Weakness in the U.S. dollar (USD) during November provided a tailwind for global equity markets, which built upon gains achieved in October. However, there was notable dispersion among local equity market returns, with strong gains in the U.S. and several Asian markets but declines across the U.K and Europe. Despite broad equity market gains, November proved to be challenging for long/short equity managers due to sharp shifts in sector leadership.
Outside of a select few developed and emerging markets currencies, the USD weakened broadly during the month with the Dollar Spot Index falling 1.6%. The chart shows the performance of the top five and bottom five developed market and emerging markets currencies against the U.S. dollar. The likelihood of tax reform in the U.S. was an underlying theme of moves in the USD. After a one-day delay, November began with House Republicans releasing their tax reform plans and ended with the Senate Budget Committee voting to advance its version to a floor vote. The Senate ultimately passed the bill on December 2nd, allowing it to proceed to reconciliation with the House. Despite the appearance of a smooth process that should have been dollar-positive, the path to tax reform was rather arduous, and coincided with exogenous factors that, when taken together, negatively impacted the dollar.
Early in the month, the Senate version of the tax bill was adjusted to ensure it did not violate the Byrd Rule of the budget reconciliation process. Markets soured somewhat on the prospects for tax relief as the adjustments made some cuts temporary and others permanent. Another growing concern was the number of differences between the House and Senate versions, which must now be reconciled. These include but are not limited to: (i) the number of individual tax brackets, (ii) deductibility of state and local taxes, (iii) new equipment expensing phase-outs, (iv) allowances for child tax credits, and (v) the repeal of the individual tax mandate of the Affordable Care Act. As the month came to a close, markets had difficulty assessing what the final bill will look like and whether it will reach President Trump’s desk—as both Congress and the President hope—before Christmas.
It is important to note that there are a number of items on the legislative agenda that, unlike tax reform, will require the support of Democrats. Meanwhile, the potential for a government shutdown looms as funding is set to expire on December 8th. Democrats are also pushing for a solution on Deferred Action of Childhood Arrivals (DACA) by year-end rather than the March 2018 deadline. After failing to repeal and replace the Affordable Care Act, the singular focus on tax reform in order to gain a legislative win could ultimately prove to be a costly victory for GOP lawmakers as the year comes to a close.
In addition to political-related uncertainty, macro headwinds caused the USD to trade lower. U.S. economic data weakened in November, most notably during the middle of the month and the week leading up to Thanksgiving. Core consumer spending disappointed and durable goods orders missed market expectations by a wide margin. While Germany reported stronger than expected GDP growth and continued to serve as the growth engine for Europe, it did not translate into strong equity market gains.
Foreign developed market equity returns were lackluster in local terms, but USD weakness served as a tailwind for U.S.-based investors. The Asia-Pacific region was an exception, driven by a rally in Japanese equities. The Nikkei 225 Index rose 3.3% in local terms on the back of strong economic data. Japan’s manufacturing sector showed its strongest expansion in more than three years as overseas demand boosted the Purchasing Managers’ Index from 52.8 in October to 53.8 in November. Japan’s 1.4% third quarter GDP growth (annualized) reported during the month marked the seventh consecutive quarter of growth—the longest such streak since 2001. Elsewhere in the region, Hong Kong (+3.5%), Singapore (+2.7%), and Australia (+1.5%) posted gains in local terms.
The rotation out of a key hedge fund trade—long consumer oriented technology vs. short retail—during the last few days of the month resulted in a poor month for many long/short equity managers. The FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google [Alphabet]) were large holdings for many hedge funds in recent periods and helped propel growth-oriented managers in 2017. However, while many traditional retailers rallied as the month closed, many FAANG stocks experienced sharp sell-offs. The death of brick and mortar retail has been predicted for several years, which has resulted in considerable short exposure across hedge fund managers. With heavily shorted companies, any sign of favorable news can lead to a reversal in share prices that begets a cycle of short covering by hedge funds. This dynamic appeared to play out, with better-than-expected sales data early in the holiday shopping season.
The chart on the following page shows the month-to-date performance of the S&P Retail Select Index versus a basket of widely held consumer technology companies (indexed to 100). The price movements on November 28th and 29th were significant on a percentage basis and massive on a dollar basis. For added emphasis, we included Macy’s, a heavily shorted stock, to show how dramatic the movements were for certain retailers that had been all but left for dead.