Markets were mixed in August and performance between risk assets was diverse. Unlike several recent meetings, the Federal Reserve’s annual symposium at Jackson Hole on August 25th contained a more hawkish tone, putting upward pressure on U.S. Treasury yields. Despite a growing view that the Fed put a September rate hike into play, the impact on the U.S. dollar (USD) was mixed. The greenback appreciated versus many currencies, but depreciated against a number of emerging market currencies, particularly those in Latin America and Asia-Pacific. The move in interest rates hurt sovereign fixed income and the REIT market; however, equity market performance was generally positive and below-investment-grade fixed income posted strong results.
Emerging markets (EM) equity outpaced its developed market counterparts, with the MSCI EM Index rising 2.5% in August in USD terms, bringing year-to-date (YTD) returns to 14.6%. Meanwhile, the S&P 500 and MSCI EAFE indices each rose only 0.1% for the month, bringing YTD gains to 7.8% and 0.5%, respectively. Emerging markets investment flows have picked up considerably in recent months, with investors allocating approximately $30 billion and $25 billion to EM equity and debt portfolios in July and August, according to the Institute of International Finance. Several factors have supported the increased EM appetite, including expectations of continued low global interest rates, stabilizing commodity prices, positive GDP growth in several Asian markets, and improvements in domestic macroeconomic data in select markets—particularly compared to some developed countries.
China was among the strongest performing equity markets in August, boosted by strong monthly gains from several of the U.S.-listed Chinese large cap companies. During the month, China announced approval for the Shenzhen-Hong Kong connect program, which will allow foreign investors to buy directly on the Shenzhen Exchange by year-end. This comes roughly two years after the Shanghai-Hong Kong Stock Connect was established, and will provide broader access to the country’s technology and smaller public companies. The program is viewed as an important step toward China further opening its domestic markets and gaining inclusion into the MSCI equity indices. Second quarter GDP data released during the month was favorable for several Asian countries, including Indonesia (+5.2%), the Philippines (+7.0%), and India (+7.1%). However, the quarterly economic results did not necessarily translate into strong equity market returns for the month. Equity markets in Indonesia and India rose 1.5% and 1.1%, respectively, in August (in USD terms), but the Philippines declined 1.8%. Equity returns in Latin America were mixed, ranging from Colombia’s 9.6% gain to Peru’s 4.4% loss. Investor reaction to the Brazil Senate’s vote to impeach President Dilma Rousseff was rather muted as this was the expected outcome. Both the equity market and the Brazilian real were flat for the month, but the country remains one of the top performers (+62.4% in USD, +32.7% in real). Political developments and hopes of economic change have fueled strong YTD returns in Brazil following steep losses in 2015, when the MSCI Brazil Index plummeted 41.4% in USD terms and 12.7% in local terms.
Sector rotation in August was largely positive for hedge funds. Technology and financials were active areas for many managers, while the stretched valuations of the high dividend utilities, telecom, and consumer staples sectors led to increased short activity. The underperformance of the health care sector was a drag for some managers, but dispersion within the sector created opportunities. The increased likelihood of a rate hike in the U.S. spurred a rally in banks and insurers. Many hedge funds have maintained longs in the sector, believing that investors are overlooking the improved capital positions of banks and their ability to expand margins, particularly as rates rise. Widely held top performers included Bank of America, Citizens Financial, and Citigroup. Chinese companies Baidu, Alibaba, and JD.com led the way in technology, while popular domestic names like Netflix, Pandora, and Broadcom also outperformed.
Distressed credit managers continued their strong run in August, benefiting from a tailwind of spread compression in the high yield market. U.S. high yield spreads tightened by 50 bps, ending August at 4.9%, which is below the 15-year average of 5.7%. The rally in the high yield energy sector since the lows of February rivals that of the broader high yield market after the 2008 market correction. Exposure to the sector has been a key factor in the performance of credit managers YTD. Many distressed managers avoided the energy sector early in the year as the situation looked quite dire and default activity was expected to pick up. Distressed credit managers generally focused on asset valuations and the bankruptcy process. In the case of energy companies, it was unclear what value existed due to the low price of the underlying commodities, high debt loads, and poor recovery rates for the first wave of defaults that occurred in 2015. While there have been defaults in 2016, the rebound in oil and natural gas prices allowed many troubled companies to get by without having to file. Credit managers that were willing to take on the commodity risk have been rewarded over the last six months.
Marketable real assets generally declined during the month, though there were a few exceptions such as crude oil (WTI). Despite the broad sell-off, most marketable real asset categories continued to post strong absolute year to date returns, including global REITs (+12.0%), energy equities (+20.1%), metals and mining equities (+40.6%), and commodities (+5.6%). Within the commodity complex, gold declined 3.1% during the month on a strengthening USD and expectations for a policy rate increase. Industrial metals (−4.1%) appeared to trade lower on concerns that the impact of Chinese stimulus measures, which boosted demand in the first half, may be fading. Weaker than expected Chinese trade data and a stronger dollar also appeared to weigh on prices for these metals. The impact of lower gold and industrial metal prices flowed through to the metals and mining sector (−6.0%) within the equity market. Crude oil prices (+7.5%) were a bright spot as the commodity traded higher on hopes of a potential production freeze by Organization of the Petroleum Exporting Countries, Russia, and other large producers, as well as continued market sentiment that oil markets will come into balance later this year. The oil price rally occurred despite a strengthening USD, higher than expected domestic inventory data, and another modest increase in domestic rig counts. Energy equities advanced modestly (+0.3%) in response to higher oil and petroleum product prices.
Elsewhere within real assets, global REITs declined 2.6%—led by the U.S. region (−3.4%), which accounts for 55% of the FTSE EPRA/NAREIT Developed Index. U.S. REITs traded lower on expectations of a policy rate hike in the near term. The triple net lease sector, which consists of assets with longer duration bond-like leases (10–15 years), is particularly sensitive to rising interest rates and sold off 6.3%. Another area of notable weakness was the specialty REIT sector (−12.7%), which includes prison REITs. Names in this category sold off sharply after the U.S. government stated it would stop using private companies to manage federal prisons.