US economic data trended in positive territory for the better part of Q4. The Citigroup Economic Surprise Index (CESI) declined into negative territory briefly during the month of November before trending sharply upwards and well into positive territory to end the year.
Consumer sentiment indicators trended higher throughout the quarter. Both Consumer Confidence and Consumer Sentiment Indices pushed higher after slight dips following the government shutdown in October. After falling from 80.2 in September to 72.4 in October, the Consumer Confidence Index finished the year at 78.1 as consumers grew more confident on the US economy going into the New Year. The Consumer Sentiment Index followed suit, finishing the year at 82.5.
Developments within the manufacturing and service sectors were somewhat mixed. The ISM Manufacturing Index trended in positive territory for much of the year and all of Q4, ending the year at 57. However, the ISM Non-Manufacturing Index trended down throughout Q4, declining to 53 in December from 55.4 in October. December readings came in well below consensus estimates of 54.7. Despite trending down, the service sector remains in expansionary territory.
On the jobs front, the declining unemployment rate continues to be a bright spot as it dropped to 7% in November. The December jobs report will be much anticipated as investors look to evaluate progress made in the US labor market throughout 2013. Inflation continues to be subdued. Consumer Price Index (CPI) month-over-month growth remains below 0.1% while the Core CPI Index, which stripes out food and energy, rose roughly 0.2% in November. Inflation continues to be monitored as economic growth remains somewhat modest.
The housing market remains a hot spot as housing prices continue to appreciate. Property prices, as measured by the S&P/Case-Shiller Index, increased 13.6% from October 2012 to October 2013, marking the largest year-over-year increase since February 2006. This is very beneficial to more and more homeowners as many are emerging from being underwater on their mortgages following the housing market collapse. This should be a big help to the overall economy as consumers’ financial situations continue to improve. US housing starts rose 22.7% in November where single-family homes also reached their highest level in nearly 6 years. An improving housing market and declining unemployment resulted in the US Fed deciding to start the tapering process of its asset-purchasing program in January 2014.
December marks the month in which the US Federal Reserve, after a year of speculation by the market, has decided to taper its $85 billion asset-purchasing program to $75 billion a month which is not strikingly impactful on the US money supply. However, it is a sign to markets that US economic growth is becoming more apparent. Contrary to market expectations, US equity markets jumped roughly 2.4% following the announcement on December 18 as the S&P 500 closed above 1810. With uncertainty regarding taper timing out of the market and signs of economic improvement becoming more real, markets rallied going into the New Year.
Across the pond, the European Central Bank (ECB) continues to grapple over the idea of implementing a quantitative easing program similar to theUS. Such implementation blurs the lines between fiscal and monetary policy, as the European Union is made up of 28 fiscal nations with one overarching monetary structure. However, with private sector lending remaining considerably depressed and the euro continuing to strengthen, it seems more probable that the ECB will have to implement some type of stimulative policy.
In Japan, inflation continues to be a key concern for policy makers. It was reported in November that inflation rose 1.2% year-over-year, marking a 5-year high. Core CPI was reported to have risen 0.6% year-over-year in November, marking a 15-year high. An increase in household spending and an improving labor market are helping Japan escape from a deflationary environment. Despite much improvement in Japan’s economy, many argue that the BoJ will have to do more in order to hit their 2% inflation target and keep rates down in light of a growing balance sheet.
Source: CentralBankNews.info, BEA, BLS, ISM, Econoday, Capital Economics, Reuters, WSJ
Global equity markets ended 2013 with the MSCI ACWI Index rising 7.4% in Q4 to end the year up 23.4%. Developed market equities continued to lead as improving economic momentum and supportive monetary policies drove investors in these regions to assume more risk in investment portfolios. The bullish bias toward easy monetary policy was most evident in the US and Japan, which rose 9.1% and 2.3%, respectively. Despite a brief period of outperformance in November, emerging market equities continued to lag in Q4, rising just 1.9%. Seasonal tailwinds may persist into the first few weeks of 2014, but a broad array of overbought signals in many developed markets suggest a correction may be in order in the first half of the year.
