Volatility makes a comeback
The first month of 2018 saw equity markets race to new highs as last year’s headwinds become tailwinds – including increased stimulus from tax cuts, possible wage growth and inflation, and rising interest rates that seemingly confirmed the growth trajectory. However, the equity market was significantly turbulent in February after an exceptional period of low volatility that saw equities rise for fifteen straight months. The first three months of 2018 saw twenty-three 1% daily absolute moves by the S&P 500, compared to just eight such days in all of 2017, giving you some perspective on how volatility jumped in the first quarter (Q1). CBOE’s volatility index, the VIX, spiked 177% to 37.32, even as the S&P 500 fell -8.5% over a five-day period. Equity markets fell into correction territory, with peak drawdowns larger than -10%, recovered and then fell again toward the end of the quarter.
The rise in volatility in the first quarter can be attributed to four causes. Two were fairly predictable – a surge in interest rates that saw the yield on US ten-year treasury bonds rise from 2.40 to 2.90 over the first three weeks of the year, followed by an employment report on February 5th that showed wages growing 2.8% year-over-year in January. The wage report raised the specter of rising inflation and more aggressive Federal Reserve policy in response. A tightening labor market should naturally see wage growth rising, but at the time of the report’s release we discussed how the market was over-reacting to a single data point that was likely to be smoothed as more numbers came in. This turned out to be the case as inflation reports over the next couple of months suggested that inflation is not accelerating, yet.
The two other drivers of higher volatility in Q1 were curveballs. It started with President Trump’s announcement of across the board steel and aluminum tariffs on March 1st, raising fears of a trade war between America and its largest trading partners. Equity markets fell immediately after the announcement but rallied over the next two weeks as the administration gave temporary waivers to several allies. There was always a possibility of increased protectionism and trade related actions since President Trump came into office (we discussed this in several of our pieces), but the administration continuously pushed it further and further back as 2017 progressed. So it was the sudden move to enact a policy priority, one that was on the backburner until now, that caught markets flat-footed.
The other driver that took everyone by surprise was the Facebook privacy scandal that erupted on March 17th. This basically involved a London-based election consultancy firm scraping Facebook users’ private data for campaign activity, in violation of commercial use policies. It led to the Federal Trade Commission (FTC) opening an investigation into whether the technology firm had violated a prior settlement reached with the agency over user privacy protection. This was followed by President Trump’s tweets against Amazon, suggesting that the US Postal Service was getting a raw deal on its shipping arrangements with the company, and highlighting their avoidance of state taxes. The fear of increased regulation by lawmakers saw the high-flying S&P 500 Information Technology sector pullback more than -8% over the next ten days, compared to a -5.3% drawdown for the S&P 500.
Nevertheless, the Technology sector ended the first quarter with an overall gain of 3.50%, significantly outperforming the benchmark S&P 500 index, which fell -0.80% over the quarter. The only other sector to register a positive quarter was Consumer Discretionary, which gained 3.10%. Developed markets outside the US underperformed, with the MSCI EAFE Index (net) falling -1.53% in Q1, while Emerging Markets outperformed, with the MSCI EM Index (net) rising 1.42%. The MSCI ACWI Index (net) fell -0.96% in Q1.
Overseas returns were boosted by a falling dollar – the trade-weighted US Dollar index against major currencies fell -1.38% over the quarter. In local currency terms, the MSCI EAFE Index (net) fell -4.28% and the MSCI EM Index (net) gained 0.72%, while the MSCI ACWI Index (net) fell -1.86%.
Q1 2018 was the first quarter since Q3 2008 when stocks and bonds fell, an occurrence that has happened only eight times over the past thirty years. Rising interest rates led to the Bloomberg Barclays US Aggregate Bond Index falling -1.46% in Q1. The Bloomberg Barclays Global Aggregate Index outperformed thanks to a lower US dollar, gaining 1.36% over the quarter.
The Spouting Rock/Convex Global Dynamic Risk Fund (Institutional and Advisor classes) (CVXIX and CVXAX) fell -2.54% and -2.64%, respectively, in the first quarter, compared to a return of 0.36% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index. The returns for the one-year period ending 3/31/2018 are 6.94% for CVXIX and 6.52% for CVXAX, compared to 1.11% for its benchmark. As of 3/31/2018, the average annual returns since the fund’s inception on 11/24/2014 were 3.78% for CVXIX and 3.51% for CVXAX, compared to 0.48% for its benchmark.
The Fund uses Convex’s proprietary risk rating to assess the economic situation across the world and this did not change significantly between the fourth quarter of 2017 and the first quarter of 2018. So the overall position of the Fund toward equities, especially US equities, did not change substantially across the two quarters. While it helped the Fund to outperform its benchmark in Q4 2017, this was reversed in Q1 2018 when market volatility picked up.
