The pace of positive economic data weakened in January. While some reports have been relatively healthy, negative surprises such as home sales and Q4 GDP weighed on the economy.
- The first estimate of fourth quarter GDP revealed that the US economy contracted 0.1% during the period. This was the first contraction in more than three years and was well below even the most pessimistic estimate.
- Declines were concentrated in inventory investment and government spending, specifically defense spending. The 22% drop in defense spending was the biggest decline since 1972 and illustrative of the belt tightening that has occurred in anticipation of Congress’ looming sequestration.
- Below the headline were some encouraging signs. Consumption increased 2.2% and nonresidential and residential investment also showed strength. These are all pillars of sustainable growth and suggest the country is on stable footing.
- Nonfarm payrolls expanded by 157,000 and private payrolls grew 166,000. Consistent with the post recession environment, the strongest growth occurred in the retail, business services, education and health & leisure sectors.
- Less encouraging was the unemployment rate, which moved higher to 7.9%. The household survey showed a modest rise in labor force participation. At the same time however the share of the population currently employed remains historically low at 58.6%.
- Institute of Supply Management (ISM) reported that its manufacturing index accelerated to 53.1 in January. This was a jump of nearly three points and ends a string of reports that hovered around the 50 level.
- New orders improved by 3.6 points, returning to expansionary territory and boosting the headline index. At 53.3, new orders are solidly in positive territory and foreshadow sustained growth moving forward.
- The easing campaign of global central banks continued in January as nine banks cut rates during the month, mostly from emerging and frontier markets. Only two banks raised rates.
- The FOMC meeting in January resulted in little new guidance as the Fed maintained its current policy stance of zero interest rates and its purchases of $85 billion per month of Treasuries and mortgages.
Global equities continued their upward trajectory in January, rising 5.1% as investors became more confident with the macro environment and cycled capital into equities. Developed markets led the rally, as improved clarity in Europe (+5.9%) and the US (+5.4%) drove higher valuations and lower volatility in the absence of significant earnings growth. Contrasting from recent months, emerging markets (+1.4%) lagged their developed counterparts as investors gauged local Asian currencies to be less competitive after Japan aggressively depreciated the yen.
After a strong January equity markets may see a pause as the Q4 earnings season concludes and investors look to US budget cuts scheduled to occur on March 1. While a compromise was ultimately reached to delay the debt ceiling and avoid the fiscal cliff, early signs indicate that Republicans are prepared to let sequestration occur if Democrats are unwilling to make cuts to entitlement spending. Furthermore, Q4 earnings remain mixed and investor sentiment surveys have reached levels of excessive bullishness. The majority of firms in the S&P 500 have reported results in-line with consensus but lowered forward guidance. Analysts have responded by trimming 2013 EPS estimates by 1% since earnings season started.
- After lagging in Q4 on election and fiscal cliff uncertainty, January was a strong month for US equity markets as strong capital flows into equities pushed the market to new recovery highs. While the rotation into equities was a “tide that lifted all boats,” value generally outperformed growth as expanding price-to-earnings multiples drove the majority of outperformance. Conversely small and midcap stocks outperformed their large cap peers as disappointing earnings results from several large cap growth stocks constrained overall performance.
- The relief-driven rally was also evident by the significant decline in implied volatility, with the S&P 500 VIX index falling 20.8% in January to multi year lows. Stock correlations also dropped significantly.
- Energy was the top performing sector in January after lagging most of 2012, rallying 7.6% due to stronger commodity prices and positive earnings results.
- Europe continued to show improvement in January as investors gauged stabilization efforts as a buy signal. Non-eurozone countries also had significant gains.
- The UK continues to struggle in the face of a potential triple-dip recession. GDP contracted again in Q4.
- Japan (+3.7%) slowed from its December advance as investors took profits. The Bank of Japan continued efforts to fight deflation, setting the inflation target at 2% and committing to continued open ended monetary easing. The effects have been positive on corporate sentiment as expectations surveys have improved markedly.
