2018 Q1 Quarterly Report – 4th Quarter Review

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US Economic Commentary

GDP growth for Q2 and Q3 were both at or above 3%, marking the first time this has occurred since Q1 of 2015. This economic strength is part of the rationale used by the Federal Open Market Committee (FOMC) to raise its benchmark interest rate by 0.25% to the 1.25%-1.50% range, which it announced after its meeting on December 13th. The Federal Reserve also continues to shrink its $4.5 trillion portfolio of assets it amassed after the financial crisis, removing some liquidity from the marketplace.

The Federal Reserve further elaborated on reasons for hiking its key rate stating that the labor market continued to strengthen, economic activity has been rising at a solid pace, and the unemployment rate has been declining. Looking forward, on the day of Janet Yellen’s final news conference as the Chair of the central bank, the Fed announced that the economy is on track to expand at 2.5% and unemployment is expected to dip to 3.9% in 2018. The 2.5% GDP forecast is an increase from September forecast of 2.1%. Here at Hanlon we believe that a 2018 GDP growth rate closer to 3% is in the cards for the US if tax reform has the desired effect of spurring businesses to increase capital expenditures.

Emphasizing the Federal Reserve’s rosy assessment, Janet Yellen at her news conference told reporters, “Now, the U.S. economy is performing well.” Yellen went on to say, “There’s less to lose sleep about now than has been true for quite some time.” While being optimistic about the direction the U.S. economy was moving, Yellen did mention one regret about her tenure. Despite years of near-zero interest rates, inflation remains below the Federal Reserve’s 2% target. The Fed’s current forecast anticipates inflation will end 2017 at around 1.7% before rising to 1.9% by year-end 2018.

Inflation has been one of the metrics that the Federal Reserve has been monitoring as a green light for pushing short-term rates higher, but rising inflation has yet to materialize. Nevertheless, the strength of the U.S. economy has trumped the tepid inflation readings and given the Fed the ammunition it needed to hike rates at its December meeting. The Federal Reserve is not without dissenters. Minneapolis Federal Reserve Bank President Neel Kashkari, who has dissented against rate hikes three times this past year, on December 19th reiterated his view that hiking rates should wait for signs of stronger inflation.

The FOMC December two-day meeting was Janet Yellen’s last before the imminent change in leadership. Yellen, a Democrat, is stepping down in February when Chairman nominee Jerome Powell, a Republican, assumes power. Powell will most likely keep in place the interest rate policy pursued during Yellen’s tenure. The forecast released by the FOMC at the end of its December meeting projects quarter-point hikes three times in 2018 and two times in 2019, according to the Federal Open Market Committee dot plot, shown on the next page. The FOMC elected not to change its estimate of a 2.7% federal funds rate for year-end 2019. However, the estimate for the rate at the end of 2020 was increased to 3.1% from 2.9%.

Everyone should be reminded that the Fed’s own forecasting of the interest rate it controls is poor at best. They have time and again forecasted incorrectly during the last 9 years, with interest rates consistently ending up much lower than the Fed has projected. We shall see if this pattern holds in 2018. We believe two, not three rate increases are more likely, and instead the Fed will increase the pace of their balance sheet liquidation.

FOMC 2017 - 2020 Forecast

The Federal Reserve’s ambitious plans for raising short-term interest rates have caused some concerns about impeding economic growth. We do not feel these concerns are anything to worry about at this juncture. With the consistent 3%+ GDP growth, brisk jobs growth, and robust readings from most other economic indicators such as manufacturing and housing, the economy is strong. Tax Reform legislation was just signed into law, which should help spur consumers and businesses, releasing the animal spirits that have been so lacking in the US economy during this now 8.5-year-old recovery. Regulations are also being relaxed. Each of these factors will help give the economy a boost, so it seems rather unlikely that a recession is on the horizon, despite the prolonged length of the current economic recovery.

While the FOMC hiked its key interest rate, the European Central Bank (ECB) and its President, Mario Draghi, kept monetary policy unchanged at its December 14th meeting. “The Governing Council expects the key ECB interest rates to remain at their present levels for an extended period, and well past the horizon of the net asset purchases”, the ECB said in a statement following a meeting in Frankfurt, Germany. The central bank confirmed its plan to extend its quantitative easing program into the new year, but with lower monthly purchases. In October, the ECB had announced a reduction in the level of its monthly purchases from 60 billion euros ($72 billion dollars) to 30 billion euros ($36 billion dollars).

The ECB is ready to increase asset purchases, if the economy should stumble. “If the outlook becomes less favorable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the APP (asset purchase program) in terms of size and/or duration,” the ECB said after its December meeting.

Nevertheless, the ECB remains optimistic on the Eurozone’s economic prospects. At its December meeting, it revised its GDP forecasts to 2.4% for 2017 and 2.3% for 2018. This is an increase from the last forecast in September when GDP was expected to grow by 2.2% in 2017 and only by 1.8% in 2018. As is the case in the US, inflation remains elusive in the Eurozone, but other indicators suggest the economy is firing on all cylinders.

So as far as monetary policy goes, both here in the US and abroad, all appears to be going well, with no surprises recently or on the horizon. This should bode well for equity and fixed income markets in 2018.

Market Commentary

TThe S&P 500 index has been in a strong uptrend since the end of August, and this rally has continued through the 4th quarter. As the S&P 500 index rallied sharply higher during the quarter, it has set many new all-time highs. The pace of this 4th quarter rally accelerated in the middle of November as passage of the Tax Reform legislation became more assured, as we can see in the chart below.