Domestic equity performance during Q4 followed a pattern that characterized the entire year: despite periodic headwinds from weak earnings guidance, political brinkmanship in Washington, and Fed-related volatility in interest rates, US stock markets rallied strongly and ended at new highs. Volatility spikes in early October and December ultimately proved to be short-lived as dovish indications from the Federal Reserve quickly alleviated fears and drove investors into riskier assets. Fears stemming from the brief government shutdown in October were quickly erased by a bipartisan agreement to extend the debt ceiling, the official nomination of noted “dove” Janet Yellen as new Fed Chairman, and generally better than expected Q3 earnings results. Even the long-anticipated tapering of QE, which had been a source of market anxiety most of the year, proved to be inconsequential as stronger Fed guidance indicating “lower for longer” implied that easy monetary policy would be here to stay in support of the economic recovery.
The reporting season for Q3 earnings concluded in mid-November, continuing a trend of reporting slightly better-than-expected results after analysts slashed expectations in the two weeks before the season began. The technology sector saw the highest percentage of stocks beating expectations (84%), while industrials enjoyed the best YoY earnings growth (+11.9%). While this cyclical leadership in earnings is increasingly constructive for the economy, forward guidance continued to be disappointing, with an overwhelming majority of companies reducing earnings outlooks. Furthermore, the underlying composition of earnings growth remains a concern, with revenues largely in line with expectations and disappointing results from small-cap stocks. With the scope for further cost cutting limited and rising interest rates likely to impact corporate borrowing costs, it is increasingly important to see improvement on the top line for earnings growth to continue.
Europe led developed markets for the quarter, with German and Spanish equities dominating. Continued monetary easing by the ECB appears to have dampened the impact of the beginning of Fed tapering. Positive economic news continues to buoy German investor sentiment, while Spanish 10-year yields have fallen to their lowest point in over three years. The impending asset quality review and stress tests for the banking sector will be important events for continued growth in the Euro area. Japan was relatively weak for the quarter in dollar terms; however, the Nikkei 225 (yen-based) was up 12.8%. The yen closed lower, at 105 to the dollar at year-end as the easing cycle in Japan continues at full speed. Investors’ focus will turn to the success (or lack thereof) of fiscal policy and structural reforms in the coming year.
The emerging markets index turned in another losing month but ended the quarter on the positive side due to strength in October and the end of December. The index seemed to shrug off the Fed’s taper decision, and gained over 2% from December 18th to month-end. India led, rebounding 10.3% in Q4 as monetary policy decisions continue to stem deficit fears.
Source: MSCI, Bloomberg, WSJ, The Economist, Morgan Stanley, Bespoke, FactSet, Russell, Reuters, J.P. Morgan, Barclays Capital, Financial Times, Goldman Sachs
The FOMC closed the year with a holiday surprise announcing the start of tapering. Fed purchases of Treasuries and agency MBS will drop by $10 billion from its current level of $85 billion starting in January 2014. Quantitative easing, (QE) a program which injected almost $3 trillion dollars into the financial markets since 2009, will likely come to a halt by the fall of 2014 based on current expectations. With the removal of QE, the Fed funds rate once again becomes the main lever through which the FOMC directs the economy.
With growth still low, the Fed will work to assure the markets that it envisions a loose monetary stance for the foreseeable future by signalling the Fed funds rate and short-term interest rates will remain anchored. For fixed income investors, paying attention to these signals will be paramount to a succesful peformance campaign in 2014.
High-quality fixed income, as represented by the BC Aggregate, was flat for the quarter with a 0.1% loss. Income was wiped out by Treasury rates drifting higher. Spreads for corporates and agency MBS were modestly tighter over the quarter.
In review of specific fixed income sectors and markets:
- TIPS lost 2.0% in Q4 to close out a forgettable 2013 with a 8.6% loss. The sector has been a victim of its longer duration and an unusual rates market with rising real rates and falling inflation expectations.
- Agency MBS was down 0.4% during the quarter for a 1.4% loss on the year. The agency MBS market held up relatively well post the taper announcement – spreads in the space are actually tighter than they were at the start of the year albeit with much higher all in yields due to higher rates.
- Non-agency MBS had another stellar year with lower-quality securities posting 10%-20% returns. The continuing housing recovery is the dominant driver of returns of the space and the last couple years have seen a remarkable turnaround in the US housing markets. With rosy housing sentiment already priced into valuations, the price appreciation prospects are steadily declining.