The BC Aggregate Index, a proxy for high quality fixed income, lost 0.7% during January. Treasury rate movements were the main impediment to returns. Spreads for corporates and agency MBS were essentially stagnant and thereby yields rose in sympathy with Treasuries.
- US TIPS marginally outperformed nominal Treasuries in January with a (0.7%) return. Inflation expectations increased as equity markets rallied and commodity prices rose. Increases in inflation expectations were not enough to offset the price depreciation caused by increases in real rates.
- Investment grade corporate bonds lost 0.9% during the quarter. Negative returns were almost entirely driven by a back up in Treasury yields.
- Within the sector, financials were a strong outperformer compared to industrials and utilities. The sub sector has a shorter duration which insulated it form the Treasury sell-off.
- Investor sentiment also continues to improve with strong earnings reports and less macro economic uncertainty. Corporations continue to take advantage of low rates with over $100 Billion of issuance during the month.
- Intermediate municipals returned 0.2% during the month, outperforming Treasuries as muni rates did not follow the same hike as Treasuries. Higher yielding and longer duration munis continued to outperform as investors reached for yield.
- Long maturity muni performance may also be impacted by the dearth of long dated issuance recently. Municipalities are refinancing paper in intermediate maturities and wary of taking on new debt and issuing long maturities. The supply and demand mismatch has seen the muni curve remain flat for the better part of a year.
- Illinois and California, two of the largest state muni issuers, made headlines for very different reasons. S&P downgraded Illinois to A-, making it the lowest rated state. The rating agency expressed concern about the state’s massive amount of unfunded pension liabilities. On the bright side, S&P upgraded California to A. The state’s budget is stabilizing with a brighter economic outlook and higher taxes. Taken together, the two issuers provide a good dichotomy of broad dynamics in the muni markets – municipalities are generally taking in more revenue but pension liabilities represent a very real threat to the muni credit landscape.
Hedge funds started the year with positive performance in most styles. Directional managers were the beneficiary of the rally in risk assets, while diversifying strategies were mostly positive in the first month of 2013.
- Equity managers gained 2.3% in the month as measured by the HFRX Equity Hedge Index. Fundamentally based strategies posted solid performance across growth and value strategies. In aggregate, the equity hedge index captured 44% of the S&P 500’s performance, slightly better than anticipated given the index’s 0.25 beta.
- Event driven was the top performing category for the month, gaining 3.3%. Activists made news over the month, including the much publicized Herbalife situation. M&A activity was notable throughout the month with deals such as Clearwire and Avis/Zipcar contributing to returns.
- MLPs started the New Year off with a bang, more than doubling the returns of their real asset peers. The quarterly earnings season brought the latest round of distribution growth with data thus far mostly positive (only two coal MLPs cut or suspended distributions).
- The distribution season also brought structural tailwinds. January, April, July, and October are the distribution months for most MLPs. Unlike traditional dividend stocks where investors may want to sell prior to the ex-date to avoid taxed income, MLP investors tend to do the opposite. That is they buy in advance because most distributions are 80 to 90% return of capital and therefore tax deferred.
- Correlations continued to fall during the month, extending the trend that started in 2011.
- Natural gas traded down on reports of a lesser than expected inventory withdrawal in the last week of January. A warm winter continues to be a major headwind for natural gas as well as other heating commodities such as propane and coal.
- Crude oil on the other hand rebounded as global risk reappeared via escalating tensions between Israel and Syria.
- Gold (-1.0%) lagged other metals in January, as silver (+3.7%), palladium (+6.0%), and platinum (+8.6%) rebounded on investor interest and strong demand.
- Despite the decline in gold, several tailwinds remain, particularly Chinese buying and a strengthening Rupee. India’s financial minister mentioned no immediate plan for additional import taxes on the metal, a prospect that had concerned many in the marketplace.
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