With the government shutdown at the forefront of headlines during the first half of October, US economic data appeared to trend in a mostly negative direction for much of the month. The Citigroup Economic Surprise Index (CESI) traced noticeably higher during Q3, but sharply reversed in early October. The index touched negative territory in the final days of the month, marking the first negative print since July 30.
Consumer psyches, as measured by the Consumer Confidence (CCI) and Consumer Sentiment (CSI) indexes, followed suit, trending down in the month. The CCI dropped nine points (80.2 to 71.2), marking the largest month-over-month decline since February 2010. The CSI also fell from 77.5 to 73.2. The considerable decline in consumer sentiment was largely associated with the government shutdown that stretched on for more than two weeks.
On a somewhat positive front, the ISM Manufacturing Index continues to tick higher as it increased from 56.2 to 56.4. The last time the index was above 56 was in April 2011. This is even more impressive as expectations were calling for a drop to 55. The service sector followed suit as the ISM Non-Manufacturing index rose to 55.4 from 54.4. This exceeded expectations as the index was expected to decline to 54.0. This is a more robust measure of the US economic growth as the service sector makes up an overwhelming majority of GDP.
Other positive news came from the labor and housing markets. The delayed September unemployment rate came in lower at 7.2% (previously 7.3%) while adding just 148,000 jobs. Despite coming in below expectations, many market participants viewed this positively as it increased the probability that the Federal Reserve will continue their bond-purchasing program. The housing market continues its climb as housing prices increased once again in the month of August. The S&P/Case-Shiller 20-city home price index rose 12.8% over the trailing 12 months. This marks the fastest yearly price increase since February 2006. It is worth noting that price appreciation eased in many cities from July. With mortgage rates climbing higher and housing prices appreciating at a rate not seen since pre-2008, talks of a peaking housing market are beginning to make their way to the forefront of financial headlines.
Following the FOMC meeting in the final days of the month, the US Federal Reserve confirmed that they will maintain their bond-purchasing program as expected. With labor markets gradually improving and growth characterized as somewhat moderate, the Fed will “await more evidence that progress will be sustained before adjusting the pace of its purchases.” The only difference from the Fed’s statement in September was their acknowledgement of a slowdown in the housing market. With the unemployment rate now at 7.2% (due in large part to a fall in labor force participation) and annual GDP growth at 1.6% following the second quarter, it remains blurred on whether the Fed will decide to begin tapering prior to year end.
In Europe, sluggish inflation data from last week has many big banks expecting that the European Central Bank (ECB) will cut its benchmark interest rate. The refinancing rate (rate banks can borrow from ECB) currently stands at 0.5%, an all-time low. However, the ECB has stated that they “will remain as accommodative for as long as necessary” and that it is not out of the question to push rates lower. With euro-zone inflation slowing to just 0.7% year-over-year in October, many banks (Royal Bank of Scotland, BofA Merrill Lynch, etc.) are pushing for the ECB to act at its next meeting in early November.
Source: CentralBankNews.info, BEA, BLS, ISM, Econoday, WSJ, Reuters
Global equity markets surged higher in October, with the MSCI ACWI Index rising 4.0% as the resolution of the US government shutdown and positive global economic data drove increasing demand for risk assets. Emerging market equities uniformly led on the upside, with the group rising 4.9% on strong economic data and strength in local currencies relative to the US dollar. US and European equities also performed well, benefitting from diminishing fiscal policy headwinds and generally better-than-expected corporate earnings results. Conversely, Japanese equities lagged their global counterparts and remained flat in October, continuing to consolidate as investors await clarity on the BOJ’s commitment to “Abenomics” and progress on essential structural reforms. September’s rise in volatility was quickly unwound in October, with the VIX plummeting 17.1% to 13.8. While a few signs of “frothiness” and overly complacent bullish sentiment may precede a near-term correction, improving breadth and the resolution of several key macro headwinds appear to have set the stage for global equity markets to push higher into year end.
US investors shrugged off concerns about the fiscal debate in Washington in October and pushed the S&P 500 to new all-time highs. Domestic equity indices bottomed around October 9th as earnings season kicked off to a solid start and signs of optimism emerged that government leaders would put aside partisan differences to come to an agreement to raise the debt ceiling, reopen the federal government, and avoid a potentially catastrophic default. Stocks continued to gain momentum in the latter part of the month amid speculation that the Fed would delay the tapering of QE due to the shutdown’s negative impact on employment and economic growth.
