The decline in risk assets subsided in April and U.S. equity market volatility fell from elevated levels exhibited in recent months. Earnings reports in the U.S. were generally positive, with more than 80% of companies in the S&P 500 exceeding expectations thus far in the first quarter reporting cycle, which Bloomberg reported as an all-time high. The initial GDP release showed U.S. economic growth was positive in the first quarter and exceeded expectations, but the pace of growth slowed once again. With this backdrop, equity market returns were generally positive and high yield credit spreads tightened. Non-U.S. developed market equities posted strong gains in local terms, led by the U.K and Europe. However, the rising U.S. dollar served as a headwind muting gains for U.S.-based investors.
The U.S. dollar (USD) reversed course and rose during April, erasing much of the first quarter’s decline. The Dollar Spot Index rose 1.9%, with gains across five of the six underlying member currencies, and finished April down only 0.3% YTD. The chart to the right shows how the USD appreciated against all developed market currencies aside from the Canadian dollar. In addition, the dollar rallied against a large majority of non-managed, emerging markets currencies.
U.S. economic data reported during the month was mixed, with somewhat weak housing data and a softer GDP report but solid durable goods orders and rising consumer confidence. Perhaps most important, inflation reports came in stronger than expected, with import prices rising 3.6% year-over-year and core CPI growth of 2.1%, modestly above the Federal Reserve’s 2% target. Also several commodity prices, including oil, rose during the month. As a result, inflation expectations widened with the five-year breakeven inflation level—the difference between five-year TIPS and five-year nominal Treasuries—rising from 1.9% to 2.1%. Over the next 10 years, inflation expectations rose 10 bps to 2.2%.
Following the March 2018 hike, the markets expected two additional hikes in 2018. However, as a result of widening inflation expectations, markets started to consider the possibility of three more hikes in 2018. According to the CME Group’s FedWatch tool, markets projected a 93.8% chance of a 25 bps rate hike at the June meeting, to a range of 1.75–2.00%. Furthermore, futures prices predict a 66.7% chance that the Fed could hike by another 25 bps at its September meeting. If this holds true, the federal funds rate would enter the fourth quarter of 2018 at 2.00–2.25%. The prospect of higher front-end rates was positive for the U.S. dollar during the month.
The U.S. Treasury yield curve shifted higher during April. For the first time since 2014, the U.S. 10-year Treasury yield breached the 3.0% level toward the end of the month, before ending April modestly lower. For the month, the 10-year yield rose 21 bps, and is up 50 bps YTD. Yields also moved higher at the front end of the curve. For the first time since 2008, the 2-year yield topped 2.5% intra-month before ending just below that level.
Yields were pushed higher during the month due to the potential for higher Treasury issuance and rising inflation expectations. Soon after the debt ceiling was suspended, the Treasury Department increased the issuance of U.S. Treasuries. Tax reform is projected to increase the U.S. fiscal deficit, which will need to be financed with incrementally more issuance. At the same time and amid rising supply, foreign demand for U.S. Treasuries fell during the month. Foreign participation rates in the 10-year auction during the month came in at 12.8%, down from the 23.2% participation rate observed in mid-March. As previously noted, inflation expectations—as measured by the difference between the yields on nominal Treasuries and TIPS—have risen, partially due to increasing commodity prices. Toward the end of the month, speculator’s net short exposure on U.S. 10-year Treasury note futures hit a record high, indicating that bearish sentiment on U.S. interest rates is elevated.
Marketable real assets posted strong results during the month, led by natural resource equities (+7.8%), and master limited partnerships (+8.1%), both of which traded higher as oil prices rallied (+5.6% WTI). Crude prices have increased 13.5% YTD and 39% over the trailing 12-month period on declining global inventories, driven by robust global demand and restricted aggregate output from the Organization of the Petroleum Exporting Countries and Russia. Most recently, higher prices have been supported by rising geopolitical concerns, including that the U.S. may renew sanctions against Iran and that Venezuela’s economic crisis may cause further declines in that country’s exports. While investor sentiment toward the energy sector has been notably negative in recent periods despite higher oil prices, the combination of the most recent leg-up in oil prices and another quarter of strong earnings for the sector appear to have reversed that trend in April. Metals and mining stocks also posted positive returns (+3.4%), on a combination of generally higher metals prices, strong Chinese import data, and some easing of concerns around the impact of protectionist U.S policies on global economic growth.
Elsewhere in real assets, U.S. REITs advanced 1.3% despite a rise in U.S. interest rates. The sector rallied as REITs reported generally stronger than expected earnings. The industrial (+4.8%) and lodging/hotel (+3.9%) sub-sectors led the advance on easing supply concerns combined with robust space demand and generally strong earnings. Within the retail sector, higher quality retail REITs posted stronger than expected earnings. Recently, share prices were driven down by concerns over the impact of ecommerce on brick and mortar retailers and ongoing store closing announcements.
While the exceptionally long trailing period of low and generally declining interest rates makes it difficult to analyze REIT and real estate performance in a rising rate environment, in periods when interest rates have risen materially in the last several decades, REITs have fared relatively well.