April 3, 2018

Highlights:

  • Global equity markets closed down less than 1% for the first quarter. Emerging markets led all regions while Europe lagged. 
  • The beginning of the quarter saw a euphoric start for global equities as investors celebrated the passage of the Republican tax plan that lowered the tax burden for U.S. corporations as well as optimism over capital spending plans. 
  • However, the market regime abruptly shifted following the January employment release at month-end.  Investors were spooked over the rising wages component that sparked initial inflation fears which saw the 10-Year Treasury Yield rise as high as 2.95% from 2.40% at the beginning of the year before settling down to 2.75% at quarter-end.  TIPs/nominal Treasury spreads are now pricing in 2% long-term inflation. 
  • At the end of January, we argued that investors had front-loaded about half their annual performance with the strong January performance.  That assumed no change to the underlying risk regime which abruptly shifted following the January employment release at month-end.
  • February saw a major unwind of the so-called short volatility trade following the January employment release.  Investors betting on tight risk premium pricing and the continuance of low volatility were caught off guard.  Those shorting the S&P VIX via exchange-traded portfolios lost most of their investment.
  • Global markets did recover from the initial bout of selling in early February 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. 
  • In March, more signs of market stress emerged as a key corporate funding signal (LIBOR-OIS spread) rose to levels not seen since 2009.  At first there were concerns of another dollar funding crisis within the banking system, but the widening LIBOR-OIS spread can be partly attributed to the Republican tax plan that resulted in lower demand for short-term corporate paper from global companies. 
  • However, the higher LIBOR-OIS spread spilled over into the credit markets that saw wider spreads in investment grade and high yield credit.  This combined with heightened market volatility, Trump trade war rhetoric, and a Fed resolved to remove its implied ‘put’ to support the markets resulted in the quarter-end sell-off. 
  • When the dust settled, U.S. large cap growth emerged as the winning style for the quarter, although its key sectors, U.S. technology and consumer discretionary stocks came under pressure at quarter-end. 
  • The removal of the Fed Put along with an elevated interest rate environment and uncertainty arising over fiscal and trade deficits have produced a new risk regime resulting in higher risk premiums being demand by investors.  
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