Q1-2018 Market Review

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One month into the new year, it seemed as though markets were lining up for another torrid quarter of stock market
performance; 2018 saw the biggest January gain since 1997. Market participants continued to digest another dose of
impressive quarterly earnings, the profit-enhancing impact of the Tax and Jobs Act, and a host of other positive economic
data in the U.S. and abroad. Likewise, across global bond markets, global sovereign yields rose with expectations of
monetary policy normalization by major central banks (the BOJ and ECB in particular), while corporate credit markets
outperformed given the positive global economic environment. However, much changed during the first week of February;
a sharp correction in global markets accompanied a spike in volatility, seemingly triggered by an accumulation of data that
reflected a shift in investors’ inflation expectations. The S&P 500 Index posted its first monthly loss (-3.7%) and largest
weekly decline (more than 10%) since January 2016, while the CBOE Volatility Index soared to its highest level since
August 2015. Volatility was exacerbated by anxiety about overly optimistic sentiment, de-risking on the part of systematic
investors, and accelerating wage growth. Other noteworthy events and activity on the economic and political fronts
included: a new and larger than anticipated spending bill in the U.S.; talk of tariffs and fear of potential trade wars; volatility
within the MLP sector following changes in tax treatment by FERC; further deterioration of relations between Russia and
U.S.; a more hawkish tone by global Central Banks (Fed and ECB, notably); and continuing changes within the Trump
Administration’s cabinet, as Veteran Affairs Secretary David Shulkin, Secretary of State Rex Tillerson, and the National
Economic Council Director Gary Cohn all vacated key offices during the quarter.

Despite the market gyrations experienced during parts of the third quarter of 2017, U.S. economic data continued to
support the view of a relatively healthy, steadily growing economy. Fourth quarter GDP in the U.S. was revised upward by
40 bps, from 2.5% to 2.9%, and the unemployment rate sunk further to 4.1%—the lowest since 2000. Inflation notched
higher but has still remained surprisingly low given the length of the current economic expansion and the degree of
tightness in labor markets. Estimates for Personal and Disposable Personal Income both increased by 0.4% in February.
On the corporate earnings front, the market appears to anticipate another year of strong EPS growth (~20% according to
February IBES estimates), due in some part to the recent tax cuts. The National Association of Realtors’ March report
offered more supportive data: existing home sales bounced back in February after two straight months of declines, with
sales now 1.1% above a year ago. Souring the mostly good news through the first three months, President Trump signed
a memorandum targeting up to $60 billion in Chinese goods with tariffs over what his administration says is
misappropriation of U.S. intellectual property, in addition to tariffs on steel and aluminum imports. Additional headwinds
included expectations of continued rate hikes (two to three by year end), popular companies drawing the ire from the
administration (e.g., Facebook, Amazon, Tesla), and continued political tensions with Russia and North Korea.

Overseas, economic activity across the euro zone remained solid throughout the first quarter, though stock market
performance was weak in local currency terms. Euro area GDP growth continued to hover above 2%, unemployment still
trended lower (8.6% as of January 2018), and credit growth continued to expand while inflation remained manageable at
just over 1% as of February. However, lingering political risks remain in place, including uncertainty around Italy’s ability to
manage coalition talks as well as ongoing Brexit-related negotiations between the U.K. and European Union. In Japan,
labor markets continued to tighten, wage growth modestly ticked up, and inflation remained tempered. Many market
participants expect a GDP boost from 2020 Tokyo Olympics-related spending in the coming quarters. In China, where the
government continues to target growth of around 6.5% with a somewhat tighter fiscal stance, the market remained
focused on the country’s ability to balance much-needed supply-side reform (including an effort to reduce excess capacity
in certain segments of the economy and debt levels) without disturbing continued growth. Growing trade-related tensions
between the U.S., China and other global trade partners is a key issue to monitor in the near term.

Equity Markets
Volatility returned to the equity markets in February and March, spurred by an unexpected uptick in wage gains,
geopolitical tensions, and the looming threat of a trade war. The S&P 500 Index saw six days of movements greater than
2% during the quarter versus zero 2% swings in all of 2017. The Index fell 0.8%, its first quarterly loss since 2015. This
modest loss belied volatile intra-quarter results where the S&P 500 reached a record high on January 26, then fell about
8% to close the quarter. Volatility, as measured by the VIX, spiked 116% on Feb 5 when the market sank 4%, marking the
biggest jump ever recorded—albeit from historically low levels. In this environment, performance across styles and
sectors was mixed. Growth continued to outperform value (R1000 Growth: +1.4% R1000V: -2.8%) across the
capitalization spectrum. Small caps outperformed large in both the value and growth spaces. With respect to sectors,
Consumer Staples and Telecommunications both fell over 7% for the quarter while Consumer Discretionary and
Technology posted gains of more than 3%. Amazon (+24%) and Netflix (+54%) were key drivers in Consumer
Discretionary. Amazon and Microsoft were the top contributors in the quarter and added a meaningful 73 bps to the total
return of the S&P 500.

