The US economy appeared to build some momentum during August. The Citigroup Economic Surprise index moved solidly into positive territory during the month, boosted by unexpected positive reports from the Institute for Supply Management (ISM) and the unemployment rate. Data subsequent to these releases was fairly middling, however, as the economy struggles to find traction amid a lethargic consumer.
One exception to that generalization was second quarter GDP: a second estimate revised the initial figure higher from 1.7% to 2.5%. The new estimate was boosted by an increase in exports that was larger than previously estimated. The quarterly trade balance was also aided by a downward revision to the level of imports. In comparison to the previous quarter, second quarter GDP advanced due to an increase in personal consumption expenditures, exports, and private inventory investment. These were partly offset by a dip in federal government spending.
Despite the surprise fall in the unemployment rate to 7.4%, nonfarm payrolls rose by a less-than-expected 162,000. This was off the pace of 189,000 jobs per month added during the previous 12 months. The prior two months were revised lower by 26,000 jobs. There is ongoing concern that the quality of this job recovery is below par, with continued gains in lower-paying and part-time industries like retail trade and food & drinking places. In August, food and drinking places accounted for more than half of the jobs added. Meanwhile, goods-producing jobs like construction and manufacturing added exactly zero jobs in the period.
Housing marched forward at a subdued pace compared to previous months. The impact of higher mortgage rates started to filter through to national data, with new home sales plummeting more than 100,000 from their original estimate and housing starts tapering off. Existing home sales saw an unexpected surge, which many attributed to the recent spike in interest rates.
The manufacturing sector did experience some brief level of momentum, when the ISM Manufacturing index for July, released in early August, rebounded from just above the zero growth line to 55.4. The survey indicated sharp improvement in new orders, which often portends future activity. During the month though, the Empire State and Philadelphia Fed Manufacturing surveys suggested August could be a weaker month. Ultimately, however, the ISM report released for August in early September indicated the manufacturing sector remained robust with a reading of 55.7. This is the highest reading in more than two years.
Central bank news in August centered on the race for the chairmanship of the Federal Reserve between Janet Yellen and Larry Summers. Both are considered ‘dovish’ in their approach to monetary policy. Ms. Yellen is considered more of a Bernanke type, publicly conducting herself in a technocratic way, while Mr. Summers is a bit more outspoken. Bernanke’s replacement will have the uphill task of determining how to exit quantitative easing going forward.
Brazil’s central bank continues to be active in promoting growth and controlling inflation. Latin America’s largest economy in terms of GDP has been working to stimulate growth and combat inflation since 2011. Throughout 2012, the central bank cut its benchmark Selic rate by 375 bps in order to counteract slowing growth. Throughout 2013, the central bank has fought inflation (most recently topping 6%), that has persisted since 2012 by raising its rate by 175 bps.
The Bank of Japan (BoJ) and European Central Bank (ECB) continue to keep rates historically low. The BoJ meets this week and will debate whether to upgrade its economic outlook. The BoJ remains cautious about announcing a recovery is underway as positive news is often negatively welcomed due to expectations of tapering their bond-purchasing program. Eurozone manufacturing data continues to show signs of growth as the purchasing managers’ index for manufacturing rose to 51.4, marking the second straight month of expansionary growth above 50. The ECB has indicated that it does not plan on raising rates anytime soon, and that lowering rates even further is not out of the realm of possibility.
Source: CentralBankNews.info, BEA, BLS, ISM, Econoday, Economist, World Bank, WSJ, TradingEconomics
Global equity markets broadly faltered in August, with the MSCI ACWI Index falling 2.0% as renewed tapering fears, weak earnings guidance, and Syrian geopolitical risks caused investors to take profits. US equities significantly lagged other regions of the global market as generally stronger than expected economic data increased expectations that the Fed would begin to unwind its monthly liquidity injections at its September meeting. Emerging markets were very much a mixed bag in August, with South Korea and China boosted by stabilizing economic data, while India and Indonesia fell sharply due to significant currency volatility. The dollar appreciated against most global currencies, supported by rising bond yields and positive fundamental data in the US. Volatility also rebounded substantially, with the VIX rising 27% to 17.1. With Fed policy again coming to the forefront in the middle of September, volatility appears likely to persist until clarity is provided on the direction of monetary policy.