Dispersion across investment styles was minimal and largely inconsequential during the month, while performance across market caps was wildly divergent. Leadership across market caps reversed from its general trend in Q3, with large cap stocks significantly outperforming their small cap peers across all styles. We believe this can largely be explained by the diminishing outlook for US economic growth, which is where small cap equities generate an overwhelming majority of their earnings. Conversely, synchronized economic improvements in international markets have driven investors back toward large cap stocks, which generally provide more diversified global earnings exposure.
Developed international markets were broadly positive during the month, led again by Europe. Stocks in the region continue to rise as a modest recovery takes hold. Italy and Spain were strongest as bond yields fell significantly. Spanish 10-year yields fell to their lowest level since 2010, and the country exited its two-year recession with a 0.3% Q3 GDP report. The upcoming ECB review of the banking system aims to improve investor confidence in the financial sector, and the market as a whole. Japan was flat for the month, as positive momentum in stock prices were hampered by a strengthening of the yen vs. the dollar. The currency has traded below 100 since early September. Investor doubts about Abenomics appear to be creeping in as well, as the Prime Minister continues his structural reform efforts.
Emerging markets turned in a second consecutive strong month, led by India and Brazil. EM countries were buoyed by both the Fed’s non-taper decision as well as the appointment of dovish economist Janet Yellen as the new Fed Chair. In India specifically, the current account deficit is shrinking and the currency has stabilized, and new RBI governor Rahguram Rajan implemented steps to unwind many of the emergency measures taken during the late-summer currency crisis. The RBI also raised rates as expected during the month in an effort to stem inflation. Investors exhibited renewed optimism in Indian equities with the release of unexpectedly positive earnings from a several larger cap companies. Brazilian stocks reached their highest level since March, and have outperformed the broad EM index over the last three months. The banking industry in Brazil received a welcome boost as the government raised the maximum stake that foreign investors can hold in Banco do Brasil, the largest state-owned bank. Analysts also expect a tapering of public sector loan growth, which should allow private sector banks to gain market share. Chinese GDP grew faster than expected in Q3, at 7.8% YoY. Investments made up the bulk of the growth, highlighting that the overall transition to a more consumption-oriented economy is still a long way off. East Asian PMIs were generally positive, with South Korea breaking through 50 for the first time since May.
Source: MSCI, Bloomberg, WSJ, The Economist, Morgan Stanley, Bespoke, FactSet, Russell, Reuters, J.P. Morgan, Barclays Capital, Financial Times, Goldman Sachs
For the second time in two years the willingness of the US government to meet its obligations came under intense scrutiny. This time the debt ceiling brinkmanship led to a government shutdown that closed large swaths of the federal government and furloughed all ‘non-essential’ government employees. Fortunately, a deal was reached approximately 24 hours before the drop dead date set by the Treasury with the specter of technical default. Fortunate for those furloughed employees, in the end they were granted a paid vacation.
While the worst was avoided, the manufactured uncertainty was felt in the fixed income markets. Short term Treasury yields spiked in the days leading up to the drop dead date as investors priced in the possibility of a delay in payment. With the furlough of government employees, important statistics such as the employment and inflation were delayed generating a bit of uncertainty regarding valuations of longer term fixed income securities. The combination led to a retrenchment in Treasury yields and a testing of technical bottoms. As a result of this activity, high quality fixed income, as represented by the BarCap Agg, posted a healthy gain of 0.8% in October. Income was supplemented by price appreciation from falling Treasury yields and tightening of corporate spreads.
In review of specific fixed income sectors and markets:
- TIPS marginally under performed Treasuries with a 0.6% gain as inflation expectations fell. The traditional relationship between inflation expectations and real yields was reestablished in October.
- Agency MBS returned 0.7% during the month. The sector’s extended duration was a positive for price performance as Treasuries rallied especially in intermediate maturities. In unison with Treasuries, mortgage rates have fallen around 0.5% since the highs of 4.7% reached in early September. Refi activity is beginning to come back but still well short of the feverish levels seen in the fall of last year.
- Non-agency MBS had a very constructive October across the board with some areas such as Alt-A and subprime up 5%. While the market is still contracting, supply is coming to market from a variety of sources.
- Corporate bonds had a good month with a return of 1.5%. The asset class was a beneficiary of falling Treasury yields and tightening credit spreads. For the first time since the Financial Crisis, finance credits are trading tighter then non finance credits.