As we discussed above, volatility initially spiked in February after interest rates surged and an employment report suggested rapidly rising wage growth. However, we did not react to this since rising interest rates were only to be expected given a tight labor market and a hawkish Federal Reserve. We did not believe inflation was accelerating as fast as the market believed at the time — which was confirmed in future data releases. We also did not react to trade-related volatility later in the quarter since our assessment was that a trade war was not imminent. At this time the various sides are only threatening significant tariffs and it will be months before they are actually imposed, if at all. Even then, the most likely scenario is that we will see a proportional tit-for-tat that eventually ends without blowing up into a full-scale trade war.
We currently believe the economic environment remains positive, and should favor equities if it remains so, as idiosyncratic noise gets filtered away – whether on Federal Reserve interest rate hikes, trade or technology sector regulations.
US economy continues to ride high
With all the market volatility, one could be forgiven for thinking that the US economy was buckling over. This could not be further from the truth as US economic momentum continued apace in Q1. Convex’s proprietary risk rating for the US held at a strong Hold-Buy throughout the quarter, reflecting the strong economic numbers that continued to pour in. The labor market continued to tighten while business optimism grew thanks to recently passed tax cuts.
Strong economic data gave us reason to increase the allocation to US equities from 52% at the beginning of the quarter to 65% in February. The fund increased its weight in large-cap cyclical sectors like Technology (10.6% allocation), Financials (5.5% allocation) and Industrials (4.2% allocation). However, these positions adversely impacted the Fund performance amid the market drawdown in February and March. Allocation to Financials, Industrials and Technology sectors dragged the quarterly portfolio return down by -20 bps, -14 bps and -12 bps, respectively. At the same time, interest rate sensitive and defensive sectors like Real Estate and Consumer Staples declined sharply in January amid the surge in interest rates, dragging the portfolio return down by -23 bps and -22 bps, respectively.
Over the entire quarter, large-cap equities (41.8% allocation) dragged the portfolio return down by -123 bps. Mid-cap (13.6% allocation) and small-cap (4.8% allocation) equities dragged the portfolio return down by -20 bps and -16 bps, respectively.
A mixed economic picture abroad
Economic data in Europe slowly softened across the first quarter, even as Convex’s risk rating for the region held at Hold. Manufacturing PMIs fell from last year’s record highs and business confidence dipped. Other than Germany, which was rated Hold-Buy, most of the other countries in the region were rated as Hold throughout the quarter. The exceptions were the United Kingdom – which was rated Caution amid a significant slowdown in growth – and Italy, Ireland, Switzerland and Denmark, which were all rated Caution-Hold. The Fund averaged a 4.9% allocation to Germany across Q1, which dragged the quarterly return down by -16 bps.
Convex’s risk rating for Japan maintained at Hold across the quarter, as economic data pointed to steady on-trend growth even as the Bank of Japan maintained its stimulus programs. The Fund averaged a steady 5.3% allocation to Japan in Q1, and the allocation contributed +9 bps to the Q1 return.
The Fund also held a 2.6% allocation to Canada in January on the back of a Hold rating for the country. However, the position was removed as NAFTA negotiations continued with resolution and risks of a trade-related disruption grew. The allocation contributed +1 bps to the portfolio return in Q1.
Emerging markets were a mixed bag in the first quarter, with China, India, South Korea, Taiwan and Malaysia rated as Hold, while Singapore, Philippines and most of Latin America rated as Caution-Hold or lower. The Fund eschewed any allocations to most Emerging Markets due to higher volatility. The portfolio did initiate a 2.4% allocation to Brazil in February on the back of a solid Hold-Buy rating that reflected the country’s steady climb out of a recession that saw its economy contract in 2015 and 2016. The allocation dragged the portfolio return down by -10 bps in Q1.
The overall rating for the World held at Hold-Buy across the quarter, which was reflected in the Fund’s 73% average allocation to growth assets over the period – 60% in US equities and 13% in International equities. The Fund averaged a 21% allocation to fixed income and 5% allocation to cash in Q1, while a Real Estate allocation accounted for the remaining 1%.
Fixed income allocation was concentrated in corporate bonds, with an average 16% allocation, while mortgage-backed securities (4% average allocation) and long-term treasuries (1% average allocation) comprised the rest. Allocation to fixed income and Real Estate dragged the portfolio return down by -54 bps and -23 bps, respectively, in Q1. Most of these losses came early in the quarter when interest rates surged.
As we discussed above, the first quarter threw up a few surprises that caused market volatility to spike. Some of these we believe were market over-reactions but at the same time, we are closely monitoring the situation for any fundamental shifts that can have an adverse impact on the global economy, and lead to a sustained bear market.
