February marked another positive month for most risk assets, with several domestic equity indices hitting record levels once again. Investor sentiment continued to be positive as monetary policies among large central banks remained relatively accommodative and U.S. economic indicators were largely positive. Amid strong results, there was dispersion among capital market returns as natural resource stocks fell and commodities were flat. Within commodities, metals continued to rally, offsetting declines in energy-related categories. There was also notable dispersion among currencies. In aggregate, currency helped emerging markets (EM) returns and hurt non-U.S. developed markets returns during the month. Broad equity market volatility remained relatively low, despite rising uncertainties at home and abroad.
The Global Economic Policy Uncertainty Index — which tracks the frequency of newspaper articles discussing economic policy uncertainty, aggregated across 18 countries — spiked in July after Brexit and hit new highs in December and January, reflecting the election of Donald Trump and a number of upcoming elections worldwide. However, the VIX remained subdued through the period.
After rising sharply in the fourth quarter, U.S. Treasury yields have been relatively stable to start 2017. The U.S. 10-year Treasury yield ended January where it began the year, at 2.45%, before declining 9 bps in February. However, short-term yields moved higher through the end of the month, and the curve flattened. Several Fed officials indicated the Federal Open Market Committee could potentially move policy rates higher in the near term, increasing the probability of a March rate hike. Conversely, the long end of the curve was supported by stabilizing inflation expectations, as bond investors tempered their faith in President Trump’s ability to lead a series of pro-growth measures through Congress in short order.
This was a positive environment for credit; high yield continued to rally and finished February up 21.8% over the trailing one-year period. However, the past year was marked by significant sentiment shifts related to below-investment-grade bonds. At the end of February 2016, option-adjusted high yield spreads were 726 bps and default rates were spiking, most notably in the energy sector. By the summer of 2016, trailing 12-month energy defaults exceeded 20% and the broader high yield default rate peaked at nearly 5%. However, the rise in the price of oil buoyed many energy issuers over the last year and there was significant restructuring activity. While credit markets were shaky in the first quarter of 2016, distressed managers—many of which were recovering from their own drawdowns—stepped in aggressively. Over the course of the last year, a number of energy companies executed debt exchanges or moved quickly through bankruptcy. High yield spreads fell 50% over the last year, ending February at 363 bps, while defaults have declined. The high yield energy sector gained 59.5% through February, representing the sector’s best one-year return in its history. Distressed investors who took risks and provided capital to the energy sector benefited in a meaningful way. The HFRI ED: Distressed/Restructuring Index experienced its greatest one-year gain since 2010. However, managers who maintained hedges or were unwilling to make a bet on levered, highly cyclical companies lagged.
In February, global REITs advanced 3.2%, with all three regions moving higher—led by the U.S. (+3.6%) and Europe (+2.8%). Stable or declining sovereign yields across the developed world helped support the REIT advance. In the U.S., strong fourth quarter earnings reported by listed real estate companies and continued optimism regarding economic growth appeared to outweigh concerns around pockets of weakness in real estate fundamentals, including oversupply in some apartment markets and weakness in areas of the retail sector. Despite a slowdown in overall asset-level transaction volume, recent transaction pricing appeared to support higher property stock prices, as global capital continued to be attracted to the yield and perceived safety of U.S. real estate. Elsewhere, European property stocks rallied (+2.8%), led by the U.K. (+5.2%), which rallied despite heightened concern around the impact of a potential hard Brexit on the London commercial real estate market. As part of Brexit, financial firms may lose these rights, potentially forcing them to increase operations in continental Europe and trim operations in London, which account for a significant portion of tenant demand in that market. However, many have not moved operations or a considerable number of employees to the continent, where elections in France and other countries have increased uncertainty. Despite Brexit fears, property fundamentals and asset prices in the U.K. remained stable, fueled in part by increased overseas investor interest and the weaker pound. These factors, combined with solid real estate company earnings and surprisingly positive economic data recently, appeared to support higher property stock valuations during the month.
Elsewhere in marketable real assets, natural resource equities fell 3.0% during the month; the energy sector (−2.2%) was one of only two S&P 500 sectors to post negative returns. Despite higher crude prices (+2.3%, WTI), energy equities fell on lower overall energy commodity prices (−2.7%). This was led by a sharp decline by natural gas (−16.3%), as warmer weather reduced demand and contributed to higher-than-expected inventories as the end of the winter heating season nears. Energy equity returns also appeared to be negatively impacted by the continued ramp up in U.S. shale rig counts, production, and inventories. This tempered optimism around the Organization of the Petroleum Exporting Countries’ production cuts and the potential for further price increases. Lastly, after rallying 32% over the trailing 12 months, investors appeared to engage in profit-taking and rebalancing away from the energy sector.
The impact of currency movements on non-U.S. markets as a whole appeared relatively muted in February. However, there was a fair amount of volatility and dispersion at the region and country levels. With the help of positive economic data and hawkish comments from the Fed, the Dollar Spot Index rose 1.8% after a challenged start to the year. Developed market currencies were generally weak relative to the U.S. dollar (USD), particularly in the European region. Poor retail sales data weighed on the U.K. pound, which fell 1.1%. The sterling came under additional pressure at month-end on reports that Scotland may call a second independence referendum as early as March. The euro (−1.7%) also faltered despite the release of favorable GDP (+0.5% in the fourth quarter) and inflation (+1.1% in January) data during the month. These signs of economic recovery in the region were not enough to offset ongoing political concerns, as anti-euro candidate Marine Le Pen gained momentum in France’s upcoming presidential election.
Conversely, currencies of several large EM countries gained relative to the USD. The Russian ruble (+2.9%) rally extended into February, hitting a 19-month high as the Russian economy displayed more signs of improvement. Ruble strength came in spite of the Central Bank of Russia’s attempts to slow the currency’s appreciation. The Egyptian pound rose 19.9% as improvements in trade and tourism prompted a rebound off of historic lows. Entering the month, the Egyptian pound had fallen over 50% since the Central Bank of Egypt decided to float the tightly controlled currency in early November 2016. Another notable turnaround story was the Mexican peso, which declined 10.6% relative to the USD since the U.S. election through January. The peso clawed back 3.8% in February due in part to the Trump administration’s efforts to ease U.S. tensions with its neighbor to the south. Toward the end of the month, Mexico’s central bank also unveiled a $20 billion currency-hedging program aimed at reducing volatility in the peso without compromising the country’s national reserves.