Risk assets started 2018 strong with global equities building on gains from 2017. Investors embraced the enactment of U.S. tax reform and optimism rose regarding improving economic activity in Europe and a generally favorable backdrop for global growth. In this environment, merger and acquisition activity was robust to start the year despite high valuations. For the month, the S&P 500 Index rose by 5.7%, bringing the year-over-year gains to more than 25.0%. Equity market volatility remained well below historical averages, but began to pick up off exceptionally low levels at the end of the month. The VIX closed the month at its highest level since December 2016.
Gains in global equity markets were led by emerging markets equities, which grew 8.3% and brought returns over the trailing 12-month period to 40.8%. While top constituents such as Asia’s tech giants Alibaba (+18.5%), Tencent (+14.4%), and Taiwan Semiconductor (+13.5%) continued to account for an outsized portion of returns, gains were broad-based from a country and sector perspective.
Brazil (+16.7%) led the way as markets soared following the dismissal of former president Luiz Inacio Lula da Silva’s corruption conviction appeal, diminishing his chances in this year’s election. In Russia, investors saw signs of fundamental improvements, with the country reporting a rise in GDP growth for the first time in three years. This seemingly outweighed continued political turmoil as markets shrugged off the potential for additional economic sanctions. Brazilian and Russian financial service and energy companies delivered the strongest performance, with a continued uptick in energy- and metals-related stocks providing a tailwind.
The continued strength of emerging markets equities sparked renewed interest in the asset class. Investors were also attracted to compelling valuations relative to U.S. equities and a weak U.S. dollar (USD). In January, emerging markets equities took in a reported $13.5 billion across passive and active strategies, marking an 18-month high and adding to the growing demand for the asset class.
Amid improved sentiment regarding global growth, there was an increase in inflation expectations. In response, global bond yields rose and the USD declined. After flattening significantly in 2017, the U.S. Treasury yield curve steepened in January as yield increases were more pronounced at the long end of the curve. The U.S. Treasury 10-year yield ended the month at 2.72%—a 32 bps increase from the start of 2018. Yield increases were more modest at the front end of the curve, with the two-year increasing 25 bps. The spread between the two- and 10-year yields widened 7 bps to end the month at 58 bps. While yields moved higher, demand for credit remained strong as spreads grinded tighter. Investment-grade corporate option-adjusted spreads declined 7 bps, ending the month at 86 bps, a level not seen since before the global financial crisis.
The interest rate sell-off and the decline of the dollar had secondary effects, both positive and negative, on other parts of the markets such as real estate and commodities. Domestic REITs fell 4.2% as investors grew concerned that rising interest rates may result in less attractive yields relative to other asset classes while also increasing debt financing costs. The negative impact of interest rate concerns offset strong early earnings announcements by some REITs. While interest rates are one factor influencing REIT performance, the state of underlying real estate fundamentals (supply and demand) and the strength of economic growth are also important variables as REITs can pass through price increases to tenants via higher lease rates. Further, in a strong economic environment where rates are rising, existing asset prices may benefit from growing construction and replacement costs. Commodities (+1.9%) moved higher during the month with crude advancing 7.1% (WTI) on the back of stronger than anticipated global demand—particularly from the U.S. and developed Europe, as well as continued drawdowns in domestic inventories. The advance of crude and other commodities also appeared to be aided by weakness in the dollar, which makes USD-denominated commodities less expensive for foreign currency holders.
The sell-off in U.S. Treasuries was accompanied by an extension in the downtrend for the USD. The Dollar Spot Index, a measure of changes in the dollar versus large developed markets, fell 3.3% during the month. However, the decline does not adequately capture the broad weakness of the dollar. The greenback fell against all developed market and 27 of 30 emerging markets currencies tracked.
Several GDP reports were released during the month that added credence to the aforementioned synchronized global growth theme that emerged last year. This was supported by the actions of a number of central banks that took steps to start the process of normalizing policy rates—either through rate hikes (e.g., the Fed, Bank of England, Bank of Canada, and Reserve Bank of New Zealand) or through quantitative easing tapering and forward guidance (e.g., the European Central Bank). The Fed is no longer the only central bank moving to a more restrictive policy, and the market appeared to be pricing this trend into currency market valuations.
Another factor that contributed to pressure on the dollar was uncertainty stemming from the Trump administration’s dollar and trade policy. At the World Economic Forum in Switzerland, Treasury Secretary Steve Mnuchin offered comments on the benefits of a weak dollar that ran counter to the long-standing “strong dollar” policy of past U.S. administrations. Also, while NAFTA negotiations were underway, President Donald Trump placed steep tariffs on imported solar panels and washing machines. Growing investor concern regarding a potential shift in the dollar policy and the inflationary aspect of protectionist trade measures caused many to sell dollars.
A second-order impact of USD weakness, however, were gains in commodities. As commodities are largely priced in dollars, the decline stoked incremental demand for commodities, leading to gains in oil (+7.1% WTI), gold (+2.5%), agriculture (+1.4%), and industrial metals (+0.2%).
Despite a favorable macroeconomic backdrop, global equity markets pulled back in early February and volatility rose sharply in just a few days. The S&P 500 Index fell more than 6% in the first five days of the month, erasing strong YTD gains. Similarly, foreign markets have followed suit. After having been muted for several years, volatility, as measured by the VIX, has returned and hit its highest level since August 2015 as evidence emerged that leverage was being forced out of the market. However, it is important to put the recent environment in context. The U.S. equity market has posted 15 consecutive monthly gains; the last negative month of performance was October 2016. Also, the YTD declines represent a 0.8% drop in the S&P 500 Index, while the MSCI ACWI ex-U.S. Index remained up 2.1% in USD terms as of February 5th.
It is important to consider context regarding these moves. While the magnitude of the point drop in the Dow garnered many headlines, in percentage terms, it was only the 25th worst drop since 1960. The decline illustrates the importance of diversification, which, coupled with consistent rebalancing, should help portfolios weather periods of heightened volatility.