterly gain for the Alerian MLP Index since the second quarter of 2016, with a return of almost 12%. REITs also experienced solid gains, as economic fundamentals remained strong and interest rate volatility moderated.
Second quarter 2018 was marked by concern over global trade wars. Following through with his campaign promise of reversing unfair trade practices, U.S. President Donald Trump announced tariffs on imports of aluminum (10%) and steel (25%) in early March. Initially exempt from the tariffs, the scope was later expanded to include the European Union (EU), Mexico, and Canada. This year has provided a rally in the USD, as the ICE Dollar Index (DXY) advanced 5%. Conversely, emerging market currencies witnessed significant downside pressure during the quarter. The liquid JP Morgan Emerging Market Currency Index (EMCI), for example, concluded the quarter with the steepest single-quarter decline (-8.6%) in almost three years amid volatile currency markets. Interestingly, President Trump’s approval rating appears to be a recently reliable leading indicator for the directionality of the USD. This is intuitive, as market participants discount the likelihood and magnitude of the President’s “America First” policies
In addition, the U.S. threatened to levy tariffs on imports of European automobiles, prompting the EU to respond with potential retaliatory tariffs on select imports from the U.S., such as apparel, bourbon whiskey, and motorcycles. China has also proposed a set of tariffs on U.S. exports such as soybeans, which would affect vast areas supportive of President Trump.
So far, punitive trade war concerns have led to steep losses across risk assets in economies heavily reliant on U.S. demand, particularly emerging market (EM) economies like China. The Shanghai Composite Index, for example, reached its lowest level since early 2016, entering bear market territory during the second quarter.
Predicting the severity of any trade disputes, whether limited to deteriorating conditions or a full-blown trade war, and the downstream consequences of any disputes in the complex, adaptive global economy is irresolvable. Recent market performance, however, has exposed the heightened initial sensitivity of emerging markets equity, debt, and currencies to this uneasy environment. Meanwhile, U.S. risk assets appear relatively insulated to date with mostly positive returns posted year-to-date across large and small cap equities, high yield bonds, REITs, and other risky domestic sectors.
RISE IN THE U.S. DOLLAR AND "AMERICA FIRST" POLICIES
Volatility in the value of the U.S. dollar (USD) is not new, but the past few years have witnessed significant oscillation in the value of the dollar. By many measures, the USD appreciated approximately 20-30% from the summer of 2014 to the end of 2016. This period drove significant dislocations across asset classes that are most sensitive to a sharply appreciating USD, such as non-U.S. equities, precious metals, and energy among others. However, USD appreciation reversed course in 2017, declining by approximately 10%.
This year has provided a rally in the USD, as the ICE Dollar Index (DXY) advanced 5%. Conversely, emerging market currencies witnessed significant downside pressure during the quarter. For example, the liquid JP Morgan Emerging Market Currency Index (EMCI) concluded the quarter with the steepest single-quarter decline (-8.6%) in almost three years amid volatile currency markets.
Interestingly, President Trump’s approval rating appears to be a recently reliable leading indicator for the directionality of the USD. This is intuitive, as market participants discount the likelihood and magnitude of the President’s “America First” policies.
In addition to growing favorable sentiment for President Trump, both inflation and economic growth continue to march higher. Consequently, the Fed may be “forced” by the market to follow a tighter-than-expected path in the near term.
Concurrently, softening GDP and inflation data in the euro zone and Japan may have the opposite effect on the European Central Bank (ECB) and the Bank of Japan (BOJ). GDP and inflation may potentially pressure these central banks to moderate the pace on their path towards more normalized policy. As a result, this push-pull dynamic may continue to serve as a tailwind behind the USD in the near term.
DIVERGING ECONOMIC HEALTH
Performance disparities across domestic and international asset categories materialized in the second quarter and coincided with the divergence of underlying economic conditions. While most U.S. macroeconomic data have remained robust, a modest amount of deterioration has occurred abroad.