- Corporate bonds gained 1.1% for an income-driven quarterly return as spread appreciation was sufficient to offset higher Treasury rates. For the year, corporate bonds are down 1.5% to handily beat duration-matched Treasuries due to spread compression.
- High-yield bonds closed out the year strong with a 3.3% Q4 gain to tally a 6.3% 2013 return. The recent outperformance has been powered by spread compression with high yield bond spreads 100 bps tighter than they were at the start of the year. The yield for the index is currently lower than at the start of 2013 despite five year Treasury yields increasing 100 basis points.
- Bank loans gained 1.7% to post a 5.4% gain for the year. In addition to healthy performance, bank loans have also delivered very low volatility to investors in a year where the rate markets experienced substantial turbulence. Demand for bank loans was extraordinary with flows strong even as investors pulled assets from other fixed income sectors.
- Convertible bonds gained 6.1% in Q4 to gain 25.0% in 2013. Equity was the star asset class for 2013 with the S&P delivering a 32.4% annual return. Convertibles were a disproportionate beneficiary as the sector is over exposed to SMID capitalization companies that generated even more outsized gains.
Muni returns treaded water in Q4 to close out an indifferent 2013. In a reversal of 2012 and 2011, lower quality and longer maturity munis were the clear performance losers. Intermediate high-grade munis were flat in 2013 while high-yield and long maturity munis lost 5.5% and 6.0% respectively. Capital flows were the big story for the year as investors withdrew $63 billion from muni funds. With the selloff, yields reset to more attractive levels, especially for longer maturity bonds. Over the year, yields for 30 year AAA munis have increased 120 bps to 5.2%. It remains to be seen whether higher yields will attract skittish retail investors.
With some notable exceptions including the euro and sterling, the US dollar posted healthy out-performance relative to widely traded currencies. The performance differential was especially acute for developing countries such as Indonesia, South Africa, and Turkey, all down over 15% versus USD in 2013.
The gradual removal of Fed purchasing may herald more dollar strength in addition to continued volatility for currencies. Higher rates in the US, as well as Japan, are likely sucking up liquidity from some developing countries just when they are in need of investor support. Specific concerns over widening current account deficits and shrinking reserves of countries such as Turkey and Brazil may impact performance of the emerging market bond and currencies indices.
Sources: Barclay’s Capital, Bloomberg LP, Financial Times, J.P. Morgan, Municipal Market Advisors, US Treasury
The fourth quarter was respectable for hedge funds, particularly those with a higher beta tilt. Unsurprisingly, in a quarter in which the S&P 500 was up 10.5%, directional strategies performed best. This has been a recurring theme throughout the year, a period characterized by near constant stock market gains. In fact, markets never experienced a drawdown deeper than 5.6% throughout 2013.
This type of environment provided a challenge for hedge fund strategies, particularly those less dependent on market directionality for returns. The HFRX Relative Value and HFRX Market Neutral indices both generated quiet returns in 2013, although market neutral strategies fared better in the fourth quarter. Steeply lower equity market correlations in the period were likely a tailwind for Market Neutral strategies.
Trading strategies wrapped up a difficult year with divergent performance. More diversified macro strategies continued to struggle in a narrowly led market environment in the fourth quarter, ending 2013 with a slightly negative return. Systematic trend following strategies were more successful, largely due to increased equity market exposure. In fact, measures of beta and correlation among such strategies reached their highest levels in years, as equity markets have been one of the few market segments to consistently trend.
Event driven strategies finished out the year as the top performing segment of the alternative investment universe. As we have noted repeatedly through 2013, the more directional components of this index including activist and distressed managers generated robust returns, offsetting the muted performance of merger arbitrage.
Alternative Investment (AI) mutual funds finished the year with mixed returns against their hedge fund peers. Long/short equity mutual funds outperformed, but broadly diversified multi-strategy solutions lagged.
Long/short equity mutual funds gained 14.6% for the year, beating comparable hedge funds by nearly 400bps. Long/short equity mutual funds have slightly more directionality than the typically hedge fund, as evidenced by their 2013 beta of 0.51. Alpha production for long/short equity managers was negative over the course of the full year, but roughly flat in the fourth quarter. Sector dispersion created some opportunities for equity managers on the quarter, particularly in industrials, tech, financials and consumer discretionary.