1. Will the trade spat with China, and others, escalate?
Trade is on everyone’s mind and a quick recap of what we have seen to date would be useful. In the weeks following the initial announcement of broad steel and aluminum tariffs, the Trump administration temporarily excluded Canada, Mexico and other allies in Europe, Latin America and Asia. Notably, China was not granted an exemption and on April 2nd they retaliated with tariffs on US imports worth $3 billion. The very next day the US trade representative (USTR) threatened to target almost $50 billion worth of Chinese goods – proposing a 25% tariff on more than 1300 goods, mostly hitting machinery, mechanical appliances, and electrical equipment. China was quick to respond, proposing their own 25% tariffs on $50 billion worth of US goods. These would mostly hit US transportation (vehicles and aircrafts) and agricultural sectors, shrewdly chosen to put maximum political pressure on President Trump. The tit-for-tat continued with the President immediately counter-punching, threatening to target an additional $100 billion of Chinese imports.
On April 10th China filed a trade case at WTO against the original steel aluminum tariffs. However, the same day saw Chinese Premier Xi Jingping lowering the temperature at the Boao Forum for Asia. He outlined plans to to reduce tariffs on imported vehicles, open up financial services and automotive joint ventures, reduce restriction on foreign investment, strengthen intellectual property protections, and expand imports. All of these are essentially recycled proposals that have been made in the past but it did appear to give both sides a way to back out of their respective corners, with President Trump reacting positively.
At the same time, the Chinese Commerce Ministry said that these proposals have been in the works for a while and should not be seen as concessions. The USTR is also proceeding with public hearings and a comment process on proposed tariffs on $50 billion in Chinese goods, which will end on May 22nd. So it may be late May at the earliest before a final decision is reached, giving both sides ample time to negotiate/de-escalate. The administration will also have to decide whether or not to permanently exclude its allies from the steel and aluminum tariffs.
With the US-China spat dominating headlines, it was easy to forget that NAFTA negotiations continue to proceed without agreement on key issues like dispute settlements, rules of origin on vehicles, the sunset clause and major market access rules. All sides would like NAFTA negotiations to conclude in the second quarter, to avoid running up against Mexico’s presidential election in July (a leftist, nationalist candidate is the current front-runner) and to allow the US Congress to ratify the treaty before midterm elections in November.
A full-blown trade war is not imminent at this time. Right now the various sides are playing a game of chicken and waiting to see who blinks first. As we have written before, the most likely scenario is a proportional tit-for-tat that eventually ends. However, the risk of escalation remains a possibility, especially if President Trump feels that America’s trading partners have not ceded enough ground and significant tariffs actually go into force.
2. Will the yield curve continue to flatten?
The positive string of economic data in Q1 made the Federal Reserve’s (Fed) March meeting a mere formality with respect to market expectations for yet another rate increase. More eyes were focused on whether the Fed would project an extra, fourth rate hike in 2018. While the median consensus amongst officials did not shift from three rate hikes, several participants shifted toward the more hawkish scenario. This was reflected in the fact that the market implied probability of four rate hikes in 2018 rose to 38% after their meeting (the probability was as low as 10% at the beginning of the quarter).
However, despite all the positive data and surge in long-term yields at the beginning of Q1, the yield curve ended the quarter slightly flatter than it was at the end of 2017. The spread between yields on ten-year and two-year treasury bonds fell 4 basis points (bps) over the quarter, while the spread between thirty-year and five-year yields compressed by 13 bps. Given that the US has been growing above its post-recession trend over the past three quarters, and expected to do so this year (especially in the face of stimulus from tax cuts), one would have expected the yield curve to steepen. The opposite has happened.
Market odds of another rate hike in June is higher than 95% as of this writing, but if long-term yields do not move higher, we could see yet more flattening. A flattening yield curve (both nominal and real) by itself is not indicative of a recession – only an inverted one is – but it does suggest that the bond market is not so optimistic about the growth outlook in the US. One way to square this circle is to assume that markets believe the Federal Reserve will explicitly turn toward restrictive policy in the next couple of years to intentionally slow the economy.
3. Will the downshift in economic momentum in Europe be temporary?
Another unexpected development that occurred during the first quarter was the marked downshift in economic momentum in Europe. Economic data consistently came in on the softer side in Q1 and Convex’s proprietary risk rating for the region fell from Hold to Caution-Hold by the end of the quarter. Manufacturing PMIs fell across the board, with PMI for the entire Euro Area falling to an eight-month low of 56.6, down from 60.6 in December. Business confidence also steadily declined across the quarter while core inflation refused to budge higher than 1% year-over-year. Economic data could only tear higher for so long but the extent of the softening is puzzling.
All of this comes as the European Central Bank (ECB) hints at cutting its crisis-era stimulus program sooner rather than later. Expectations are for the ECB’s bond-buying program to end in September. However, the ECB’s current plans are conditioned on upgraded growth forecasts that were made at the end of 2017. The question is whether the recent data, along with stubbornly low inflation, will be seen as a temporary blip, or as a sign of a more protracted slowdown.
The Convex proprietary risk rating for the world stands at Hold as we move into the second quarter of 2018. We continue to monitor economic prospects of thirty different countries across five regions of the globe and remain vigilant about potential risks.
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