The U.S. economy is showing signs of broad-based strength across the labor market, the manufacturing and services sectors, and commercial and residential real estate. Renewed optimism for a continuation of the recent improvement has manifested in both expected and realized inflation rates. In addition, most indicators that tend to lead the business cycle still indicate solid near-term growth prospects. Indeed, the Atlanta Fed’s GDPNow™ model is pointing to a near 4% quarterly growth rate for the U.S. economy in the second quarter, which would be the strongest measure in almost four years.
The recent passage of tax stimulus at both the corporate and individual level has spurred growth and should continue to help counterbalance incrementally restrictive Fed monetary policy. This transition from monetary-to-fiscal policy support, if smooth, could help alleviate concerns around the market response to a Fed that is no longer providing economic life support.
As U.S. conditions have advanced, economic growth across the euro zone and Japan has recently eased. This dynamic has surfaced in both realized levels and survey-based measures of economic growth. For example, Purchasing Manager Indices (PMI)—which provide survey-based data across the manufacturing and services sectors–have steadily increased in the U.S., but have cooled in the euro zone throughout 2018, albeit from materially higher levels and still in the expansionary zone above a level of 50.
From 2016-2017, GDP growth across the U.S., euro zone, and Japan rose in unison, leading many to label this period as the “global synchronized recovery.” More recently, however, economic growth has slowed across both the euro zone and Japan, potentially calling into question the sustainability of this harmonized expansion.
While it is likely premature for investors to lose assurance in broad-based global growth, one should recognize the substantial cyclical headwinds in the global environment: rising geopolitical tensions between the U.S., China, Russia, North Korea, et al.; a worsening global trade landscape; and a looming return to “normalcy” across the world’s largest central monetary authorities.
GLOBAL CENTRAL BANKS SHIFTING GEARS
According to National Bureau of Economic Research records dating back to the 1850s, the current U.S. economic expansion, which is in its ninth year, remains the second longest on record. The potentially maturing economic cycle coupled with fiscal stimulus and a tight labor market has served as a driving force behind the Fed’s efforts at tightening policy through a combination of interest rate hikes and a partial wind-down of their nearly $4.5 trillion balance sheet.
During the quarter, U.S. labor fundamentals continued to tighten. The U-3 unemployment rate of 3.8% through May matched April 2000’s reading as the lowest rate since December 1969. First-time claims for unemployment insurance reached multi-decade lows, while wage growth increased modestly. These indicators, along with other improvements in the labor situation, have bolstered expectations for a steeper Fed tightening path over the cyclical horizon.
Abroad, the ECB and the BOJ are grappling with how and when to best implement their own policy normalization efforts. Even though the U.S. continues to enjoy the world’s reserve currency status, and thus U.S. monetary policy initiatives tend to carry more “weight,” the hyper accommodative policies of the ECB and BOJ since the Global Financial Crisis have helped support monetary conditions—and likely investment conditions in Europe and Asia.
The recent tightening of ECB quantitative easing and a partial wind-down of the Fed’s balance sheet helped drive year-over-year balance sheet growth rates lower—a trend expected to continue—to 5.4%, the lowest since late 2015. Although still growing, primarily due to the Bank of Japan, this trend reflects central banks “taking the foot off of the economic accelerator.
Thankfully, the Fed is tightening the monetary reigns at a time when the U.S. economy is strengthening. However, the same cannot be said for the ECB and BOJ, which, as described above, are currently witnessing a soft patch in their economic expansions. In the coming quarters, the pace of balance sheet asset growth across these three key global developed market central banks is likely to enter negative territory. The cascading implications of such a movement are difficult to imagine materializing as a tailwind to global growth and returns for asset classes already exhibiting rich valuations.”
Numerous global equity themes reversed course in the second quarter. Front and center was domestic equity’s impressive outperformance over international developed and emerging market (EM) counterparts. The S&P 500 Index, for example, generated a total return of 3.4%, whereas the MSCI EAFE Index declined 1.2% and the MSCI Emerging Markets Index slumped 8.0%—both in USD terms and with much of the negative results driven by the appreciating USD.
As previously mentioned, heated global trade wars rhetoric—particularly between the world’s two largest economies (U.S. and China)—helped pressure emerging market equities lower during the quarter. Moreover, EM equities have exhibited elevated sensitivity to Fed policy, and as an extension, the USD and U.S. Treasury interest rates.
