Risk asset performance was mixed in October, after largely exhibiting gains in September. Outside of positive returns in financials, U.S. equities were broadly lower, led by meaningful weakness in health care and real estate. U.S. equities underperformed their international counterparts which produced positive local returns. However, currency was a significant headwind as the U.S. dollar (USD) rallied against developed market currencies and most emerging markets (EM) currencies—outside of strength in the Mexican peso and Brazilian real. Rising sovereign yields also hurt markets, particularly global real estate and fixed income markets. Despite dampened investor sentiment, optimism was evident in the merger and acquisition space, where there was an uptick in deal activity.
The USD rally mitigated losses that occurred throughout much of the year. The Dollar Spot Index (DXY), a measure of the value of the USD relative to a basket of currencies, rose 3.1% in October. The gain in October helped narrow YTD declines in the DXY from −3.3% on September 30th to −0.3% on October 31st. The USD rose against all six underlying constituents, but displayed notable strength against the British pound (−6.0%), the Swedish krona (−5.0%), the Japanese yen (−3.6%), and the euro (−2.5%). The reasons behind the U.S. dollar’s rise were country-specific. Rhetoric from British Prime Minister Theresa May points to heightened risk of a “hard Brexit” from the European Union, which put additional downward pressure on sterling. The krona has been a favored borrowing currency for carry trades. Sweden’s Riksbank signaled a willingness to move rates deeper into negative territory, which would further lower the cost of borrowing the currency. With markets pricing in increased odds of a December rate hike by the Fed, policy divergence seemed to drive weakness in the euro and yen, particularly since markets expect additional accommodation from central banks in Europe and Japan.
Select EM currencies appreciated against the USD, but the most notable increases occurred in the Mexican peso (+2.9%), the Brazilian real (+2.6%), and the South African rand (+2.0%). Recent U.S. presidential polls have shown a more difficult path for Donald Trump to get elected, which investors have viewed favorably for future trade relations with the U.S. Elsewhere, in Latin America, markets seem to be increasingly comfortable with the policies of Brazil’s Interim President Michel Temer’s administration, helping the real continue to retrace losses sustained in 2015. South Africa’s high interest rates are drawing investors to the rand despite a weak political and economic backdrop.
The U.S. equity market, as measured by the Russell 3000 Index, retreated 2.2% in October. All sectors posted drawdowns with the exception of financials and utilities. Health care (−7.2%) was the worst performing segment as multiples compressed across all health care industries due to investor anxiety over political risk. Financials (+1.8%) was the best performing segment on the strength of the banking segment. Large money center banks such as Bank of America (+5%), Citigroup (+4%), and JPMorgan (+5%) reported better than expected earnings due to robust bond trading activity. By contrast, real estate stocks, which were broken out as a separate GICS sector earlier in 2016, posted a 5.2% decline. While the MSCI EAFE Local Index posted a 1.2% gain for the month, declines in currency relative to the USD resulted in the Index dropping 2.1% in USD terms. The British pound was among the weaker currencies in both developed and emerging markets, falling 6.0% relative to the USD. The weakened currency boosted U.K. exports and the country’s manufacturing sector continued to expand at a brisk pace. The Purchasing Managers’ Index for the U.K. construction industry increased to 52.6 in October from 52.3 in September—when it rose above 50 for the first time since May. Likewise, while the Nikkei was up 5.9% for the month in local terms, the 3.6% decline in the yen relative to the USD dampened the dollar-denominated returns. The Bank of Japan announced early in November that it does not expect to reach its 2% inflation target until 2019, demonstrating the country’s struggle to escape deflation despite significant monetary expansion.
U.S. Treasuries yields increased across the curve while the broad Treasury market fell 1.1% in total returns. The 10-year U.S. Treasury yield rose 24 bps to end the month at 1.84%—the largest one-month increase since June 2015. Amid firming inflation expectations, the yield curve experienced a bearish steepening, with a larger increase in long-term yields compared to short-term yields. With yield increases more pronounced farther out on the curve, long-term U.S. Treasuries declined 4.1%. As yields increased, the broad fixed income market, as measured by the Bloomberg Barclays Aggregate Index, declined 0.8%, despite modest spread tightening. Securitized assets (−0.3%) fared best, largely driven by the shorter duration profile of the sector.
Global REITs dropped 5.7% on a jump in bond yields across developed markets, as well as expectations of diminished effectiveness of central bank easing measures within the U.S., Europe, and Japan. The European region led the decline, falling 9.2% in USD terms. Within Europe, continued concern over the impact of Brexit contributed to the sell-off, and a weaker British pound and euro materially reduced USD returns. North American real estate securities also fell sharply (−5.9%) on expectations of a near-term policy rate hike and higher longer-dated Treasury yields. The triple-net lease and health care sectors in the region were notable underperformers, falling 11.7% and 6.4% respectively. These sectors consist of assets with longer duration bond-like leases (10–15 years) and are particularly sensitive to rising interest rates. Elsewhere within the region, the retail sector declined materially on rising interest rates, including regional malls (−9.8%) and shopping centers (−7.3%). This happened despite generally strong earnings reports and a continued drop in reported retail vacancy rates. Despite the sharp downturn in October, global REITs gained 4.7% over the year-to-date period.
While most risk assets posted declines, some signs of optimism were evident. Merger activity picked up during the month after a summer lull. Various measures put the number of deals at roughly $500 billion—one of the largest months for deal volume in history. However, it was the size of the deals that has made this merger environment so unique, not the volume. The largest deal, AT&T’s bid for Time Warner, surprised many investors who were skeptical that it could be completed in the current regulatory environment. Other sizable deals included Qualcomm-NXP Semiconductors, CenturyLink-Level 3 Communications, and British American Tobacco-Reynolds American. Merger-arbitrage played an important role in the portfolios of event-driven and multi-strategy managers as spread levels offered attractive rates of return. These large deals are often more difficult to handicap due to the global nature of the companies involved. In addition, there are fewer arbitrageurs in the market than in the past, creating potential opportunities for experienced investors comfortable with arbitrage. The timing of the deals also appears fortuitous as cash levels had increased at many multi-strategy managers following the successful closures of the ABInBev-SABMiller and Dell-EMC deals in recent months. We anticipate merger-arbitrage allocations will remain elevated within manager portfolios unless opportunities in the credit market emerge.