After rebounding in July, US stock markets again turned south in August. Federal Reserve policy clearly remained the top concern for investors, with rising interest rates leading to sharp declines in yield-sensitive sectors like utilities, telecom, and consumer staples. Conversely, long underperforming cyclical sectors like industrials, materials, and energy held up reasonably well during the August selloff as rising commodity prices, improving economic data, and depressed valuations limited further downside. Financials, which had been the best performing sector since September 2012, lagged considerably in August across all market caps, which may portend a deeper correction in the broader markets moving into this September.
Earnings season came to an end in the first half of August and results were largely better than feared. In the Russell 1000 index, 67% of companies reported earnings above consensus expectations, with an average surprise of 3.0% and YOY growth of 4.3%. The bulk of positive surprises came from the financials, with 71% of companies beating expectations with an average surprise of 10.4% and YOY growth of 29.4%. However, forward guidance continued to be disappointing, with mega cap companies like Cisco Systems and Wal-Mart providing earnings forecasts below consensus expectations. With many analysts projecting strong earnings acceleration in the second half of the year, and valuations beginning to get stretched, near-term upside may be limited as analysts revise their estimates to reflect this more uncertain outlook.
Market cap dispersion was noticeably low relative to prior months, although small-cap stocks generally underperformed their large-cap equivalents by a small amount. However, divergences among investment styles rose significantly, with growth stocks vastly outperforming value across all market caps. This is largely consistent with the view that multiple expansion is largely played out as an investment theme, and investors are looking to stocks with solid earnings growth potential to provide a more attractive source of investment returns going forward.
Developed international markets fell slightly negative in August. European equities were buoyed early on by a positive Q2 GDP report, which indicated that the euro area grew 0.3% after six straight quarters of contraction. The strength was short lived, as the region sold off later in the month on concerns about France, Spain, and Italy. The upcoming German elections will be of interest, though Angela Merkel is expected to retain power. Japanese Q2 GDP came in below expectations, but exports continued to rise on yen weakness. Broad CPI continued to grow in Japan, though core CPI remained flat.
Emerging markets were fairly mixed, with South Korea and China turning in positive monthly performance while India fell sharply. China was the lone bright spot amongst Asian PMIs, moving above 50 for the first time since April. The country also saw improvements in industrial production and retail sales. India was again the worst performer among the major world markets. Incoming Reserve Bank of India Governor Raghuram Rajan faces a plummeting currency (the biggest drop in 20 years), a record current account deficit, and GDP growth at its slowest pace since 2009. So far, the RBI has elected to sell dollars to stem the rupee depreciation, but this measure can only be temporary considering the country’s limited foreign reserves. A rise in interest rates is highly likely.
As has been documented ad nauseam, the impacts of Fed tapering, along with China’s slowdown and reduced demand for commodities, have all contributed to near-term headwinds and negative momentum for emerging market equities. However, current weakness breeds opportunities for active managers. Broad currency weakness will support export growth as developed economies begin to grow more quickly. Current valuations have EM equities priced fairly attractively.
The end of summer will coincide with some important developments at the Fed. Generally positive economic news is leading to market expectations of a reduction in the Fed’s quantitative easing (QE) efforts. Consensus forecast suggests the Fed reduces purchases of Treasuries and Agency Mortgage Backed Securities (MBS) by $10 and $5 billion per month, respectively, starting in October. Under this trajectory, the Fed will be on track to phase out its purchasing program by the summer of 2014. While this change may largely be priced into the fixed income markets, there is uncertainty regarding who will be leading the FOMC in 2014 and beyond. It appears Larry Summers is the next nominee for Chairman of the Fed, if you believe recent reporting among the business press. His appointment creates uncertainty in the broader markets and, specifically, the fixed income markets. While his efforts in the political arena are well known, how he will fit in as Fed Chairman is an unknown. Historically, Summers has maintained a skeptical view of QE and other unconventional monetary policy, and how that view is applied if he becomes Chairman will be hotly discussed. The twin currents of tapering and Chairman uncertainty will likely create volatility that can reverberate across the markets.