Juxtaposing the DXY Index against the ratio of the S&P 500 to the MSCI EM Index highlights the relative headwinds U.S. investors in EM equities face when the USD is sharply appreciating. Of note on the graph is the blue line (DXY Index) moving higher since late 2017, coinciding with U.S. equity’s impressive outperformance versus EM.
Another theme that shifted in the second quarter was domestic small cap equities outperforming domestic large cap. An appreciating USD, which applies downward pressure to corporate profits earned abroad, has a disproportionately negative effect on large cap companies, as most small cap companies derive the majority of their profits within domestic markets.
After generating positive returns for eight consecutive quarters, frontier market equities fell 15.2% in the second quarter, the steepest decline for the MSCI Frontier Markets Index (in USD terms) since the first quarter of 2009. Similar to emerging markets, frontier market equities have fallen victim to an increasingly perilous global trade environment, immense currency pressures, and capital flight—among other macro headwinds.
Interest rates rose sharply to start the year, with the yield on the benchmark 10-year Treasury Note hitting 3.11% on May 17 before settling back to 2.86% to round out the quarter. Notably, 10-year yields took out summer 2013 Taper Tantrum highs, leading some to speculate that the 1982-to-present secular decline in interest rates is showing signs of exhaustion.
The somewhat alarming takeaway here is not that U.S. nominal rates may be in the process of breaking out of a 30+ year downward trend, but that nominal rates may not have as much room to fall in the next recession as one might think.
Each of the past three recessions—indicated by the gray bars in the chart—saw the 10-year Treasury yield move between one and two standard deviations (sigma) below trend once the disinflationary pressures of the recession took root. Today, both the minus-one and minus-two sigma trend lines for the 10-year Treasury sit in negative territory. This is not to say that 10-year rates will go negative in the next recession, but that approaching 0% is not out of the question. This is a possibility that the Fed would presumably prefer to avoid.
Despite rising rates, high yield bonds provided a nearly flat return and have exhibited relatively low volatility and modest outperformance versus core bonds. Yield spreads have also changed little, on balance, with the option-adjusted spread on the Bloomberg Barclays High Yield Index nearly 200 bps below the long-run average and with little meaningful upward pressure.
The possibility for a reversal of the secular decline in interest rates combined with historically tight spreads and low yields necessitates an emphasis on actively managed fixed income solutions, which FEG continues to thoughtfully implement in client portfolios. When the next cycle turn presents “fat pitch” opportunities, we will seek to capitalize on the opportunities presented.
After a bumpy first quarter that saw sizable declines across real estate investment trusts (REITs) and energy master limited partnerships (MLPs), the second quarter brought relief to real assets. The returns generated across REITs, MLPs, and commodities during the quarter were particularly impressive when considering the strength of the USD, which tends to exert downward pressure on inflation and often serves as a headwind to most real assets categories.
The FTSE NAREIT All Equity REIT Index generated an impressive 8.5% total return for the quarter, as interest rate volatility moderated and the economy gathered momentum. Real estate fundamentals appeared solid throughout the quarter: vacancy rates remained low, commercial property price appreciation was strong, and cap rates generally remained low and stable. Demand for commercial real estate loans, however, appears to have peaked in 2013 and has waned since. This data is produced by the Fed on a meaningful lag; however, overall demand appeared fairly neutral through the first quarter.
With a total return of 11.8% in the second quarter, the Alerian MLP Index (Alerian) produced its strongest quarterly return in two years. Underpinning the sizable gain included a rebound in energy spot prices, record high U.S. crude oil production at 10.9 million barrels per day, an improved inflationary backdrop, and robust domestic economic conditions. The rally across the MLP space helped tighten the Alerian’s yield spread versus 10-Year Treasuries by 1.0 ppt, concluding the quarter at 5.1% and 160 bps above the long-term average.
Despite the tightening of the MLP yield spread, this valuation metric continues to reflect an attractive embedded risk premium, albeit less attractive when compared to levels witnessed during the energy market dislocation of 2015 and 2016. Client portfolios that were overweight energy infrastructure experienced a sizable contribution to portfolio alpha during the second quarter, and FEG remains optimistic regarding the potential for continued strong performance for investors that can tolerate bouts of interim volatility.
