Kai W. Hong, CFA
Managing Partner & Chief Investment Strategist
The year began largely as the prior one had ended – with generally sanguine views on economic fundamentals leading to rationalization of asset valuations. The boost of a significant fiscal stimulus in the form of US tax cuts also helped to stoke animal spirits in the markets. Technology stocks continued to be major beneficiaries of positive sentiment and momentum, helping propel many US indexes to record highs. After raising rates as expected in December, US Fed policymakers appeared in agreement as to the need for more increases but divided in the number of them. Sharpening the debate were signs of a nascent pick-up in inflation. On the geopolitical front, a short US government shutdown had only a modest impact on markets but once again served as a reminder of the current dysfunction in US politics. As concerns over rising interest rates and some profit taking in the high-flying Technology sector emerged, the beginning of February saw an acceleration of the market decline which had begun late the prior month. Yields on benchmark 10Y US Treasuries hit a four-year high, and volatility, both implied (VIX) and observed, rose dramatically. However, the passage of another stopgap spending bill in the US along with reassuring comments from central bankers and the IMF (and some amount of FOMO) appeared to assuage investor fears, and the long-lived bull market continued its upward climb by mid-month. However, by March, while consumer confidence and employment metrics continued to be robust and overall economic conditions were largely positive, markets were unsettled by ongoing political dysfunction in the US and the threat of an escalating trade war between the US and the rest of the world. The potential impacts of tariffs on steel and aluminum may ultimately be mitigated as many of the largest exporters to the US (who also happen to be significant geopolitical allies) were eventually exempted. That left China as the main target of those and other potential tariffs. A widening data privacy controversy involving Facebook also served to rattle investor nerves a bit, particularly in the previously high-flying large cap tech sector.
After an impressive run of months with historically low volatility and scant negative results, the first quarter of 2018 saw two down months in a row. For the quarter, the US broad market Russell 3000 Index finished at -0.6%. Returns in US small cap stocks were modestly better at -0.1%. Outside of the US, performance was mixed as developed markets lagged the US while developing markets continuing their recent leadership. The MSCI World ex USA Index returned -2.0%, and the MSCI Emerging Markets Index returned +1.4%.
Market volatility spiked up during the quarter with the VIX climbing over 80% and realized volatility at multiples of the levels from the prior year. Trade volumes picked up incrementally but still remained at the lower ends of the historical range. At the factor level, Value and Yield were meaningfully negative as Momentum and Quality continued to lead. Equal-weighted portfolios underperformed market-cap weighted portfolios which, despite the late quarter reversal in large cap Tech, highlighted the ongoing narrowness of the markets. At the sector level, Technology and Consumer Discretionary were once again the best performers for the quarter, and the only positive sectors to boot. Yield and cyclical areas such as Consumer Staples, Energy, and Utilities were fairly negative.