While the 5 year Treasury started 2017 yielding 1.96%, the 24 basis point yield increase throughout the year caused an offsetting price decline, dragging the 12 month return down to 1.31%. In December, municipal bonds were the top fixed income performer. For the year, they outperformed Treasuries and the Broad Market, but trailed Investment Grade Corporates by 106 basis points.
The large Municipal new issue volume in December, spurred by changes to issuer eligibility in the tax reform bill, had been expected to push yields higher. Instead, the market easily took down the wave of issuance, even as rates declined. This was driven by many buyers becoming eager to put cash to work in December, as the likelihood that the tax bill would cause a significant contraction in 2018 issuance became more apparent.
Investment Grade Corporate spreads rallied in December, and ended the month at their tightest levels since July 2007. Due to the continued bear flattener yield curve movement, long duration holdings have performed better than short duration. The bear flattener is also responsible for Investment Grade Corporate’s 2017 performance coming in very close to High Yield, having trailed it by only 100 basis points for the year. The longer duration of the IG index gave it a performance boost, while the shorter duration of the HY index was a hindrance, due to rising rates on the shorter end of the curve.
The Emerging Market Sovereign & Credit Index locked down another year of impressive returns. 2017 is the third year in a row that it has returned more than +9%. This exposure has been favored by the risk-on environment and return chasing investors. Many consider this a crowded trade that may face a reversal in 2018.
Alternative Investments
Alternative Investments closed out the month of December largely on a high note, with the majority of alternative investments posting positive returns for the month. Commodities, as measured by the Bloomberg Commodities Index, closed the month up +2.9%. The index was helped higher thanks to a surge in West Texas Intermediate (WTI) crude oil, which gained +5.3% on the month to close at $60.42/bbl on the NYMEX. December’s close marks the first monthly closing high above $60/bbl since November 2014. After 2016’s +45.0% gain, crude gained another +12.5% in 2017, a more than doubling from the February 2016 intra-month lows below $30/bbl.
Commodities were also helped higher due to a weaker U.S. Dollar, as measured by the DXY Index, which shed -1.0% in December. The Dollar was the year’s worst alternative investment, losing -9.9% after surging +28.1% from June 30, 2014 through year end 2016.
The Dollar’s weakness also buoyed Gold, which gained +2.2% in December to close at $1,303/oz. The precious metal remained in favor in 2017, gaining +13.1%, after posting an +8.6% return in 2016. Looking ahead to 2018, Gold remains a viable hedge against inflation and a market correction, but could remain challenged if real interest rates rise sharply.
Real Estate, as measured by the FTSE NAREIT All REIT Index, had another somewhat challenging year, losing -0.8% in December and gaining a scant +4.8% on the year (compared to the S&P 500, which gained +21.8% on the year).
This comes after a lackluster 2016 in which Real Estate gained +5.0%, compared to an +11.95% gain for the S&P 500. Real Estate remains a viable diversification tool, but remains overly sensitive to rising interest rates in 2018.
On the currency front, the Canadian Loonie, Japanese Yen, British Pound, and the Euro all strengthened meaningfully against the U.S. Dollar in 2017 as improved economic fundamentals overseas, coupled with a weaker U.S. Dollar propelled the currencies. As for the Hedge Fund universe, nearly all strategies posted positive returns in December, with Equity Hedge (L/S) returning +1.11% on average, while Equity Market Neutral strategies lost-0.79% on average.
For the year, Hedge Funds were again expensive hedges, with all strategies underperforming the broader equity markets.
This article was written by Nottingham Advisors, a participant in the ETF Strategist Channel.