Meanwhile, developed non-U.S. equity market returns were helped by U.S. dollar weakness. The dollar has been hurt by
growing worries over a trade war with China as well as signs that rates may be poised to rise in other countries as global
economies improve. The yen was the best performing currency among developed markets, hitting a 17-month high as
worries over trade policy spurred demand for the safe-haven currency. In local terms, Japan’s equity benchmark fell
nearly 6%, but the strength of the yen brought returns in U.S. dollar terms to +0.8%. Likewise, Brexit woes sank the local
U.K. market (-8%) but the pound’s appreciation versus the dollar offset a good portion of the loss for U.S. investors (-4%).
Overall, the MSCI EAFE fell 4.3% in local terms, but only lost 1.5% in USD terms. Emerging markets performed relatively
well (+1.4%), though there was wide dispersion among individual countries: Poland and India fell roughly 8%, China
posted a modest gain (+ 1.8%), and Russia and India were up 9% and 12%, respectively).

Fixed Income Markets
Through the first two months of the first quarter, the 10-year U.S. Treasury yield marched steadily higher on the heels of
positive economic data, only to fall through March as equity market weakness and concerns over a looming trade war
pushed yields lower. The new Fed Chair, Jerome Powell, announced his first (widely expected) rate hike in March, raising
the Fed Funds rate to 1.50 – 1.75%. Investors are projecting another two hikes this year, and three to four more in 2019.
The 10-year U.S. Treasury yield climbed to a peak of nearly 3% during the quarter before closing at 2.74%, 34 bps higher
than at year-end. Two-year U.S. Treasury yields rose nearly 40 bps to their highest level since 2008, closing the quarter at
2.27%. The Bloomberg Barclays U.S. Aggregate Index fell 1.5%, with corporate and securitized sectors underperforming
Treasuries for the first time in many quarters. High yield corporates suffered outflows and the Bloomberg Barclays High
Yield Index fell 0.9%. The S&P/LSTA Leveraged Loan 100 Index benefited from higher rates and rose 1.4%. Conversely,
Developed non-U.S. fixed income market returns were also buoyed by U.S. dollar weakness. Generally, currency
movements drove global fixed income returns more than interest rate changes in the first quarter, as seen by the return
differential in the hedged and unhedged versions of the Bloomberg Barclays Global Aggregate Index (-0.1% and +1.4%,
respectively). Credit underperformed government bonds and local currency emerging market debt was a top performing
asset class in the first quarter (JPM GBI-EM Global Diversified Index: +4.4%). U.S. dollar-denominated emerging market
debt did not perform as well (JPM Global Diversified Index: -1.7%) as spreads widened in sympathy with the broader risk-off
environment. Finally, municipal bonds underperformed Treasuries in the first quarter in spite of shrinking supply and
continued inflows to the sector. As a result, the ratio of the yield of AAA rated 10-year municipals relative to the 10-year
U.S. Treasury climbed to 89% as of quarter-end, up from 81% at year-end 2017. The Bloomberg Barclays Municipal Bond
Index lost 1.1% and the shorter duration 1-10 Year Blend fell 0.7%.

Real Assets
Commodities were among the top-performing major asset classes in the first quarter of 2018 as strong grain and crude-oil
prices offset weak livestock and base metal performance. Despite the strength of Energy commodities (+4.8% for the
Energy component of the GSCI), energy-related equities (S&P Energy sector) were down nearly 6% in the first quarter.
Across other sub-sectors, agriculture was the largest contributor during the quarter, led by corn, soybeans, and wheat.
Meanwhile, precious and industrial metals were about flat, but with wide dispersion (steel was up 33% on strong demand,
while palladium, copper, and aluminum were down between -8% and -12%). Both listed infrastructure and real estate
suffered negative returns (DJ-Brookfield Global Infrastructure Index: -5.3%, MSCI U.S. REIT Index: -8.4%) throughout the
quarter as higher yields and prospects of more rate hikes ahead weighed on these and other rate-sensitive assets. The
midstream infrastructure space felt a double whammy (Alerian MLP Index: -11.1%) from rate hike concerns and a
negative ruling by FERC on March 14, which led to a widespread sell-off across the sector. Meanwhile, TIPS
outperformed nominal Treasuries in the first quarter, with the Bloomberg Barclays U.S. TIPS Index returning -0.8%.

Closing Thoughts
Reflecting on these last three months, the environment and general mood in the market appear to have shifted to a more
cautious state. The broader, macro-oriented stories on which we and many other investors are watching closely include
elevated tensions between the U.S. and other, key global trade partners (China chief among them), the pace of rises in
both domestic and global interest rates and inflation, the return of equity volatility, currency trends (i.e. continued USD
weakening, yen appreciation) as well as further policy normalization by global central banks. While doing so, we continue
to suggest that investors temper return expectations, maintain a long-term perspective, and adhere to prudent asset
allocation with appropriate levels of diversification.

Source: The Advisory Group & Callan

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