The slope of the U.S. Treasury yield curve, often used as recessionary early warning signal, flattened to a new cyclical low to round out the second quarter. Key drivers behind this dynamic include the potential full maturity of the economic expansion, continued Fed tightening, and fears of a trade war-induced global growth slowdown. In the second quarter, domestic equities—particularly small cap—generated solid returns while international developed and emerging market equities lost traction. Most fixed income sectors experienced modest performance, with relative outperformance in below-investment grade sectors. In real assets, energy infrastructure experienced a solid rebound following a slump in the first quarter, while REITs also experienced solid gains as domestic economic fundamentals remained strong and interest rate volatility moderated.
U.S. Treasury Yield Curve Flattens to Fresh Cycle Low
Business cycle expansions in their later stages are often characterized by a tight labor market, waning economic "slack" (i.e., remaining capacity of resources), bubbling inflationary pressures, and restrictive monetary policy. These competing forces help place pressure on the slope of the Treasury yield curve, with the Federal Reserve's (Fed) interest rate hikes helping to increase Treasury rates on the front end of the curve. This tightening of monetary conditions acts as a counterbalance to late-cycle inflationary pressures. As the long-end portion of the curve exhibits the most sensitivity to inflationary sentiment, these dynamics help create curve "flattening."
Throughout the second quarter and into early third quarter trading, the slope of the yield curve, as proxied by the differential between the 2-year and the 10-year Treasury notes, tightened meaningfully. Through early July, this spread stood at 29 basis points (bps), the tightest level in the current economic expansion.
A flat/flattening yield curve tends to serve as a headwind to institutions that rely on borrowing in the short-term markets and lending across longer-term maturities, as this becomes a losing proposition when the yield curve is flat-to-negatively sloped. This "net interest margin" is a key profitability gauge for financial institutions like banks. As such, those equity indices that exhibit a material constituent weighting in financials, such as domestic value equity indices, tend to lag their growth counterparts late-cycle (and vice versa).
FEG does not believe investors should become immediately alarmed despite suggestions of an early recessionary warning sign potentially being tripped, as past cycles have shown that the curve can invert one-to-two years ahead of the front end of a recession, a time often ripe with solid total returns. Moreover, the broader subset of business cycle timing tools, such as leading economic indicators growth, high yield spreads, labor market fundamentals, and Purchasing Manager Index gauges, among others, fail to corroborate the recessionary signals emanating from the yield curve, as many of these indicators appear solid.
The U.S. Recession Risk Dashboard, which encompasses a mosaic of business cycle timing indicators, shows that near-term recession risk actually remains quite low. Medium-term (one-to-three years) risk, however, remains moderately elevated. Unforeseen headwinds or tailwinds may alter today’s initial set conditions, although the recent implementation of U.S. fiscal stimulus is likely to continue serving as a business cycle tailwind over the near-term horizon.
To conclude, the ongoing flattening of the Treasury yield curve, the pace of which has accelerated in recent months, is potentially pointing to a business cycle inflection on the horizon. Ongoing Fed rate hikes and a maturing business cycle are likely culprits of this recent dynamic. While recently-enacted tax stimulus may prolong the current expansion, the mosaic of business cycle timing factors points to a moderate risk of a downturn in the medium-term, with near-term risk appearing low at present.
- The U.S. stock market, represented by the S&P 500, posted solid returns during the second quarter on strong reported earnings as well as increased earnings expectations that were supported by positive economic data.
- Rising energy prices placed the energy sector in a position of leadership for the quarter with returns of almost 15% that dwarfed the 8.1% returns of the second-place sectors, real estate and consumer discretionary.
- Growth stocks continued their dominance over value stocks, led by the FAANG stocks’ (Facebook, Apple, Amazon, Netflix, and Google) strong performance.
- Small capitalization stocks led over large capitalization stocks for both the quarter and trailing one-year period, with a quarterly performance of over 7%.
- Europe faced headwinds during the quarter including disappointing data releases from the European Union, which included continued low core inflation, and news from the European Central Bank (ECB). The ECB postponed increasing interest rates until the summer of 2019, however, they confirmed that quantitative easing would cease by the end of 2018. Apprehension around Italy’s new populist government also likely contributed to volatility.
- The quarter was difficult for emerging markets. The Indian rupee fell to a record low during the quarter, followed by the Chinese yen. Stock in Brazil suffered under political turmoil and a crippling truck-driver strike. China, the largest emerging market economy, suffered a steep decline on trade dispute tension.
- Currency movements had a significant impact on returns for U.S. investors, as the United States dollar (USD) appreciated approximately 4% against a basket of major currencies.