High-quality fixed income, as represented by the BarCap Agg, lost 0.5% in August. The Treasury curve twisted, as intermediate rates increased more than short and long rates during the month. Intermediate Treasuries receive the heaviest Fed support and will be disproportionately impacted by taper. Corporate and agency MBS spreads were static during the month.
In review of specific fixed income sectors and markets:
- TIPS was the worst performing taxable sector in August. The environment that that led to historically bad TIPS performance in May and June returned in August. TIPS yields once again rose more than nominal yields as falling inflation expectations accompanied real rate increases.
- Agency MBS lost 0.3% in August. Mortgage rates have increased dramatically since May and gross issuance for agency MBS is down. Mortgage refinancing activity is currently 40% of its 2013 peak and new home sales are also slowing. While the Fed is expected to gradually remove support from the agency markets, its relative sponsorship of the market may actually stay constant as the new issue market shrinks.
- Non-agency MBS was largely flat during the month. It is interesting to note that jumbo mortgage rates breached an historic level as rates are now below conventional mortgages. Performance has recently been hampered by portfolio liquidations from banks, and Fannie and Freddie. The price pressure offset the higher income thrown off by these securities.
- Corporate bonds lost 0.7%. Leverage measures for investment grade companies continue to rise. Debt has increased faster than profits for six consecutive quarters; notably, a portion of new debt was applied to capital expenditures, a positive sign for economic growth.
- High-yield bonds shed 0.7% during the month. Spreads for the sector were unchanged. Performance was hampered mostly by US Treasury adjustments as higher quality bonds price relative to the intermediate portion of the Treasury curve where rates increased the most in the month. Less interest rate sensitive CCC bonds outperformed BB peers by 50 bps.
- Leveraged loans were flat with a 0.1% loss. Bucking trends across fixed income, loans continue to attract investor inflows. YTD investor flow into the funds stands at $46 billion – the previous annual record of $18 billion was set in 2010.
- Convertible bonds lost 1.1% during the month. The standout fixed income sector in 2013 pulled back as the equity markets took a breather in August.
Current investor sentiment for munis represents a 180° turn from the robust markets of 2012. Muni flows for the past two months are reminiscent of the Meredith Whitney crisis of early 2011. Headlines about Detroit’s messy bankruptcy and Puerto Rico’s tenuous finances are contributing to a retail malaise towards munis. Outflows combined with rising interest rates are driving the worst muni performance in recent memory. According to MMA (Municipal Market Advisors), the MMA price index has shed more than 2.0% for four consecutive months. YTD MMA index performance through August would represent the worst annual decline for the market since 1983.
Some areas of the muni market are faring better than others in the selloff. Short munis have held up well whereas long munis and lower-rated credits have been disproportionately hit. Biased retail flow is leading to distortions in the market. The muni curve is at its steepest point since 1983, when MMA began tracking data. Yields on AAA rated long munis are at parity with levels last seen during the Meredith Whitney crisis. The ten-year Treasury was yielding around 3.3% to 3.7% then. Compared to high quality taxable bonds, longer maturing munis are at the most attractive valuations in two decades offering tax equivalent yields that rival some long-term equity market returns. Credit spreads for out of favor bonds are also unusually wide. Puerto Rico GOs are pricing at over an 8% yield in the aftermath of a Barron’s cover article on the territory’s precarious fiscal profile. As triple tax-exempt securities, investors in the highest tax bracket could be clipping 16% tax equivalent yields for some Puerto Rico debt.
