May 2017 Monthly Market Review
Global equity markets continued to gain ground in May, led by non-U.S. developed- and emerging-market equities. Political corruption generated headlines once again in Brazil, but contagion was limited and the broader market impact was muted. Political uncertainty was also high domestically given news of ongoing investigations into alleged communications with Russia by members of the Donald Trump administration. This dampened expectations regarding the success of future policy initiatives and their potential positive impact on domestic growth. However, equity volatility remained low and select equity markets remained at or near all-time highs.
Weakness in the U.S. dollar (USD) persisted into May, providing a tailwind for non-U.S. investments. Although first-quarter gross domestic product (GDP) was revised higher in the second estimate, economic data outside of the U.S. generally surpassed expectations, while U.S. data was somewhat mixed. The Dollar Spot Index declined 2.1%, with relative gains in most constituents, including the euro (+3.3%), Swedish krona (+2.1%), Swiss franc (+2.9%), Canadian dollar (+1.2%), and Japanese yen (+0.8%). The sole exception was the British pound, which fell 0.2% as a result of recent polling data indicating the Conservative Party may not fare as well in the June 8 snap election as initially expected. Outside of the British pound, the Australian dollar (-0.5%) was the only other developed-market currency to trade lower against the U.S. dollar. Despite positive Australian economic data, the currency fell as a result of weaker economic reports out of China and weaker commodity pricing. Against most emerging-markets currencies, the U.S. dollar depreciated, with notable exceptions being losses against the dollar in the Argentine peso
(-4.3%) and Brazilian real (-1.4%).
On May 18th, allegations emerged that interim Brazilian President Michel Temer offered a bribe to a witness in an ongoing corruption probe. The Brazilian real declined 6.5% that day but, over the course of the following weeks, retraced some of the losses to end the month down 1.4%. Argentina’s central bank took more steps in support of the peso—policy rate hikes and market intervention. However, elevated inflation, which has persisted since President Mauricio Macri allowed the currency to free-float, put downward pressure on the peso in May.
Global equities were broadly positive for the month—particularly international markets, where strong local returns were further bolstered by weakness in the USD. Developed non-U.S. (+3.7%) and emerging markets (+3.0) again outpaced their domestic counterparts, while the S&P 500 Index rose only 1.4%. European equities maintained their upward trajectory, climbing 4.1% on the back of easing political risk and continued economic recovery. Emmanuel Macron’s victory in the French presidential election—although widely expected—at least temporarily quelled populist fears in the region. Economic indicators remained positive as well. PMI in the euro area stood steady at 56.8, in line with the six-year high reached in April. Euro area unemployment fell to 9.3%, beating expectations and marking its lowest level in over eight years.
Strong returns were generated across emerging-markets equities despite heightened political uncertainty. Brazilian equities, as well as the real, came under heavy pressure following allegations of corruption against President Michel Temer. The prospect of economic reform under Temer (following Dilma Rousseff’s impeachment in August 2016), as well as the recovery in commodity prices, drove strong equity market results in Brazil over the last year. As of May 17th, the day leading up to the news of the alleged scandal, Brazil had surged 48.3% over the one-year period, compared to the 28.8% gain of the broad benchmark. Brazil’s Bovespa Stock Index tumbled more than 10% after the market open on May 18th, triggering its circuit breaker limit before closing down 8.8% for the day. Though Brazilian equities stabilized in the closing days of May and finished down 5.0% for the month, concerns persisted regarding Temer’s future and the advancement of much-needed economic reforms.
Investor concerns regarding the Temer scandal were generally contained to Brazil. Emerging European markets gained with the help of currency tailwinds following Macron’s election win. Hungary (+10.9%) and the Czech Republic (+5.9%) were supported by the strength of the Hungarian forint and Czech koruna, which appreciated 4.8% and 5.2%, respectively, relative to the USD. It was also a record month for Asian equities. Strong corporate results, improving economic data, and the election of Moon Jae-in helped elevate South Korean stocks (+8.1%), as the Kopsi Index reached a six-year high. Indian (+1.8%) and Indonesian (+2.4%) equities also recorded peaks during the month. Taiwan (+2.4%) achieved a 17-year high, as the country’s technology companies—most notably those levered to Apple—excelled. The resilience of these equity markets, despite the issues faced by Brazil, represents a departure from past contagion-like behavior experienced in emerging markets.
U.S. small cap was one of the few equity market segments that posted a drawdown in May, falling further behind its large cap counterpart year-to-date. The Russell 2000 Index sold off 2.0% for the month, lagging the Russell 1000 Index by 331 bps and bringing the year-to-date differential between the benchmarks to 703 bps. Small caps were expected to be beneficiaries of Republican policy overhauls; as the visibility into the scope and the timing of these reforms dimmed, small caps fell out of favor with investors. Specifically, materials (–4.6%) and financials (–4.2%) posted drawdowns due in part to the lack of progress in infrastructure spending and financial regulation reform. The losses in small caps were broad-based, with just two of the 11 index sectors posting gains. IT (+3.4%) was buoyed by the momentum of price action from earlier in the year, and the defensive utilities sector (+2.2%) also rose.
Within real assets, the energy-heavy S&P North American Natural Resources Index declined 3.6% on lower crude oil (–2.0%) and natural gas prices (–6.3%). The index was down 10.5% year-to-date, after advancing more than 30% during calendar year 2016. During the month, natural gas prices fell on significantly higher-than-expected inventories and generally mild domestic temperatures that limited cooling demand. Crude oil retreated and settled at approximately $48 dollars per barrel (WTI), despite an agreement between OPEC and other major oil producers (including Russia) to extend current production cuts of 1.8 million barrels a day for an additional nine months. Following the initial cuts agreed to in November 2016, crude prices were driven to the mid-$50 range and subsequently traded north of $50 through most of the first quarter of 2017. However, the continued ramp-up in U.S. production has undermined the full impact of OPEC cuts, increasing concerns that a rebalancing of global supply and demand could potentially take longer than expected. According to the Energy Information Administration (“EIA”), U.S. crude production has moved above the mark of 9 million barrels per day for the first time in 12 months. A growing number of domestic producers are now profitable at $40–50 per barrel, as rapidly improving efficiencies and technologies—as well as cyclically low service costs—have deflated these producers’ costs.
Hedge fund performance in May was mixed, but growth-oriented managers continued their strong run, as many widely held technology and consumer/internet companies outperformed. On the whole, hedge fund performance has been quite strong over the last year, with the average long/short equity manager (as measured by the HFRI Equity Hedge Index) capturing roughly 65% of the equity market’s upside. Many distressed managers have kept pace with—or have even outperformed—the high-yield market. Multi-strategy managers have also benefited from these trends and continued to profit from a robust merger environment in the month. A recent Morgan Stanley prime brokerage report estimated that year-to-date through April, long positions for hedged equity managers outperformed shorts by 5.6%. This spread was one of the strongest in years and appeared to be largely driven by security selection, rather than style or factor exposures. Despite this recent strength, the hedge fund industry continued to experience net outflows in the first quarter; however, the pace of redemptions slowed.
While we do not recommend investors place too much weight on short-term performance, we are encouraged by the recent strength in hedge fund performance—particularly during a period of significant appreciation in risky assets. Managers have also expressed high conviction in their portfolios, both long and short, during recent conversations. This view is supported by increases in gross exposure and portfolio concentration, while net exposure generally remains at or slightly below historic average levels.