- Bond market sell-offs began during the quarter after healthy retail sales growth was reported in April, causing investor concerns regarding inflation to heighten. The U.S. 10-year Treasury yield briefly topped 3% for the first time in over four years, rising to a high of 3.1% in mid-May. Sell-offs tapered towards the end of May, and the 10-year Treasury yield reverted back to 2.9% to finish the quarter.
- At the June meeting of the Federal Reserve (Fed), the Fed raised rates by 25 bps to a new range of 1.75-2.00%—in line with market expectations—and signaled two additional hikes for the second half of the year, as unemployment continued to fall and inflation overshot the Fed’s target.
- The USD rally throughout the quarter against the euro and most other currencies—particularly the Argentine peso, Turkish lira, and Indian rupee—negatively impacting emerging market debt returns.
U.S. REITs returned 8.5% during the second quarter and while yielding more than BBB corporate bonds for the first time in 10 years. Self-storage (15.1%), health care (14.2%), and lodging/resorts (14.1%) were the top performing sectors. Although rising interest rates took a toll on REITs to start the year, rising rates also provided a sign of economic improvement that supported REITs, as property owners raised rents in response to rising rates and inflation.
Oil prices gained 25% through the first half of 2018. Oil prices hit multi-year highs around $75 due to a combination of tightening supplies, growing demand, and geopolitical issues while U.S. oil production reached over 10 million barrels per day. The U.S. withdrawal from the Iran nuclear deal and the return of sanctions on Iran has been expected to disrupt oil shipments, with varied estimates ranging from essentially no decline to a reduction of as much as one million barrels per day of Iranian supply.
- Agriculture was negatively affected by soybeans and trade tensions during the quarter, with few signs of a trade resolution. Additionally, corn demand has exceeded supply, which detracted from performance
As measured by the Alerian MLP Index, MLPs gained 11.8% in the second quarter following a similar decline in the first quarter that left MLP performance just slightly negative year-to-date. MLP fundamentals are stable and improving, with the distribution yield on the Alerian MLP index at approximately 8%. Multiple announcements of MLP simplifications and corporate consolidations of MLPs and their corporate sponsors have positively impacted performance in the second quarter.
Macro strategy returns were mixed during the quarter. Discretionary strategies—particularly those focused on developed markets—enjoyed tailwinds from rising interest rates. Emerging markets strategies generally struggled due to trade tensions, political risks, and the strengthening of the U.S. dollar. Challenges for systematic trend followers continued amid choppy markets that contained trend reversals.
Merger arbitrage strategies rebounded from a challenging first quarter. The strategy benefitted from renewed optimism after the Department of Justice’s blockage of a large merger was overruled.
This report was prepared by FEG (also known as Fund Evaluation Group, LLC), 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 directly 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.
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.
Investments in private funds are speculative, involve a high degree of risk, and are designed for sophisticated investors.
All data is as of June 30, 2018 unless otherwise noted.
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.
Barclays Capital Fixed Income Indices is an index family comprised of the Barclays Capital Aggregate Index, Government/Corporate Bond Index, Mortgage-Backed Securities Index, and Asset-Backed Securities Index, Municipal Index, High-Yield Index, and others designed to represent the broad fixed income markets and sectors within constraints of maturity and minimum outstanding par value. See https://ecommerce.barcap.com/indices/index.dxml for more information.
The CBOE Volatility Index (VIX) is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index option bid/ask quotes. The Index uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index. FTSE Real Estate Indices (NAREIT Index and EPRA/NAREIT Index) includes only those companies that meet minimum size, liquidity and free float criteria as set forth by FTSE and is meant as a broad representation of publicly traded real estate securities. Relevant real estate activities are defined as the ownership,
HFRI Monthly Indices (HFRI) are equally weighted performance indexes, compiled by Hedge Fund Research Inc. (HFX), and are used 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
J.P. Morgan’s Global Index Research group produces proprietary index products that track emerging markets, government debt, and corporate debt asset classes. Some of these indices include the JPMorgan Emerging Market Bond Plus Index, JPMorgan Emerging Market Local Plus Index, JPMorgan Global Bond Non-US
Merrill Lynch high yield indices measure the performance of securities that pay interest in cash and have a credit rating of below investment grade. Merrill Lynch uses a composite of Fitch Ratings, Moody’s and Standard and Poor’s credit ratings in selecting bonds for these indices. These ratings measure the risk that the bond issuer will fail to pay interest or to repay principal in full. See www.ml.com for more information.
Morgan Stanley Capital International – MSCI is a series of indices constructed by Morgan Stanley to help institutional investors benchmark their returns. There
S&P 500 Index consists of 500 stocks chosen for market size, liquidity and industry group representation, among other factors by the S&P Index Committee, which is a team of analysts and economists at Standard and Poor's. The S&P 500 is a market-value weighted index, which means each stock’s weight in the index is proportionate to its market value and is designed to be a leading indicator of U.S. equities, and meant to reflect the risk/return characteristics of the
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