Market neutral managers were positive 1.4% in the fourth quarter and finished the year up 2.9%. On an absolute basis, the result is quite modest, but dispersion of performance among underlying managers was high, with some gains in excess of 15% despite little to no net market exposure.
Nontraditional bond funds gained 1.1% in the fourth quarter, which was the categories’ best quarterly performance for the year. The BC Aggregate Bond Index lost 14bps for the quarter. Manager performance was widely dispersed during 2013, with top performing managers gaining more than 5%, but bottom performing managers losing more than 4%. A challenging interest rate environment overwhelmed many managers, but exposure to credit sensitive sectors was largely a tailwind, particularly in the high yield space, which was up nearly 7.5%.
Finally, managed futures funds had their best quarter of the year by a wide margin, finishing up 3.1%, but remaining in negative territory for the year. Much like their hedge fund counterparts, managed futures strategies held exposure to equities in the quarter and that was the largest contributor to performance.
Sources: Bloomberg LP, Factset, Credit Suisse, Barclays, JP Morgan, Morningstar Direct, Hedge Fund Research, NewEdge
Liquid Real Assets
The year ended much like it began with real assets lagging broad US equities. MLPs offered the only reprieve, catching a bid in mid-December after nearly three quarters of flat returns.
With the exception of West Texas crude (WTI, -4.4%), energy commodities finished Q4 higher, led by a 12.5% rise in natural gas. Cold weather prompted a sizable natural gas inventory withdrawal, pushing storage levels below the 5-year average for the first time in years. Crude oil succumbed to weakness solely within US borders, as Brent Crude (the global proxy for oil) rose 4.0%.
The decline in precious metals did not relent, with gold off 9.5% and silver down 11.0% in Q4. As has been the case for most of the year, negative investor sentiment proved a significant headwind, this time compounded by the mini-taper in Q4 and strength in the US dollar. Investor outflow from ETFs reaccelerated during the quarter, reaching more than 800 tonnes in 2013. This equates to more than 30% of annual goldmine production.
Industrial metals brought mixed returns, as zinc (+6.2%) rose while aluminum (-5.0%) faltered. Copper and nickel were effectively flat. Zinc’s rise came via a surprise decision by Century Mine (2nd largest zinc mine in the world) to shutter its doors a year ahead of schedule.
Soybeans (+2.0% in Q4) maintained their stronghold within grains, as corn (-6.9%) and wheat (-12.3%) sold off. A better-than-expected Canadian crop yield compounded on an already strong US wheat harvest. Within softs, cocoa (+1.9%) finished alone in the black, as cotton, coffee, and sugar sold off between 4% and 10% in Q4.
Experienced somewhat of a lull in 2013 after a record breaking Q1, providing flat returns until mid-December when several acquisition announcements by the two largest MLPs (Kinder Morgan and Energy Transfer) sent the market into a tizzy, culminating in a 6% two week year-end rally.
A 40 bps rise in the 10-year Treasury did little to help domestic REITs in Q4. Specifically, healthcare REITs, which have exhibited a correlation of nearly -0.90 to rising interest rates since May due to inherent duration sensitivity, faced significant selling pressure in Q4 (-7.5%). On the lower duration side, hotel REITs performed well, rising 8.0% for the quarter. Domestic REITs finished the year yielding approximately 3.9%, 90 bps north of US Treasuries, which is near the historical average.
European REITs told a contrasting story. Duration sensitivity actually helped as the ECB lowered rates, helping European healthcare REITs top 10% for the quarter. At the country level, the UK (+9.3%) led returns, aided by improved occupancy rates and rising commercial property values. In Asia, Japanese REITs paused after a stellar first three quarters, presumably due to profit taking. Fundamentals there continued to improve, with Tokyo office vacancies falling to 7.6%; the lowest level in nearly five years. Outside of Japan, Asia-Pac weakened with Australia, Hong Kong, and Singapore all lower in Q4. In Hong Kong and Singapore, developers continued to struggle due to residential construction regulatory squeezes. In Australia, REITs faced headwinds due to what is expected to be the end of the rate cutting cycle. Elsewhere, more rate tightening in Brazil helped drive local property indices down 15% in Q4 (-37% YTD).
Sources: MLPHINDSight, S&P, FactSet, Alerian, Barclays, Bloomberg, Food and Ag Policy Research Institute University of Missouri, Cohen & Steers
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
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