Tightening monetary policy in the US is leading to profound and unanticipated consequences in the EM markets. EM policy makers are feeling pressure to tighten along with the Fed to maintain interest rate differentials and support their currencies. However slowing economic growth in major EM countries such as Mexico, Brazil and India, limits the ability to impose rate hikes. Currencies such as the Brazilian Real, Turkish Lira, and Indian Rupee were down 4.6%, 5.1% and 8.1% in August, respectively, forcing policy makers to directly support their currencies or impose capital controls. A third wrinkle to the story is investor outflows from this area of the markets which added pressure on currencies. This is not a dire situation in terms of debt quality, but the volatility around currency valuations is hampering performance with un-hedged local currency EM bonds down 4.1% in August.
Sources: Barclay’s Capital, Bloomberg LP, Financial Times, J.P. Morgan, Municipal Market Advisors, US Treasury
Absolute return was tough to find in the hedge fund space in August. With equity markets down and broad fixed income indices flat, alternative investment strategies did little to distinguish themselves; the underlying HFRX indices ranged from +0.1% to -1.7% during the month.
- Systematic strategies performed best, scratching out a slightly positive return as measured by the HFRX index. Other measures of such strategies, however, indicated more negative performance; the Newedge CTA index suggested the space declined 1.3% during the month. Softer equity market performance was one culprit, as most intermediate trend followers are long stock markets around the world. A general short in precious metals was also painful, offsetting beneficial positioning in select currencies and bonds (mainly short).
- There was little logical cohesion to the performance patterns of the remaining indices. Some relative value strategies like merger arb and convertible arb posted better relative performance, while equity market neutral was the second-worst performing market segment. The 2%-plus negative performance spread of value to growth equities likely contributed to the latter category’s returns, which tend to be value-biased.
- Event driven, despite its general equity market sensitivity, held up due to flat performance in its merger arb and distressed sub-components. Corporate activity was somewhat muted in August, though, with just $140 billion in deals announced. Only three months in the past three years have seen weaker levels. September will shape up differently, with the massive $130 billion divestiture announced by Verizon and Vodaphone in the first few days of the month.
- Equity hedge was the laggard in August, as elevated market directionality led to losses. The index entered August with the highest beta to the S&P 500 since mid-2011, at approximately 0.46. Although that fell to 0.36 by month-end, the index still experienced 58% of the market’s decline. This suggests negative alpha generation among long/short managers, an issue that has persisted through most of 2013. This phenomenon has occurred despite falling correlations and rising single stock dispersion in recent months.
Alternative Investment (AI) mutual funds posted mixed performance relative to hedge fund peers, with some strategies easily outperforming, but others lagging. Lower levels of structural leverage helped in areas such as market neutral, which was down 0.5% against a 1.4% loss for the HFRX Market Neutral Index.
- Multi-alternative funds lost 1.1% in August and are up 0.2% on the year. A combination of interst rate sensitivity and equity bias hurt these funds over the summer months, particularly in June and August. Managers are having difficulty finding opportunities outside domestic equities, with struggles evident in currencies, commodities and fixed income.
- Long/Short equity funds lost 1.4%, less than half the 2.9% decline in the S&P 500. On the year, long/short equity managers are up 7.4%, against a 16.1% gain for the S&P 500.
- Nontraditional bond funds lost 0.6% in the month, compared to a 0.5% loss for the Barclays Aggregate Bond Index. There were few places to hide in fixed income during the month, as high yield bonds lost 0.7%, high yield loans were down 0.1%, intermediate treasuries lost 0.5% and mortgage-backed securities closed down. Managers with interest rate hedges were able to offer slightly more protection, given the 19bps increase in the 10-year Treasury from 2.59%.
- Managed futures funds were down 0.9%, matching similar negative performance by systematic hedge funds. Losses in the trend following space were largely concentrated in fixed income, currency and precious metals exposure. Many intermediate-term trend followers were also long equities, which was a losing trade in August.
