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Commentaries

PMC Weekly Review – November 2, 2018

A Macro View: October Monthly Recap

The domestic equity markets fell sharply in October amidst high volatility, with big swings day to day, and in some cases, intraday. After
leading the way up over the last six months, the growth indices led the way down in the reversal, driven by steep losses in the largest
technology names, such as Amazon and Netflix, both down roughly 20%. The pullback in the month appears to be a reassessment of risk and
some of the lofty valuations reached by these technology companies. Some of the earnings reports were very strong, some mixed (beating
expectations this quarter but reducing estimates going forward), and some missed entirely, but all were dragged down in the final two weeks
of the month. It is still unclear whether this is simply a reaction to stretched valuations, with the pullback providing a new entry point for
investors and more modest but positive price targets for growthier companies, or the beginning of a more significant shift, whereby investors
put more emphasis on the safety of companies with low price/earnings (P/E) and price/book (P/B) ratios and higher dividends.

Large caps, as represented by the Russell 1000 Index, were down 7.1% and represented the best return for the month. The Russell 2000 Index
was down 10.9%, as smaller company fundamentals, like earnings growth, have failed to keep pace with their larger cap counterparts for some
time and have raised investor concern. Smaller company leverage also is at an all-time high, with much of it in floating rate rather than fixed
rate debt during an extended period of rising interest rates. As noted, the value versions of the indices outperformed in October, down 2.0%-
2.5% less than the core indices. The Bloomberg Commodity Index as a whole was down 2.2%, and the Dow Jones U.S. Select REIT Index dropped
2.6% for the month.

The international equity markets sold off during October, as a variety of economic news released during the month pointed to a broader
economic slowdown outside of the US. The European Union (EU) reported positive but slowing growth during the third quarter at 0.6%,
decelerating from the 1.8% rate in the second quarter and well behind the US, whose economy expanded at a 3.5% rate. This marked the
weakest reading in the EU since 2013, when the continent was in the grip of a banking crisis. Uncertainty around trade policy between China
and the US seemed to have a knock-on effect in the eurozone, as exports slowed significantly during the first eight months of the year. The US
dollar continued to appreciate during the month, but its effect on non-US equities was muted relative to the prior nine months of the year. In a
reversal, dollar strength caused more problems in developed markets than in emerging markets. European markets were down 7.6%, led by
Italy, which declined 9.4% amidst its budget impasse struggles with the ECB. The UK and Spain, among the best performers in the region, were
down just 6.8%. Japan was slightly worse, down 8.5%, whereas the remainder of Asia was down nearly 11%.
Emerging markets equities also fell, slumping 8.7% for the month as a whole, but with very different results by region. China reported its
weakest quarter of economic growth since 2009: 6.5%, down from 6.8% during the first half of the year. The economic deceleration was caused
by several factors, including weakness in industrial production and faltering retail sales, and led to the Chinese equity market dropping nearly
11.5%. But optimism around Brazil’s presidential election led to a massive rebound in the equity markets, which were up 17.8% in October and
3.4% for the year.

Domestic fixed income markets posted losses in all but the shortest maturities in October, as interest rates rose and spreads widened in every
segment of the market. Yields on short- and intermediate-term Treasurys ended the month three to six basis points higher, but were nearly 15
basis points higher early in the month. The real shift in the yield curve came in the long end, as the yield on the 30-year Treasury Bond ended
the month 15 basis points higher, slightly below the high for the month. Asset backed spreads, including agency MBS and CMBS, widened by
roughly six basis points, and corporate credit spreads widened by more than ten basis points. The widening in credit spreads was driven by
investors’ risk appetite, rising rates, and falling equity prices, which tend to make investors more conservative, rather than any significant
change in economic fundamentals or supply/demand technicals. US economic data continued to show enough strength to keep the Federal
Reserve (the Fed) on its current path for another rate hike in December. The Aggregate Index was down 79 basis points in October, led by
Treasurys (48 basis points) and agency MBS (63 basis points). Investment grade corporate bonds declined 1.5%, and noninvestment grade
bonds were down 1.6%. Short-maturity indices (those with three-year-or-shorter maximum maturities), posted gains between ten and 20 basis
points for the month. Bank loans, with their floating interest rates, dodged the worst of rate hikes for the month, but widening credit spreads
left the S&P/LSTA Leveraged Loan Index down three basis points.

Short- and intermediate-term municipal yields and spreads also increased during the month, but at a slightly quicker pace than Treasurys with
similar maturities. The ten-year muni-to-Treasury ratio climbed to 88%, the cheapest level in six months. Retail municipal bond funds have had
outflows every week this month, totaling well above $2 billion. However, the outflows have been concentrated in long maturity and high yield
funds, and demand is still strong, particularly for larger, well-known municipalities, as credit fundamentals remain solid for the market as a
whole. October is on pace to be the top issuance month of the year so far at just under $40 billion, but year-to-date issuance is still off 10%-
15% from the same period last year. The broad municipal index was down 45 basis points in October, whereas the intermediate (1-15 year)
index was down 28 basis points. Like its taxable counterpart, the 1-3 year index was up a modest eight basis points. In addition to closely
watching the Fed, the municipal markets are paying close attention to the upcoming midterm elections. Although the consensus today is that
the Democrats will take control of the House and Republicans will retain control of the Senate, a significantly different outcome could affect
the municipal market

Major developed markets sovereign bonds also were down in October, with the Global Treasury ex-US Index down slightly more than
1.0%. Credit spreads widened in most markets as well, resulting in the Bloomberg Barclays Global Aggregate ex-USD Index falling 1.4% on
an unhedged basis. European high yield bonds also fell, declining by 1.3%. Developed markets currencies have faltered as US interest
rates have risen, with the Japanese yen (0.5%) the only positive performer. The euro (-2.2%) and the British pound (-2.5%) were down
through October 31. After recouping some of their year-to-date losses in September, emerging markets bonds posted negative returns in
October, as the US dollar strengthened relative to a basket of major trading partners’ currencies. Both government and corporate debt
are down, though government debt’s 1.68% decline is greater than corporates’ 0.33%. High yield government and corporate bonds also
have outperformed their investment grade counterparts. After being buffeted by crises, the Argentinian peso (12.5%), Turkish lira
(10.6%), and Brazilian real (9.5) have rebounded to be October’s best-performing currencies, though they are all significantly weaker
relative to the USD than at the start of the year.

Nathan Behan, CFA, CAIA
SVP, Investment Research

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