S&P 500 Large Cap Index

For the 4th quarter, US Large Caps (as represented by the S&P 500 Index) gained 6.64%, outperforming US Mid-Caps (as represented by the S&P 400 ETF ticker MDY) which gained 6.25%. US Small-Caps (as represented by the S&P 600 ETF ticker SLY) followed up returning 4.07%. All US equity sectors were positive for the quarter. Consumer Discretionary (SPDR ETF ticker XLY, 9.93%) finished first beating Technology (SPDR ETF ticker XLK, 8.61%) as the best performing sector, while the Financial sector (SPDR ETF ticker XLF, 8.43%) came in third.

As we entered the 4th quarter, West Texas Intermediate Crude (WTIC) rallied throughout the month of October breaking above the critical $55 level. As we moved into November and December WTIC became range-bound between $55 and $59. But West Texas Intermediate Crude (WTIC) surprised us at the end of December by breaking out of its trading range and above the $60 mark, closing out the quarter up 16.93%.

High yield debt as represented by Merrill Lynch High Yield Master II Index ended relatively flat, up 0.41%, for the 4th quarter. Investors were a bit spooked by a November pullback in high yield bonds, but the underlying data still reflects extremely low default rates, and high yield recovered quickly from the selloff.

After leading US markets for most of the year, International markets trailed in the 4th quarter but still turned in a respectable performance. Emerging markets (as represented by the MSCI Emerging Markets ETF ticker EEM) rose in the 4th quarter, up 6.76%. Meanwhile, Developed International markets (as represented by the MSCI EAFE ETF ticker EFA) ended the quarter up by 3.76%.

Hanlon Tactical Portfolio Commentary

Entering the 4th quarter, our tactical equity allocations were fully exposed to all S&P 500 equity sectors except for this year’s first half laggard, Energy. A rebound in oil prices in early November renewed confidence in the beleaguered sector and led to us scaling up to full market weight in energy-related equities. The equity portion of our tactical models end the year fully invested, with allocations to Small-Caps, Mid-Caps, and all sectors of the S&P 500 Large-Cap index.

Our tactical allocation to fixed income funds was fully invested to begin the final quarter of the year, as high yield instruments continued to grind higher backed by strong fundamentals. Early November news of a failed merger between Sprint and T-Mobile amid doubts for a tax bill compromise caused selling in the Communications and Biotech sectors. This caused yield spreads over U.S. Treasuries to spike abruptly as investors reduced high yield bond exposure, since those sectors are a significant percentage of the US high yield bond market.

To insulate investors from a more significant down-side move, we slightly reduced our exposure to high yield funds in November, but remained near fully invested in the Hanlon Tactical Managed Income Strategy, as quick sell-offs in 2017 have been followed by immediate rebounds, and this time was no different. We know that this will not always be the case and will remain vigilant for any change in fundamental credit quality and deterioration in market sentiment. But for now, things remain positive.

Hanlon All-Weather Portfolio Commentary

Entering the 4th quarter, our tactical equity allocations were fully exposed to all S&P 500 equity sectors except for this year’s first half laggard, Energy. A rebound in oil prices in early November renewed confidence in the beleaguered sector and led to us scaling up to full market weight in energy-related equities. The equity portion of our tactical models end the year fully invested, with allocations to Small-Caps, Mid-Caps, and all sectors of the S&P 500 Large-Cap index.

Our tactical allocation to fixed income funds was fully invested to begin the final quarter of the year, as high yield instruments continued to grind higher backed by strong fundamentals. Early November news of a failed merger between Sprint and T-Mobile amid doubts for a tax bill compromise caused selling in the Communications and Biotech sectors. This caused yield spreads over U.S. Treasuries to spike abruptly as investors reduced high yield bond exposure, since those sectors are a significant percentage of the US high yield bond market.

To insulate investors from a more significant down-side move, we slightly reduced our exposure to high yield funds in November, but remained near fully invested in the Hanlon Tactical Managed Income Strategy, as quick sell-offs in 2017 have been followed by immediate rebounds, and this time was no different. We know that this will not always be the case and will remain vigilant for any change in fundamental credit quality and deterioration in market sentiment. But for now, things remain positive.


The information contained herein should not be construed as personalized investment advice and are not intended as buy or sell recommendations of any securities. Past performance is not a guarantee of future results. There is no guarantee that the views and opinions expressed in this Quarterly Report will come to pass. Investing in the equity and fixed income markets involves the risk of gains and losses. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses, or sales charges. The use of a Financial Advisor does not eliminate risks associated with investing. Consider the investment objectives risks, charges, and expenses carefully before investing. Information presented herein is subject to change without notice. Hanlon has experienced periods of underperformance in the past and may also in the future. Hanlon is an SEC registered investment adviser with its principal place of business in the State of New Jersey. Hanlon is in compliance with the current federal and state registration requirements imposed upon registered investment advisers. Hanlon may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This Quarterly Report is limited to the dissemination of general information pertaining to its investment advisory services and is not suitable for everyone. Any subsequent, direct communication by Hanlon with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about Hanlon, including fees, services, and registration status, send for our disclosure document as set forth on Form ADV using the “disclosures & privacy” link atwww.hanlon.com or visit www.adviserinfo.sec.gov. Please read the disclosure statement carefully before you invest or send money.