EWM Macro View-February 2018

Post On March 2, 2018 by

The domestic equity market reminded investors in February that volatility does still exist. The modest weakness in the final week of January turned into a rout over the first few trading days of February, as investors were spooked by data showing the first signs of inflation, including continuing upward wage pressure. This data sent all of the major indices down 7.5%-9.0% by February 8. However, ongoing positive earnings reports, including the significant projected impact of the tax reform bill passed in December, allowed the market to recover a little more than half of those losses over the remainder of the month. Energy was one of the worst performing sectors, as rising US inventories caused oil prices to fall nearly 8.0%. The more defensive segments of the market were also hit hard, particularly the dividend payers and other bond proxies, as interest rates rose sharply during the first three weeks of February. The Information Technology sector had the only positive return for the month, very modest in the large cap space and essentially flat in small caps.


February was the first month since last March that posted a negative return in all three of the major US Indices: the Dow fell 4.0%; the S&P 500 was down 3.7%; and the NASDAQ dropped by 3.7%. Large caps, as represented by the Russell Top 200 Index, were down 3.5% for the month, marginally outperforming small caps (Russell 2000 Index declined 3.9%) and mid caps (Russell Midcap Index fell 4.1%). The growth indices, led by their technology weights, outperformed their value counterparts by 1.8%-2.2%, across the market spectrum. The Bloomberg Commodity Index as a whole was down 1.7% but up 0.7% when the energy component is removed. The Dow Jones Wilshire U.S. REIT Index was down 7.6% for the month.


The international equity markets1 modestly underperformed the domestic markets in February, falling in sync during the first two weeks, but failing to rally nearly as far as the US indices during the latter half. Eurozone GDP growth remains strong, relative to recent history, and has shown signs of expanding beyond the core countries, as recent data from Spain and Portugal were particularly strong. Unemployment continues to fall across the common market as well. Yet the most recent CPI data shows inflation still well below the European Central Bank’s (ECB) target of 2%. Japan also reported the eighth consecutive quarter of positive GDP growth; however, the 0.5% annualized reading was well below the market’s expectation of 0.9%. The EAFE Index declined 3.7%, dragged lower by Greece, Spain, and Germany, all of which fell more than 6.8%. The emerging markets outperformed their developed counterparts, as the Emerging Market (EM) Index was down just 3.3%. Russia led the way, up more than 3.0% for the month.


Domestic fixed income markets2 largely posted negative returns in February, as interest rates rose sharply. Economic data continued to show modest but consistent wage growth, and January’s CPI numbers surprised to the upside. The US Treasury curve steepened slightly during the month, as the yield on the 2-year Treasury note rose 12 basis points, while yields on both the 10-year note and 30-year bond were up 15 basis points. Short-term indices hovered around the breakeven point, but losses increased the further investors moved out the yield curve.


The Aggregate Index (down 95 basis points) was dragged lower by a 1.5% decline in corporate credit, its main driver over the last several years, and both the mortgage-backed security (MBS) sector (down 66 basis points) and Treasury’s (down 75 basis points) also struggled. The non-investment grade indices fared slightly better, as the higher coupons of the High Yield Index (down 85 basis points) partially shielded investors from the rise in rates, and the floating rate nature of the S&P LSTA Leveraged Loan Index created a gain of 20 basis points for the month.


The municipal market continued to outperform the taxable market in February. New supply remains scarce, while municipal mutual funds received substantial inflows in two of the first three weeks. The 1-3 Year Index was up 14 basis points, while the 22+ Year Index was down just 42 basis points. Negative monthly returns, even those as modest as February’s, have traditionally led to substantial outflows from municipal funds. When combined with the presumed seasonal outflows in late March and early April, as individual investors pay their taxes, it would be easy to predict a difficult few months for the muni market. But new issuance averaged less than $5 billion a week in February, and the 30-day forward calendar has remained stable at $9.5 billion, meaning it may take a very significant drop in demand before munis begin to under-perform the taxable market.


The international fixed income markets also fell during February, at least in dollar terms. Yields on German Bunds, UK Gilts, and Japanese Government Bonds all ended the month lower, creating a modestly positive return for the currency hedged version of the Global Aggregate ex-US Index. However, the dollar ended higher against most currencies in February, the first month of appreciation since last October, both wiping out the gain and leaving the unhedged version of the Index down 85 basis points. The dollar also rallied against a broad swath of emerging markets currencies, which weighed on the local currency JP Morgan Government Bond Index (JPM GBI) performance (down 1.0%). Negative performance was even more pronounced for the hard currency JP Morgan Emerging Market Bond Index (JPM EMBI) (down 2.0%), as rising Treasury yields put upward rate pressure on dollar-denominated emerging markets government bonds, which trade at a spread over Treasury’s.