Despite a favorable macroeconomic backdrop, global equity markets experienced a sharp pullback in early February and equity market volatility rose sharply. After several years at muted levels, domestic equity volatility, as measured by the VIX, hit its highest level since August 2015 as leverage was being forced out of the market and risk aversion was heightened. Equity markets stabilized and recovered some losses after the initial sell-off, but most risk assets still posted negative absolute returns. Interest rates rose, weighing on fixed income as well as interest-rate-sensitive assets, such as REITs. The potential for inflation seemed to rise amid tax reform and strong wage growth, which generated headlines during the month. However, market expectations for inflation, as measured by the 10-year nominal U.S. Treasury yield minus the 10-year yield on U.S. TIPS, were relatively stable at 2.1% and inflation remained low relative to history. Early results indicate that hedge fund allocations protected capital during the equity market sell-off and provided some downside protection for diversified portfolios. Amid the heightened volatility, Jay Powell took over leadership of the Federal Open Market Committee (FOMC) as Janet Yellen’s term came to an end. Near month-end he highlighted a favorable outlook for economic growth and suggested the Fed could aggressively hike interest rates during 2018.
Several factors drove longer-term U.S. interest rates higher. Early in February, it was reported that U.S. wage growth rose 2.9% over the trailing year, representing the largest increase since June 2009. This trend, coupled with optimism surrounding the positive economic impact of tax reform, led to heightened expectations for the Fed to hike policy rates at its March meeting. As February came to a close, the futures market was pricing in greater than an 85% probability of a hike in March. Lower demand from non-U.S. investors and concerns regarding increased U.S. Treasury issuance were also cited as reasons for the move higher in interest rates. In this environment, fixed income indices posted negative total returns. Unlike January, credit spreads also widened amid the equity market volatility in February. High yield spreads widened by 17 bps and the asset class fell by 0.9% in total return terms, providing some downside protection relative to the broad domestic equity markets.
Rising interest rates also weighed on other asset classes outside of fixed income. U.S. REITs declined for the second straight month, trading down 7.3% and bringing YTD losses to 11.2%. Investors remained concerned that rising interest rates may cause REIT yields to become less attractive relative to other asset classes, while also increasing debt financing costs. Another likely factor is concern around pockets of elevated new supply in certain sectors and markets, including apartments in coastal cities, senior housing, and offices in New York. While interest rates influence REIT performance, other factors impacting performance include the state of underlying real estate fundamentals (supply and demand) and the strength of economic growth, as REITs can pass through price increases to tenants via higher lease rates. This ability varies by sector; the hotel and apartment sectors typically have more equity-like characteristics because leases are reset daily (hotels) and annually (apartments). In contrast, the net lease and health care sectors largely have bond-like, single-tenant, fixed-rate leases of 10 years or more. Further, in a strong economic environment with rising rates, existing asset prices may benefit from growing replacement costs.
The 3.7% decline of the S&P 500 in February was the benchmark’s first negative month since October 2016. The 15-month streak matched the previous record set in 1958–1959. Until the recent market decline, the benchmark had established new records for length of time without 3% or 5% pullbacks—reflective of the low levels of market volatility that persisted through the end of January. The S&P 500 began February down 8.6% over the first six trading days, briefly entering correction territory as the declines exceeded 10% off the benchmark’s January 29th peak. After trading at high single-digit/mid-teen levels from late 2016 through the end of January, the VIX spiked to over 37 when markets closed on February 5th and remained closer to the long-term average of 20 for the rest of the month. Even though the S&P 500 rallied 5.2% from February 9th until the end of the month and was within 6% of its all-time high, it was the worst month of performance since January 2016.
Outside of the U.S., most equity markets gave back much of the gains generated in January. Non-U.S. developed markets, as measured by the MSCI EAFE Index, were down 4.5%; the benchmark was up only 0.3% YTD. Nearly all developed markets were negative for the month, with Finland (+2.7%) the lone exception. U.K. equities (−6.4%) and currency (−3.1% vs. the U.S. dollar) remained mired in Brexit uncertainty, while core euro area countries Spain (−8.0%), Germany (−7.2%), and Italy (−5.9%) experienced corrections after recent strength. Political uncertainty was also a headwind as Germany’s political future has been in limbo since September’s general election resulted in a hung parliament, while Italy faced uncertainty of its own ahead of its March 4th general election.
The MSCI Emerging Markets Index was down 4.6% in February, but remained up 3.3% YTD on the back of a strong January. After a two-year bull run, the MSCI China Index fell 6.4% in February. Chinese equities were particularly weak in the closing days of the month due to weaker than expected economic data and concerns over the pace of Fed rate hikes. The China Manufacturing Purchasing Managers’ Index fell to 50.3 in February, down one point from January—the largest drop in more than six years. India (−6.7%) also faltered despite stronger than expected growth figures. India reported annualized GDP growth of 7.2% at the end of the month, once again making India the fastest growing economy in the world. Indian equities; however, were weighed down by a scandal surrounding Punjab National Bank (−40.8%), which raised questions as to the overall health of the country’s state-dominated banking system.
On the surface, January and February looked like completely different months for equity markets in terms of returns and volatility. However, many underlying market dynamics remained consistent, most notably the outperformance of growth and momentum factors relative to value. Technology (+0.1%) was the only positive sector in February, causing growth-biased managers to largely outperform, which is atypical for a period marked by rising volatility. In the wake of gains from Apple (+6.4%) and Cisco Systems (+7.8%), technology accounted for more than 25% of S&P 500 assets—a level last achieved near the peak of the tech bubble in 1999–2000. Rising interest rates and falling energy prices weighed on the more value-oriented sectors, leading to even greater disparity. Within the S&P 500, notable sector declines included energy (−10.8%), consumer staples (−7.8%), and real estate (−6.7%). Hedge fund managers with the most pronounced value biases and those with net short positions in growth stocks struggled in February as they did in January. However, in general, hedge funds did what was expected as losses tended to follow net exposures and absolute return-oriented managers with less equity exposure fared better, as merger-arbitrage spreads and credit markets were less volatile and driven mainly by company-specific factors.
The equity market decline and accompanying volatility spike early in the month provided investment managers with their first stress test in some time. Anecdotally, hedge fund managers reported that tail hedges started to kick in as market losses approached 10% and some were able to harvest modest gains and reoptimize their hedging programs. Concurrently, most used the volatility as an opportunity to add to their high conviction long positions. Prime brokerage reports showed net buying activity, indicating a high degree of confidence in manager portfolios and overall market fundamentals. Outside of fundamentally oriented managers, the volatility reversal wreaked havoc on short volatility strategies, many of which had added leverage to achieve their own volatility targets amid the collapse in volatility in 2017. Risk parity and trend-following macro strategies experienced sharp losses as portfolios were delevered and repositioned to account for the surge in volatility.
Declines in crude oil (−4.8%) helped drive energy and natural resource equities sharply lower (−9.8%). Crude prices fell as Energy Information Agency data showed U.S. crude production rose above 10 million barrels a day for the first time since 1970 and domestic inventories increased. Despite the sell-off during the month, crude prices were marginally higher YTD (+2.0%) and finished above the $50 a barrel mark in each of the last seven months. This partial recovery in prices as well as improvements in technological and operational efficiencies led to a general recovery in energy company earnings (off a deep trough) and balance sheet strength. Despite the improved corporate performance and profitability, energy equities sold off during the month, partially in sympathy with equities. They remained out of favor, with investors representing less than 6.0% of the S&P 500, the sector’s lowest level in more than a decade.