February 2019 In Review

Stocks followed their best January in more than 30 years with more gains in February. The S&P 500 Index’s 3.2% gain for the month brought its two-month return to 11.5%, its best start since 1991. The Dow Jones Industrial Average (Dow) and Nasdaq also delivered solid gains with advances of 4% and 3.6% on a total return basis (including dividends).

The drivers for January’s stock market gains remained in place in February. First and foremost, U.S. trade negotiators made further progress in talks with China. A Fed on hold, the end of the government shutdown (though expected), and a strong jobs report in early February also helped buoy sentiment, offsetting a mixed earnings season, weak December retail sales data, and weaker growth in Europe.

U.S. and China negotiations continued to progress. Talks at the end of January and throughout February reportedly yielded progress on Chinese commitments to purchase U.S. goods, greater market access, intellectual property theft prevention, and eliminating forced technology transfers. Progress was sufficient for President Trump to remove the threat to impose tariffs on an additional $200 billion of Chinese goods if a deal were not reached by March 1. As March began, questions about enforcement of an eventual deal lingered, but confidence in an agreement remained high, and President Trump and President Xi are expected to meet in late March or shortly thereafter.

Fed communications during February reinforced the market’s expectation that rates would likely remain unchanged throughout 2019, although resolution of trade tensions could catalyze enough economic growth and potentially bring a late-year hike. In his congressional testimony, Fed Chair Jerome Powell reiterated the Fed’s favorable economic outlook while acknowledging challenges to growth, including an economic slowdown in major foreign economies, Brexit uncertainty, and U.S.-China trade relations.

Small caps outperformed their large cap counterparts for the second straight month, benefiting from relatively greater economic and market sensitivity. The Russell 2000 Index returned 5.2% during the month, above the 3.4% and 4.3% returns for the large cap Russell 1000 and Russell Midcap indexes.

Growth outpaced value for the second straight month, as the Russell 1000 Growth Index returned 3.6%, slightly ahead of the 3.2% return for the Russell 1000 Value Index. Growth stocks have generally performed better during rising markets in recent years and have outperformed during most of the nearly 10-year old bull market. In February, the growth style benefited from outperformance of technology and industrials stocks, while the value style was weighed down by underperformance of the financials sector.

Technology topped the February sector leaderboard with a 6.9% return, followed closely by industrials, which returned 6.4%. Software strength propelled technology while industrials got a boost from the aerospace and defense and capital goods industry groups. The strong performance by these industries, which are among the most sensitive to trade with China, reflects the market’s increasing optimism toward a deal. Sector laggards included consumer discretionary and communication services, with notable weakness in the media, retail, and telecom services industry groups.

Neither international developed market nor emerging market (EM) equities were able to keep up with U.S. equities during February. The MSCI EAFE Index returned 2.6% for the month, while the MSCI EM Index managed only a 0.2% gain. More evidence of weakening economic growth in Europe and Japan and a firm U.S. dollar weighed on developed international equity indexes. At the country level, markets in Hong Kong, Switzerland, and France performed best (based on MSCI country equity indexes). Japan and Germany lagged, with the latter narrowly avoiding recession during the fourth quarter of 2018. February’s Brexit news was well received and propelled the U.K. equity market 3.4% higher during the month.

Progress on U.S.-China trade talks, prospects for fiscal stimulus, and the Fed’s pause in hiking rates all should have helped support EM equities in February, as they did in January. However, the MSCI EM Index managed only a marginal gain. China wasn’t the problem, as its equity market rallied 3.5%. Secondary EM countries such as Brazil, South Korea, and South Africa all suffered losses and dragged the overall index down. Although oil rallied, commodities markets were not strong enough broadly to offset EM headwinds.

Treasury prices jumped, while yields dropped for a third straight month in January amid the Fed’s decision to leave rates unchanged and commitment to patience in tightening policy any further. The 10-year Treasury yield slid 6 basis points (bps) to end the month at 2.63%, after falling to a 12-month low of 2.55% on January 3. The yield curve flattened further, as the spread between the 2-year and 10-year yields fell to 17 bps (.17%).

All nine fixed-income classes we track rose in January (as shown in the Fixed Income Performance Table). Lower-quality fixed income generally outperformed higher-quality bonds as investors’ risk appetites resurged after a rocky end to 2018. High-yield corporate bonds rose 4.5%, the sector’s best month since October 2011, while bank loans gained 3.6%. Investment-grade corporate bonds, represented by the Bloomberg Barclays U.S. Aggregate Credit Index, rose 2.2%, while the broad Bloomberg Barclays U.S. Aggregate Bond Index increased 1.1%. Mortgage-backed securities climbed 0.8%, and Treasury prices rose 0.5%. EM debt climbed 4.4% in its best month since July 2012.

During January, long/short equity strategies performed in line with long-only benchmarks on a risk-adjusted basis, as the HFRX Equity Hedge gained 3.9% compared to the S&P 500 8% return. This represented an up-capture ratio of 48.6%, above the industry’s beta of approximately 0.40, which indicates managers’ added alpha. From a sector perspective, an overweight to industrials (11.4% during January) supported performance. The smaller performance gap between value (Russell 1000 Value Index, up 7.8%) and growth sectors (Russell 1000 Growth Index, up 9%) was also notable, as the recent outperformance of value by growth-related stocks has been a consistent headwind facing many strategies. 

The HFRX Merger Arbitrage Index gained 1% during January. After receiving the proceeds of several large transactions at the end of 2018, managers have been slowly adding capital to new investments. Additionally, the U.S. government shutdown caused delays in the timetable of regulatory approvals, which has added additional uncertainty surrounding the pace of deal closings this year. Overall, the merger and acquisitions environment remains healthy; however, we’re aware of the potential weakening impact of U.S. tax reform and ongoing trade conversations between the United States and China.

In the macro space, after a tremendous end to 2018, short equity exposure weighed on trend-following strategies, as the HFRX Systematic Diversified Index declined 2.6% during the month. Long bond exposure helped offset losses to a small extent, however, short equity exposure across most global indexes was difficult to overcome during such a broad-based rally. Relative value strategies continue to perform well on a risk-adjusted basis, as the HFRX Relative Value and HFRX Convertible Arbitrage Indexes gained 2.5% and 1.7%, respectively. 

The liquid real asset categories we track were all solidly positive in January, reversing December’s declines. Master limited partnerships (MLP) and U.S. real estate investment trusts (REITs) delivered the biggest gains, while commodities lagged with a more modest advance.