Realized returns across most corners of the investible universe were generally modest, if not negative, in the second quarter. Liquid diversifying strategies (DS) also produced muted returns on balance, with modestly positive returns experienced in relative value and essentially flat returns experienced in macro, event-driven, and equity hedged strategies.
Historically, investors have turned to core fixed income to help protect portfolio performance from protracted equity market dislocations. One of the strongest predictors of the total return potential over the duration of a fixed income investment is an investor’s starting yield-to-maturity (YTM). As of June 29, the yield-to-maturity (YTM) on the Bloomberg Barclays U.S. Aggregate Bond Index stood at 3.3%. With fixed income exhibiting such a low YTM, FEG has tempered expectations for the return contribution from a high quality fixed income portfolio. This is where a DS allocation can function meaningfully in a broad, multi-asset portfolio.
The current environment is particularly unique in that both stock and bond implied volatility is exceptionally, and simultaneously, low. To smooth out daily fluctuations, consider the 200-day moving averages (MA) of the CBOE VIX Index, a proxy for implied U.S. equity volatility, and the Merrill Lynch MOVE Index, a proxy for implied Treasury volatility. The graph shows that investor expectations for future realized volatility across both stocks and bonds has almost never been lower; however, this dynamic is likely unsustainable and should therefore be treated with caution and prudence.
In a market environment characterized by late business cycle dynamics, heightened geopolitical and trade tensions, elevated risky asset valuations, a potential for a secular increase in U.S. interest rates, and relatively low implied and realized volatility across many corners of the market, DS may help cushion globally diversified portfolios against adverse shocks.
The first quarter of 2018 shocked those expecting a continuation of the low-volatility regime investors have enjoyed for the past half-decade, with the second quarter heralding a possible shift to a trade war-induced global growth slowdown. While the U.S. economy reflects underlying strength, this is likely unsustainable in the long term should it persist in isolation, without shared fortunes among other key nations essential to global economic growth.
The wall of worry is well known and characterized by waning global central bank monetary support, the appearance of cracks across the emerging and frontier markets, a hastening depreciation of emerging market currencies, and the looming eventuality of a return to persistently elevated levels of volatility. In light of these factors, FEG portfolios remain cautiously positioned, placing particular emphasis on actively managed strategies that are poised to successfully navigate an increasingly challenging cyclical outlook. With an abundance of information, it is easy for investors to become overwhelmed in following daily indicators of economic stress and health, allowing fear, greed, and emotion to drive investment decisions. Instead, FEG takes the long-term view, reallocating portfolio risk exposures to maintain a positive asymmetric risk/reward profile.
This report was prepared by Fund Evaluation Group, LLC (FEG), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directed to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202 Attention: Compliance Department.
The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. FEG, its affiliates, directors, officers, employees, employee benefit programs and client accounts may have a long position in any securities of issuers discussed in this report.
Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss.
Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
Neither the information nor any opinion expressed in this report constitutes an offer, or an invitation to make an offer, to buy or sell any securities.
Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or that investors will not incur losses.
Past performance is not indicative of future results.
This report is intended for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report.
Published July 2018
The Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class.
The Bloomberg Barclays Capital Aggregate Bond Index is a benchmark index made up of the Barclays Capital Government/Corporate Bond Index, Mortgage‐Backed Securities Index, and Asset‐Backed Securities Index, including securities that are of investment‐grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.
The HFRI Monthly Indices (HFRI) are equally weighted performance indexes, compiled by Hedge Fund Research Inc., and are utilized by numerous hedge fund managers as a benchmark for their own hedge funds. The HFRI are broken down into 37 different categories by strategy, including the HFRI Fund Weighted Composite, which accounts for over 2000 funds listed on the internal HFR Database. The HFRI Fund of Funds Composite Index is an equal weighted, net of fee, index composed of approximately 800 fund of funds which report to HFR. See www.hedgefundresearch.com for more information on index construction.
The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes. The developed market country indexes included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indexes included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey* and United Arab Emirates.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Information on any indices mentioned can be obtained either through your consultant or by written request to firstname.lastname@example.org.