- High yield bonds were the top performer in October with a return of 2.5%. The rally is in part due to less investor apprehension about the direction of interest rates. The asset class is on eight consecutive weeks of inflows during which approximately $10 billion were invested into high yield bond funds.
- Leveraged loans were a relative laggard compared to their high yield bond counterparts with a gain of 0.8%. Flows have slowed down but still remain positive for the asset class. YTD, loan funds have taken in $57 billion on 72 consecutive weeks of inflows.
- Convertible bonds returned 2.1% during October. Gains were hampered by the relative underperformance of technology and healthcare SMID cap stocks. The month did see the most issuance in almost three years as companies continue to tap the robust equity markets.
A frazzled muni market found some footing. Munis posted their best monthly gain since 2004 during October, a month that is traditionally weak for muni performance. The market still experienced outflows but at the slowest pace since May. Long maturities and BBB rated paper were the best performers. Long maturities benefited from a flattening of the muni curve as a historically steep slope began to normalize. BBB paper was helped by a recovery of Puerto Rico bonds. The territory’s paper benefitted from an announcement by the Puerto Rico government that it will not tap the markets until mid-2014, and an influx of hedge fund interest. Going forward the market may find support in November and December as issuance typically falls towards year end. December will also see significant reinvestment as coupons are paid and bonds mature.
The Fed proposed new liquidity rules for large banks that may dent their voracious demand for muni bonds. Under the proposal, munis, even AAA securities, will no longer qualify as “high quality liquid assets” that satisfy regulatory requirements for credit crunch scenarios. Regulators are wary of the comparatively low volume in the muni markets. Banks hold about $390 billion worth of munis to account for roughly 10% of the market. If passed, the rule could have the most effect on high quality bonds and make the market even more retail dependent and, perhaps, more volatile.
EM fixed income recovered in October with a better tone on interest rates coming from the US. Outflows have begun to slow down recently. Since May, approximately $32 billion has exited EM fixed income. Within EM, the recent theme has been differentiation and October was no exception. Underperformers included large markets such as Indonesia and Brazil where policymakers are wrestling with current account deficits.
In the developed markets, the Eurozone surprised investors with a 0.7% inflation print in October, a number which is bordering on deflation territory. Remarkably, the Eurozone now has lower inflation than deflation wracked Japan where the latest print stood at 1.4%. The new data may push the ECB towards a rate cut or another LTRO type asset purchasing program.
Sources: Barclay’s Capital, Bloomberg LP, Financial Times, J.P. Morgan, Municipal Market Advisors, US Treasury
October began in rocky fashion for financial markets as the US government shut down and Congress bumped up against a last minute deadline to raise the debt ceiling. This created opportunities for alpha-oriented strategies early in the period, as market neutral and absolute return oriented funds took advantage of increased dispersion in securities markets. Ultimately, however, a resolution of these legislative issues reignited the upward thrust in equity markets, allowing beta driven strategies to reassume a performance leadership role.
The year of beta certainly continued in the month, with the top performing categories coinciding with those with the most market exposure: equity hedge, event driven, and market directional. Those strategies also lead YTD performance by a wide margin. While equity hedge and market directional have slightly outperformed the market on a beta-adjusted basis, event driven has generated significant alpha through the first 10 months of the year. The category continues to be boosted by its activist and special situations components, with merger arbitrage acting as a relative detractor.
Relative value type trading was more successful in equity markets than in fixed income, as equity market neutral generated a 1.4% gain in the month; fixed income relative value and convertible arb posted more muted gains of 30 bps each. Low net strategies have broadly lagged those strategies with more embedded beta on a YTD basis, as the environment for alpha production has been difficult amid a broad risk-on rally for most of 2013.
Systematic trendfollowers rebounded somewhat in October, propelled mostly by further gains in equity markets. The HFRX index indicated a gain of 70 bps in the month, but this was generally below many funds in the industry, as well as the Newedge CTA index. Trendfollowers also generally made money in fixed income, despite mixed positioning, as bonds across the yield curve in both the US and abroad rallied. Commodities, FX, and rates were flat to marginally negative.
Alternative Investment (AI) mutual funds generated performance in line with their hedge fund peers in October. The broadest multi-alternatives category returned 1.1%, their best monthly return of the year and ahead of the HFRX absolute return benchmark.
