2017 Q2 Quarterly Report – 1st Quarter Review

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US Economic Commentary

The 1st quarter started with the US stock market consolidating its gains during most of the month of January. After the January 20th presidential inauguration, the market resumed its upward trend as investors looked forward to the new administration’s planned elimination of over-regulation, initiating huge infrastructure projects, building up the US military establishment, and the restructuring of both the personal and corporate tax code, including lowering tax rates.

Investors were particularly looking forward to revised tax legislation as it could lead to the repatriation of US corporate profits held overseas that to date, have avoided high US corporate income taxes. There is roughly $2.4 trillion dollars that could come back into the US, given the proper tax incentives. This could spur US economic growth and provide some buying power entering the US stock market. All these expectations helped push US equity valuations to higher levels by the end of February.

As we moved into March, the US market enthusiasm paused as doubts began to surface about the administration’s ability to pass healthcare legislation. An additional headwind appeared for the US equity market as good economic data throughout the first quarter led to increasing expectations that the Federal Open Market Committee (FOMC or “the Fed”) would hike interest rates. Prior to March, investors believed the Fed would wait until June, but sentiment quickly shifted after data and comments from various Fed Members. In March, the Fed interest rate hike became reality, adding another challenge to weigh upon US markets.

The FOMC 2017 Forecasts table on the next page shows each Fed Board member’s prediction for where interest rates will end in 2017. We can see that at the March meeting (the far right), the dots have moved higher versus the December 2016 meeting, indicating that members expect increasing rates going forward.

The expectation of rising rates helped to temper economic growth forecasts and hurt interest rate sensitive areas. Lowered economic growth expectations, due partially to expected higher rates, and partly to questions over the viability of infrastructure legislation after the Trump healthcare law did not receive enough support to pass, lowered expectations for demand of commodities. This in turn should keep a lid on inflation expectations.

The third look at GDP growth for the fourth quarter showed that the economy expanded at a 2.1% pace to close out 2016. The average GDP growth rate since this recovery began in June 2009 has been 2.0%, approximately 1% per year lower than prior economic recoveries. Trump’s plan is to increase that GDP rate. Economic data indicates that first-quarter GDP growth will be a bit lower than originally expected. A continued rise in consumer confidence in March, however, may signal that consumer spending might begin to pick up in the months ahead.

FOMC 2017 Forcasts

Data from the Federal Reserve. Commentary and opinions are those of Hanlon Investment Management.

While consumer spending is off to a slow start this year, measures of consumer confidence continued to signal optimism. Consumer assessment of both current and future economic conditions remains high. The Conference Board’s measure of confidence climbed to the highest level since December 2000. More important for real consumer spending, the consumer’s outlook for income growth and job growth both posted rather dramatic improvements over the past two months. This should translate into stronger real consumer spending growth beyond the first quarter.

While current quarter consumer spending will likely be soft, housing market data has begun to move to the upside. Pending home sales climbed 5.5% in February. While new home construction bounced, real residential investment is expected to expand at a 10.5% pace in Q1, a good sign!

Global Economic Commentary

The strong momentum in the global economy in Q4 has carried over to this year, per available economic data for Q1. Global GDP is set to expand 2.8% year-on-year in Q1, matching Q4’s result. The recovery, however, appears to be uneven as developed countries are leading most of this year’s upswing in global growth, with robust domestic demand buttressing growth in the Euro area. Europe is benefiting from strong household spending due to a declining unemployment rate and an accommodative monetary policy.

China’s start to the year surprised market analysts on the upside, as a booming real estate market and stronger global growth are boosting manufacturing output and investment. In fact, Asian economies are benefiting the most from strengthening global trade, with exports in several countries expanding at multi-year highs at the start of the year. Latin America is gradually exiting recession, but growth remains sluggish as the region is highly vulnerable to external shocks, and structural weaknesses limit any sharp economic recovery. Finally, most oil-exporting economies are not yet feeling the effect of higher crude prices as some had to cut oil production in compliance with November’s OPEC deal.

Despite the promising start to the year, several events are threatening the nascent global economic recovery. UK Prime Minister Theresa May invoked Article 50 on March 29th, triggering the long-awaited Brexit process and sending the European Union and the United Kingdom into uncharted waters. Free movement of people between the UK and the rest of the EU, as well as the trade deal, will be the cornerstones of the negotiation. The election cycle in Europe will also be in the spotlight as the emergence of anti-EU parties is threatening the stability of the European Union. Despite the defeat of right-wing populist Geert Wilders and his Party for Freedom (PVV) in the March 15th elections in the Netherlands, France is now heading to the ballot box on April 23rd to choose a new president, with Marine Le Pen almost certain to make the second round of voting. European elections will provide headlines leading to market movements in the coming quarter.

Market and Portfolio Commentary

For most of the quarter our tactical research recommended to remain fully invested in both US equities and, for the fixed portions of our models, in high yield bonds. The expectation of rising rates negatively impacted bond prices early in the quarter. The worry of rising interest rates hurt investment grade bonds and contributed to making March a particularly difficult month in the high yield space. High yields must contend with rising interest rates and the price of oil, which had a sharp sell-off during the quarter. Oil slumped the most in more than a year in early March after government data showed US supply increasing as domestic oil stockpiles hit record high levels.

High yield debt saw the biggest outflows since December 2014 in the middle of March, as investors’ concern about high prices for speculative debt and falling energy prices pressured prices. Investors withdrew $5.7 billion in the week ended March 15th, per EPFT Global. The outflows in high yield corporate debt followed a previously strong uptrend, driven by reduced expectations for defaults backed by strong economic data. For these reasons, we lowered our high yield bond exposure in March to protect capital, moving assets to money markets.

Hanlon Tactical Models, 2017 Q1 Model Performance, net of fees

Hanlon Tactical Models

But fortunately, the end of March was kinder to both equities and high yields than the beginning. High yields and US domestic equities rallied sharply on the 2:00 pm FOMC meeting announcement on March 15th, and this provided enough confidence for us to reallocate a portion of our tactical models back into high yield bonds. High yields were also helped by oil holding at its 200-day moving average and beginning to advance from the lows, as we can see in the following chart.

$WTIC Chart

Chart courtesy of Stockcharts.com. Commentary and opinions are those of Hanlon Investment Management.

The Hanlon tactical research moved to a protective stance by raising cash during the sell-off in high yield bonds. With the improving investment environment and outlook for high yields, we’ve begun committing capital to the high yield bond space once again.

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