Monthly Commentary

EWM Macro View-January 2018

By January 5, 2018 No Comments

Domestic equity market returns were mixed, but generally modestly positive in December, with out performance shifting to the value indices in large and mid cap stocks, after growth dominated most of the year. December was a busy month in terms of impactful news and events. As widely expected and clearly telegraphed, the Federal Reserve (Fed) raised short-term interest rates in early December to a range of 1.25%-1.50%. This is the highest level for the federal funds rate since the third quarter of 2008. Retail sales numbers were strong leading into the holiday season, and consumer confidence remains positive. The major event of the month was the hurried completion of the 2017 Tax Reform and Jobs Act, right before Congress adjourned for the year. As expectations for a completed bill rose during the month, the equity markets responded in tandem, particularly in those sectors where companies’ average effective tax rate was higher than the new bill’s target, namely consumer staples, energy (also boosted by rising oil prices), and consumer discretionary. A number of individual issues climbed sharply on expectations those firms would take advantage of the “tax holiday” included in the bill, a one-time lowering of the tax rate due on profits held overseas. Congress also passed a temporary spending measure to keep the government open until mid-January, but several thorny issues must be addressed by both houses early in 2018.

Within this context, domestic equities were mostly higher for the month, as the Russell 3000 Index gained 1.00%.

Large caps, as represented by the Russell Top 200 Index, outperformed mid cap issues by a small margin, but the value-oriented indices were well ahead of their growth counterparts in both asset classes. The one outlier in the domestic market was small caps: The Russell 2000 Index was down -0.40% for the month, and the growth component outperformed the value component by more than 1%. The Financials sector, the primary driver of this reversal, and comprising roughly 31% of the value index and 18% of the core index, was down 2.50% for the month. The Bloomberg Commodity Index as a whole was up 2.99% for the month, as the rally in energy (crude oil was up 5.3% in December) continued through the end of the year. The Dow Jones Wilshire U.S. REIT Index declined 0.13% for the month.

International equity markets continued to perform well during the month, building on momentum throughout 2017. In particular, emerging markets were the strongest performer and gained 3.6% during December, easily outpacing their developed market counterparts, which gained 1.6%. Local currency returns were slightly lower, as the dollar was broadly weaker on continued moderate US inflation data, which calls into question the Fed’s ability to implement three rate hikes in 2018. Japan is still a laggard among the developed markets (+0.70%), but several positive signs are apparent. Inflation picked up slightly, though still well below target, and the unemployment rate fell more quickly than expected, to 2.7%, while household spending also ticked up. Additionally, the Eurozone enjoyed good economic news, as consumer prices were up 1.5% from a year earlier, nearing the European Central Bank’s target. In addition, unemployment has fallen to 8.8%, its lowest level since January 2009. Although China’s markets cooled during December, they still rose 1.9% and finished the year up over 54%.

Domestic fixed income markets largely posted very modest returns in December, but even that was a surprise. The US Treasury curve flattened even further in December, driven by the expected Fed rate hike at the short end and lower inflation expectations and strong investor demand for longer dated issues. Yields rose 10-14 basis points in the first two years of the curve in December, tapering off to just a 2-basis point rise on the 7-year maturity. The yield on the 10-year Treasury Note fell by 2 basis points in the month and by 9 basis points on the 30-year maturity. This led to the 1-3 Year Treasury Index falling 0.28% for the month, while the 20+ Year Index was up 2.55%. The Aggregate Index (+0.39%) was led by investment grade corporate credit (+1.05%), which outperformed both Treasurys (+0.05%) and mortgage-backed securities (+0.15%). Current corporate fundamentals remained solid, and the anticipation of increased cash flow from the lower corporate tax rate in 2018 drove spreads tighter by 4 basis points. These same drivers led the high yield index up 0.30% and the S&P LSTA Leveraged Loan Index up 0.40% for the month.

December’s biggest news in domestic fixed income was the municipal bond market, as details of the tax reform bill crystallized and clarified that the municipal market was about to undergo a significant change. The key provision in the bill was removing the ability for municipal bond issuers to refinance their debt through the pre-refunding process. This created a rush to market by issuers wanting to get ahead of the December 31 deadline. New issuance was up more than 30% in November over the previous year, and December posted a record $62.5B in issuance. Despite this massive wave of issuance, there was more than enough demand for these issues, causing spreads to tighten further and creating positive returns for even short-maturity municipal bonds.

The international fixed income markets were also modestly positive during December, aided by the dollar’s aforementioned weakness. The Global Aggregate ex USD Index was up 0.27% on an un-hedged basis, while the hedged version of the Index was up just 0.04%. Emerging markets debt also posted positive returns for the month, led by local currency bonds returning 2.00% versus 0.73% and 0.24% for hard currency sovereigns and emerging markets corporates, respectively.


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