- Long/short equity mutual funds posted a comparable return to hedge funds with a 1.9% return in the month. As we often note, however, this may be due less to alpha production and more to higher embedded systematic risk levels within the mutual fund space.
- Market neutral startegies gained 0.9% in the month, lagging their hedge fund counterparts. Despite the inability to apply leverage within the mutual fund structure, however, the category is outperforming the HFRX index on a YTD basis.
- Nontraditional bond funds were flat in the month, lagging the BarCap Agg and other major fixed income sector indices. Yields fell across the curve in both the US and abroad, potentially catching many managers off-guard following backups in May and August of this year. This category has generally underperformed expectations this year after being whipsawed by rates throughout the year.
- Managed futures funds experienced similar tailwinds as the CTA space, rising 1.2% in October. Given the inherent liquidity within futures markets, many of these Funds can run their hedge fund strategies unencumbered within the 40 Act wrapper. Performance has remained tight on a relative basis over the year as a result.
Sources: Bloomberg LP, Factset, Credit Suisse, Barclays, JP Morgan, Morningstar Direct, CBOE, Hedge Fund Research, NewEdge
Liquid Real Assets:
A resolution to the government shutdown coupled with anti-taper rhetoric pushed duration sensitive real assets higher during the month. Commodities were left behind due to weakening energy and grains prices.
Industrial metals led for the month, but they did so by not declining in concert with most other sectors. Nickel was the only metal in positive territory, aided by the prospects of a potential export ban from Indonesia to China (~15% of global nickel trade). Elsewhere, a Chinese import data release pointed to surprisingly resilient copper demand – the highest on record for copper concentrates. This was collaborated by comparable increases (30% YoY) in refined copper production.
- Precious metals were flat as net ETF buying turned into selling near the end of October. India’s import duties remain a notable headwind, as the country celebrated Diwali (traditionally a gold gifting holiday) with a 15% tax on gold imports.
- Energy: The disconnect between Brent and WTI crude oil reemerged in October, with Brent moving 2% higher and WTI 6% lower. The US shale boom was again the culprit since the US cannot export crude oil. The latest industry data points to 20% higher than expected 2013 crude drilling expectations. Natural gas (-3.5%) fell slightly on greater than expected pipeline injection data.
- Agriculture: The lack of USDA data releases due to the government shutdown did little to stall the selloff within grains, as record yields are expected for corn (-3.0% in October) and soybeans (-1.2%). The latest USDA report is set to come out on 11/8, and many believe initial yield estimates will be substantially higher. Cotton (-11.5%) and coffee (-7.3%) continued to trade down on robust supply, while cocoa (+1.4% in October; +17.4% YTD) was higher on West African weather concerns.
The sector finished higher for the month with the help of several large M&A deals. The largest was the announcement that Devon Energy would merge with Crosstex Energy LP and Crosstex Energy Inc. to create two new publicly traded entities – one general partner and one master limited partnership. The two Crosstex entities were up 28% and 50% post announcement. Elsewhere, the distribution season came in as many expected, with solid low single-digit growth in midstream MLPs, low-to-mid single-digit increases for G&Ps, and some negative growth figures for select E&Ps. The asset class finished the month yielding 5.8% vs. 2.5% for the 10-Year Treasury.
US REITs rebounded after a tough Q3 with the help of falling interest rates and a temporary resolution to the government shutdown. Quarterly earnings thus far are slightly above expectations, although guidance has been tepid. At the sector level, retail and industrial REITs led the charge topping 6% for the month, while residential REITs (+1.6% for October,
-1.8% YTD) struggled due to growing supply and improved home affordability. Domestic REITs finished the month yielding approximately 3.6%, ~110 bps north of US Treasuries, which is near the historical average.
European REITs continued to show strength on the back of improving local economic data. With the exception of France, recent PMI releases surprised to the upside across the EU. France was able to post its first positive GDP print in several years. A corollary to improved economic activity is a rise in transaction activity. In Europe, YoY transaction volumes are nearly 10% higher compared to the same period last year. In Asia, transaction volumes are up ~6% YoY. Despite the pickup in transaction volume and a recent win of the 2020 Olympics, the Japanese Property index fell in October, presumably due to profit taking as the index was up 30% YTD through September.
Sources: MLPHINDSight, S&P, FactSet, Alerian, USDA, USGS, IndexUniverse.com, Barclays, Bloomberg; property-magazine.eu
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.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.