U.S. equities posted positive returns in May, led by smaller cap stocks, which were more insulated from the impact of rising trade war rhetoric. However, equity results were mixed across the globe following the rise of several geopolitical risks. These include a fiery presidential campaign in Mexico, fears that Turkey may lessen central bank independence, and heightened concerns of growing populist pressures in Europe, most notably in Italy and Spain. Trade policy initiatives once again spurred uncertainty, as the Trump administration announced new tariffs on steel and aluminum in the latter part of the month. The tariffs may be levied against close allies including Mexico, Canada, and the European Union, which could have a broader impact on consumer products. While these factors led to pressure on emerging markets (EM) equity and currencies, the resulting flight to quality was a positive tailwind for fixed income investments. Also, marketable real asset categories performed relatively well, despite falling inflation expectations.
The Russell 3000 Index (+2.8%) gains were largely driven by growth stocks—a trend that has persisted since the end of 2016. While the Russell 1000 Value Index was up only 1.0% for the month, the Russell 3000 Growth Index rose 4.5%. Technology (+7.2%) was the top performing sector and represented one-quarter of the Russell 3000 Index assets at the end of the month. Market gains were disproportionately driven by Microsoft (+6.1%) and the FAANGs: Apple (+13.5%), Netflix (+12.5%) Facebook (+11.5%), Alphabet/Google (+8.0%), Amazon (+4.1%). In aggregate, these stocks represented nearly 13% of Russell 3000 Index assets, but accounted for nearly 40% of the total return of the benchmark during the period.
EM equities fell sharply, as the MSCI EM Index declined 3.5% in U.S. dollars (USD) and 2.2% in local terms, erasing YTD gains. Latin American markets drove the decline, where weakness in Brazil (−16.5%) and Mexico (−13.7%) accounted for the majority of losses. In addition to political uncertainty, Brazilian equity markets were pressured by a trucker strike that began on May 18th. The strike was in response to rising fuel prices following a shift from a subsidized to a free market pricing policy. A temporary price response by the country’s large, state-owned oil company Petrobras and President Michel Temer led markets to fear a shift back to populist pricing policy. The strike also dealt a blow to the nation’s already fragile economy trying to recover from its worst-ever recession. Mexico stumbled ahead of elections, concerns of growing populist sentiment and stalled NAFTA negotiations. Frontier markets pulled back sharply, declining 9.2% in the period as measured by the MSCI Frontier Markets Index. Argentina (−21.9%), the largest frontier country in the Index, was the biggest laggard as markets responded to central bank actions to stabilize currency and inflation.
EM currencies also came under pressure during the month. In addition to macro uncertainty and country-specific issues, the strength of the USD served as a notable headwind. While the Brazilian real and Mexican peso both stumbled, the Turkish lira experienced the biggest decline. The lira’s collapse was driven by investor concerns over the country’s widening account deficit, high inflation, and President Recep Tayyip Erdogan’s unorthodox views on monetary policy. The lira rebounded by over 5% in the final week of the month after the central bank hiked policy rates by 3% and committed to tightening monetary policy further if necessary. Despite the bounce, the lira closed the month down over 10% versus the USD. Argentina also experienced significant currency depreciation as the peso declined 17.8% versus the USD. Argentina’s central bank responded to the fall in the peso by hiking rates three times before holding steady at 40%. Additionally, the government entered into talks with the International Monetary Fund for assistance in continued efforts to stabilize the currency.
Political issues in Europe took center stage once again during May. Italy has been without a government since the March 2018 elections left no party with a large enough share of parliament to form a government. After weeks of deadlock and negotiations, M5S and League released the “Contract for the Government of Change,” which summarized the platform of the two parties. On May 27th, President Sergio Mattarella rejected their selection for minister of economy and finance and proposed a caretaker government be named. Four days later, a new minister that Mattarella found acceptable was agreed upon. The government was formed and Giuseppe Conte was sworn in as prime minister on June 1st, ushering in Italy’s first populist government since World War II.
In response to this political turmoil, Italy’s sovereign bond market experienced a steep sell-off at the end of the month. The yield on the two-year Italian bond spiked nearly 200 bps, reaching an intra-day high of 2.73%—its highest level since 2013. The 10-year bond yield moved 100 bps higher over the course of the month.
In Spain, implications regarding members of Prime Minister (PM) Mariano Rajoy’s Popular Party in the Gürtel corruption scandal came to a head in May. The first court ruling sent former Treasurer Luis Bárcenas to prison for 33 years, prompting opposition party leader Pedro Sánchez to set in motion a no-confidence vote against Rajoy. On June 1st, Rajoy became the first PM in Spain’s democratic era to be removed from office by a vote of no confidence. Sánchez was sworn in as PM and could stay in power until 2020. However, his socialist-led, minority government appears weak and early elections may be called. During the last week of the month, Spanish 10-year government bond yields moved higher 14 bps.
Historically, European equity volatility has traded higher than the VIX 90% of the time going back to 1999. However, this relationship diverged earlier in the year and European volatility (as measured by the EuroStoxx 50 Implied Volatility Index) traded in line or at a discount to the VIX heading into May. The last time the relationship between these “fear measures” deviated for an extended period of time was during the financial crisis in late 2008/early 2009. The negative spread earlier in 2018 was likely due to a number of factors, including central bank intervention, higher U.S. rates, and potential U.S. trade wars. However, in May, this relationship reverted back toward historical norms amid the increase in geopolitical risk in Europe, and the VIX is now trading at a discount to European volatility.
Amid the volatility and uncertainty, investors flocked to safe haven assets, resulting in declining yields in both the U.S. and Germany. After reaching a high of 3.11% earlier in the month, the U.S. Treasury 10-year yield bond ended the month at 2.83%. The sharp decline in U.S. Treasury yields was likely partially driven by short covering as net short positions on the U.S. Treasury 10-year yield hit a record high at the end of April. Outside of the U.S., the spread between the 10-year German bund and 10-year Italian bond widened from 122 bps at the start of the month to 248 bps at the end the month.