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Market Commentary

February 2018 Market Commentary – Inflation: The Fed’s MacGuffin

Data Source: Bloomberg

Highlights:

• The wage growth component of the employment report combined with concerns over fiscal stimulus (corporate tax cuts, deficit spending proposals) drove inflation expectations higher. 
• In early February, the S&P 500 dropped 8.5% before rallying to end the month down 3.7% while the 10-Year Treasury yield rose to as high as 2.95% before settling at 2.86%. 
• The U.S. and Japan led major regions while Europe lagged.  Despite a weak dollar, international markets underperformed the U.S. this month. 
• Interest rate sensitive sectors such as utilities and REITs underperformed in February.  U.S. REITs dropped 7.3% while dropped 3.9% for the month. 
• From a style standpoint, investors continue to express their preference for growth stocks, whether measured by high momentum and/or high quality.  Interest-rate sensitive styles such as low volatility and high dividends lagged as did value. 
• The U.S. dollar also weakened versus major currencies reflecting concerns over the growing twin deficits in trade and fiscal balances.  According to Piper Jaffrey, the Bipartisan Budget Act of 2018 is more than twice as large as the previous two budgets combined and that both the budget deal and tax cuts could lead to $2 trillion deficits over the next 10 years.    
• Many market observers are pointing towards the unwinding of ‘short’ volatility strategies as the proximate cause for the sharp sell-off in global risk.  Short-term volatility indicators like the S&P VIX shot up to over 100% leading to large losses for investors that held short-volatility exchange-traded portfolios.
• In addition, trend following strategies such as those employed by commodity trading advisors (CTAs) as well as risk-parity strategies, many of which bet on the negative correlation between equities and fixed income, got caught flat-footed during the sell-off and had to readjust their positions accordingly, which fueled even more selling. 
• Global markets did recover from the initial bout of selling as the earnings outlook continues to dominate investor sentiment despite the threat of higher interest rates and global central banks’ willingness to ‘normalize’ their monetary policies. 
• Other risk appetite indicators such as credit spreads were relatively well-behaved signaling that the early-month sell-off was more technical, rather than fundamental, in nature. 
• A larger debate now concerns whether we have entered a new risk regime of higher growth and higher inflation where the historical relationship between ‘risk-on’ cyclical risk and ‘defensive’ interest-rate sensitive risk no longer holds.  If so, this has larger implications for asset allocators who have relied on the negative relationship between market ‘beta’ and fixed income ‘duration’ to help bring down the overall risks to their portfolios via asset class diversification. 

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