From a sector standpoint, all 11 international sectors finished meaningfully in the red, posting losses of -3.33% (Consumer Discretionary) to -6.95% (REITs) on the month. Strength in Technology stocks was nowhere to be found, with the MSCI ACWI ex. U.S. Technology sector losing -4.04%, in sharp contrast to its U.S. brethren. As we’ve noted in the past, the MSCI EM sector is highly concentrated at the sector level (Technology, 27.6%), and the top five names in the index (Tencent, Alibaba, Samsung, Taiwan Semiconductor, Naspers) make up 19.38%.
As many of those stocks have doubled in price and become more expensive, lesser favored sectors playing on consumption driven themes, countries that have been out of favor (such as Brazil) and regions that are more localized (less correlated with the global economy) in Southeast Asia look more attractive. From a factor standpoint, Value and Quality remain favorable characteristics to ride out market volatility and add exposure within the EM space.
Looking ahead, all eyes are on Italian elections scheduled for Sunday, where the populist 5 Star Movement leads in the latest polls; however, without a majority. The wildcard will be whether or not the group has a strong showing amongst undecided voters, similar to Brexit and the French elections of years past.
Fixed Income Outlook
New Federal Reserve Chairman Jerome Powell provided a relatively bullish economic outlook in his first outing testifying before the House Financial Services Committee on February 27th, and the markets reacted with the USD strengthening, interest rates moving a bit higher, and the likelihood of a fourth rate hike in 2018 increasing substantially. He will provide additional testimony before the Senate Banking Committee today. Expectations are that Chairman Powell may present a more balanced view on the economy to avoid further market impact, having gained experience from his prior performance.
Interest rates continue to creep higher. The 2.25% yield on the two year Treasury bond has risen to a level that hasn’t been seen since 2008, while the ten year Treasury has flirted with the 3% level last breached in late 2013.
Credit spreads widened a bit along with the equity market turmoil, but do not appear to present a compelling value opportunity as they are still hovering near historically tight levels. Price impact of spread widening can be limited by keeping portfolio credit exposure within the short/intermediate maturity range. A 50 basis point increase in spread will have a roughly -0.9% price impact on a 2 year bond, a -2.3% price impact on a 5 year bond, and a -3.8% price impact on a 10 year bond.
Municipal bond prices have exhibited strength, with an assist from the technical support provided by the decline in issuance due to restrictions in the tax reform bill. A typical 10 year Aaa muni yields 87% of the current 10 year Treasury yield. This is below the recent average of 95%, but roughly in line with the longer term average. There is some talk of relaxing the restriction on the pre-refunding of outstanding bonds, which would significantly increase the amount of issuance coming to market, easing the supply drought.
There has been some concern that during the recent equity market sell off, bonds also sold off, failing to exhibit their traditional inverse price performance (stocks down=bonds up, and vice versa). While it is unusual, bonds continue to provide a portfolio volatility buffer (they did not fall in price anywhere near as much as equities), and longer term, it is unlikely that this historical performance relationship has dissolved. Higher credit quality portfolios have held up better during the turmoil, due to their insulation from excessive credit spread widening.
Alternative Investments Outlook
Alternative investments fared poorly in February, led by declines in commodities, real estate, and gold. Commodities, as measured by the Bloomberg Commodities Index, lost -1.8% on the month, helped lower by a pull back in oil prices.
West Texas Intermediate (WTI) crude oil lost more than $3/barrel, or -4.8%, to close below $62/barrel on the month.
Oil prices have come under pressure as inventories continue to undergo a supply and demand rebalance. U.S. oil production continues to hover at levels above 10 million barrels per day, levels not seen in decades. With energy companies largely profitable at $60/bbl oil prices, additional supply is likely to continue coming on line in 2018. The key question remains how much global demand rises, and how much supply comes offline from Venezuela and countries in the Middle East. These dynamics should likely keep oil prices range bound in the $55-70/bbl range this year, absent a shock to the market.
Interest rates rose sharply intra-month, with the benchmark 10-Year U.S. Treasury yield eclipsing 2.95%, before retreating. According to data from CME Group, market expectations for a fourth interest rate hike this year topped 35%, after Fed Chair Powell’s congressional testimony at the beginning of the week. With signs of a pick up in inflation firming and the likelihood of higher interest rates all but certain, bond prices are due to come under pressure.
Weakness in interest rate sensitive equities was apparent in February, with the FTSE NAREIT All REIT Index losing -7.2% on the month. With the back up in rates, and the expectations for a 4th interest rate hike increasing, the Dollar, as measured by the DXY Index rose +1.7% on the month. The Dollar’s strength, coupled with higher real yields, helped push Gold -2.0% lower on the month, to close at $1,318/ounce.
The strength in the Dollar, taken together with weaker than expected data from the Eurozone, helped put downward pressure on the Euro, which weakened to $1.22 USD/EUR on the month. Other likely qualitative contributors to Euro weakness are uncertainty from the upcoming Italian elections Sunday and repatriated cash coming back to the U.S. from abroad (including Europe). Furthermore, the expectation for NAFTA negotiations to pick up in March has put downward pressure on the Canadian Loonie (and the Mexican Peso), which weakened from $1.23 CAD/USD to $1.28 CAD/USD in February. Weaker than expected global economic data from all countries was also a likely contributor to respective currency weakness.