Most risk assets performed well in September, with the markets embracing potential domestic tax reforms and economic releases reflecting mostly positive indicators toward the end of the month. The Federal Reserve also announced plans to taper bond purchases, indicating confidence in the economic recovery. Small cap stocks outperformed their larger counterparts by a wide margin and energy stocks made notable gains as the price of oil rallied. Unfortunately, September ushered in an active hurricane season, as multiple storms caused significant damage in Florida and in Puerto Rico. Despite the devastation and uncertain economic impact wrought by these storms, investor optimism remained elevated and safe-haven assets like U.S. Treasuries sold off.
Through the first week of September, U.S. Treasuries extended a rally that began in early July. On September 7th, the 10-year Treasury yield fell 6 bps to 2.06%—its lowest level since just before the U.S. presidential election in November 2016. The factors that initially put downward pressure on yields were varied and included disappointing inflation reports, dovish rhetoric from a number of Fed officials, and rising geopolitical tensions that led to a flight to safety.
Treasury yields began to reverse course and trend upward as details about Republican tax reform efforts were released. At the CNBC Delivering Alpha conference on September 12, Treasury Secretary Steven Mnuchin discussed some aspects of tax reform, emphasizing his belief that it would be completed by year-end and that retroactive application of the tax cut to January 1, 2017 was under consideration.
Prior to the release of the tax reform framework, the Federal Reserve met and held policy rates steady. However, the Federal Open Market Committee (FOMC) announced on September 20th—as we alluded to in our recent paper Fed Balance Sheet Normalization—that the process to reduce its holdings of Treasury and agency mortgage-backed securities debt would begin in October 2017. While this news did not trigger a noticeable immediate yield increase, it likely made investors reconsider the potential for a higher term premium.
The “Big 6” released its long-awaited tax proposal at the end of the month. The proposal provides only a framework, and details still need to be hashed out by the Senate Finance and the House Ways & Means Committees. However, the proposal calls for a number of changes, including lowering tax rates for corporations and for small business pass-through entities, reducing the number of individual tax rate brackets, repealing the alternative minimum tax, and eliminating the estate tax.
As investors started to digest the tax reform proposal, economic data was released—from manufacturing data to the final revision for second-quarter GDP—that was better than expected. As a result, the reflation trade once again took hold and cumulatively drove the 10-year Treasury yield up 20 bps to end the month at 2.3%. Long-dated U.S. Treasuries fell 2.2% in total return terms as sentiment became more optimistic.
In this environment, U.S. equity markets rallied with notable patterns emerging, such as small caps beating large caps and cyclicals outpacing defensive names. The Russell 2000 Index gained 6.2% for the month compared the 2.8% and 2.1% returns of the Russell Midcap and Russell 1000 Indexes, respectively.
The largest driver of small cap outperformance was renewed investor optimism for tax reform. Small cap companies tend to be more domestically oriented; therefore, they typically benefit disproportionally from lower U.S. tax rates. When the outline of the Republican tax plan was announced on September 27th, small cap stocks rallied 1.9% compared to only 0.4% advances for the mid and large cap stocks, respectively.
From a sector perspective, eight of the 11 GICS sectors advanced during the month. The three sectors that posted drawdowns were defensive segments of the market, namely utilities (−2.4%), real estate (−0.7%), and consumer staples (−0.7%). Consumer staples was negative for idiosyncratic reasons, while utilities and real estate—each of which are typically purchased by income-seeking investors—sold off due in part to higher Treasury yields. Conversely, financial stocks benefited from rising yields because they typically offer better prospects for income, either through higher yields on loans or higher interest income from fixed income investments. As a result, financial stocks rose 5.4% during the month with financials the second-best-performing sector. Financials trailed only energy stocks, which rose 10.4% due to a rebound in crude oil prices. Small cap energy companies, which are typically more leveraged to oil price movements, handily beat their large cap counterparts (+17.1% vs. +10.1%). Energy commodity prices rose 4.9%, led by a 9.4% gain in crude oil (WTI), which ended the month at $51.67/barrel. U.S. shale producers have significantly reduced their cost structure in recent periods, primarily due to rapid advances in efficiencies implemented in their horizontal drilling operations. Many are currently profitable at less than $50/barrel oil and $3/bcf gas prices (varies by basin and play).
The crude oil rally during the month was driven in part by strong global demand data, as European and North American consumption increased in concert with a rebound in economic growth in those regions, and as other regions appeared to ramp-up strategic stockpiling. During the month, the International Energy Agency revised its global demand growth forecasts from 1.5 million to 1.6 million barrels/day in 2017. Higher crude prices were supported by data showing U.S. oil rig counts declined for three straight weeks and U.S. crude production was down, while numerous U.S. producers announced plans to reduce capital expenditures budgets for the rest of the year. Further, expectations increased that Organization of the Petroleum Exporting Countries will agree to extend current production cuts set to expire in March 2018 until the end of the year.
Hurricane Harvey had a significant impact on Texas, forcing 20 refineries to partially or completely shut down and prompting a spike in gasoline prices (+43.5%) at the end of August. This was a short-term disruption, as most refineries resumed operations by the latter half of September, increasing refined product supply as well as demand for domestic crude. Gasoline prices subsequently returned to pre-storm levels.