Sources: Bloomberg LP, Factset, Credit Suisse, Barclays, JP Morgan, Morningstar Direct, CBOE, Hedge Fund Research NewEdge
Liquid Real Assets:
Syrian headlines roused investors from their summer lull, resulting in en masse risk reduction from equity and equity-like assets. Growing fretfulness surrounding Fed tapering served only to exacerbate investor skittishness, particularly for interest rate sensitive real assets such as MLPs and REITs. Flows favored geopolitically sensitive commodities, with precious metals and oil catching a bid.
The precious metals rebound continued post the record sell-off earlier this year as global geopolitical unrest, coupled with uncertainty surrounding the September FOMC meeting, resulted in short covering across precious metals futures. Gold shorts actually fell to their lowest level since April. Silver, the strongest commodity at +19.5% in August, benefited from investor interest in the spot market. ETP inflows totaled over 400 tonnes in August, more than 2x the amount YTD through July.
- Energy: Fears of a US strike in Syria sent crude oil futures rallying, with Brent topping 5% in August. Syria accounts for less than 1% of global oil production, but fears of contagion throughout the Middle East enticed investors into the market. Recent output shortfalls in several non-OPEC nations exacerbated tailwinds. Natural gas finished the month 3% higher on no real news. Looking ahead, the return of several nuclear power plants, along with moderate injection surprises, should keep the commodity range-bound.
- Industrial Metals: Copper (+3.0%) pulled the metals complex into the black in August, as aluminum and nickel struggled. The upward push came from reduced LME inventories, which sparked a wave of short-covering. Looking ahead, copper continues to face upside supply surprises out of Chile (40% of global copper production), where production is up 7% YTD. Worker dissatisfaction across the globe, however, may stave off large price declines, as strikes are set to begin in Zambia, South Africa, and Indonesia in the coming weeks.
- Agriculture: Grain performance diverged in August. Corn and wheat fell 1.2% and 3.6%, respectively, while soybeans rose 12.5%. Soybean strength is predicated on very pessimistic US yield expectations. Wet conditions earlier in the year delayed planting, and the subsequent dry spell has many concerned about damaged crops. Approximately 54% of the US crop is rated in good to excellent condition, which is 5% below the long-term average. Cocoa (+5.1%) was again the only standout within softs, as cotton, sugar, and coffee finished lower. West African weather concerns now have cocoa near a 10-month high.
MLPs experienced a relatively benign August on a relative basis, falling less than broad equities and REITs. At the sub-sector level, midstream MLPs declined the least, followed by gathering and processing (G&P), and exploration and production (E&P) MLPs. With another weak month in the books, E&P MLPs are down 9% YTD vs. a gain of 22% for both midstream and G&Ps, with investors choosing stable business models over those with commodity exposure.
Earnings season wound down in early August with no major surprises. Enterprise Products Partners, the largest MLP comprising 16% of the Alerian Index, reported a YoY distribution increase of ~7% (in line with expectations).
With no real headlines to direct prices, some of the absolute weakness can be attributable to the continued backup in US interest rates. Given that a large component of MLP returns comes via yield, investors are sensitive to corresponding increases in less risky rates. MLPs finished the month yielding 6.1% vs. 2.8% for the 10-Year Treasury. The historical spread is ~3%.
It was a tough month for domestic REITs as investors shed exposure ahead of the September Fed meeting. Tapering expectations bear the prospects of slowing growth and more expensive financing, both strong drivers of REIT performance over the past few years. At the sector level, a 5% decline in hotel REITs was actually the relative winner. Apartment REITs again brought up the rear as the housing price rebound (Case-Shiller US National index up 7% QoQ) continued to pressure rentals.
Japan was the only major REIT market to post positive returns. Several large scale transactions in excess of $1 billion propped up performance. Elsewhere, Asia Pacific held up relatively well, with Australia and New Zealand effectively flat, offsetting weakness in Singapore and Hong Kong. In Europe, outside of a flat month for Germany, lackluster performance abounds. France proved the weakest at -6.3%, as the country’s economy seems to be deteriorating.
Sources: MLPHINDSight, S&P, FactSet, Alerian, USDA, USGS, IndexUniverse.com, Barclays, Bloomberg
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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