The latest estimate for 4th quarter US GDP was revised higher at an annualized 2.9% growth rate. So far, consensus expectations for the 1st quarter of 2018 are similar to earlier 4th quarter estimates of 2.5%, with the preliminary release coming on April 19th. Weak consumer spending and retail sales data has weighed slightly on estimates, and continues to be somewhat of a conundrum as consumer confidence has been extremely high since the Tax Cuts & Jobs Act resulted in larger net-paychecks for workers. People seem to be saving more!
An unemployment rate of 4.1% has led to the economy essentially running at full employment with a tightening labor market. Many employers are unable to find qualified candidates. This has led to increased inflation expectations caused by rising wages, and has expanded fears of an overheating economy that could threaten the nearly 9-year US expansion. When January’s employment report was released in early February, fears were substantiated when growth of average hourly earnings was reported at 2.9% and significantly above the consensus estimate. This caused many observers to postulate that the US Federal Reserve Open Market Committee (“Fed”, “FOMC”) would need to raise rates more quickly than previously planned.
At his first FOMC meeting since becoming Fed Chair, held in late March, Jerome Powell announced a 0.25% increase to the Federal Funds rate to a 1.5-1.75% range. The Fed had also indicated that members are split between another 2 or 3 increases in 2018. By raising rates and continuing the accelerated run-off of treasury and mortgage backed assets, the Fed is displaying confidence in the strength and resilience of the US economy. In its most recent statement, the Fed raised its full year GDP forecasts to 2.7% (from 2.5%) for 2018 and 2.4% (from 2.1%) for 2019.
Across the Atlantic, the European Central Bank (ECB) has kept its interest rate policy unchanged and will continue its quantitative easing program of buying €30 billion of bonds per month through September. It is unclear what the end of ECB quantitative easing will look like, but it will likely end with a gradual tapering. Although it’s possible that the program gets extended as strength in the euro currency is causing inflation below the ECB target, it appears that the ECB and President Mario Draghi are testing a more hawkish (interest rate raising) stance.
Fewer new houses being built has led to rising prices due to limited supply of single family homes in many parts of the US. High levels of consumer confidence and a strong job market have also contributed significantly to the 7.3% YoY increase in the FHFA House Price Index for the month of January. Affordability has become a growing problem, particularly at the low end of the market, and especially in parts of the western and north-western US. Rising mortgage rates have done little to dampen buyer enthusiasm in most markets, but have decreased the pace of mortgage refinancing.
President Trump has introduced import tariffs on steel, aluminum, and other products aimed at China’s “unfair trade practices”. The administration’s goal of ending China’s “dumping” of industrial metals and theft of intellectual property are unlikely to be met, but have prompted retaliation that would harm a wide range of US exports. Although the response from China has so far been limited, that is expected to change as more information is released from the White House regarding tariffs. As this positioning is widely viewed as political, there is hope that leaders from both sides can find a resolution to an impending trade war where there would only be losers.
Facebook has encountered a backlash, including its CEO Mark Zuckerberg being summoned to testify before congress, because of its handling of user data. Known as “surveillance capitalism”, users of “free” internet applications such as Facebook, Google, LinkedIn and others, have their personal information, internet navigating activities, and geographic location via mobile phone settings, all collected and shared with advertisers that pay the platforms dearly for it. Congress believes that users are not as informed as they should be about the commercial use of their private activities. In the last ten years, considerable wealth has been achieved through technology, and perhaps that speed to wealth occurred outside of consumer protection laws.
US Equities started the 1st quarter of 2018 where the previous year left off, going up. January returns went nearly parabolic as holiday season optimism and tax cuts for individuals and corporations alike promised widespread prosperity. Fear of missing out took hold as investors also expected record corporate buybacks and dividend increases from increased earnings and repatriation of overseas cash hoards. The S&P 500 Index closed at an all-time high of 2,873 on January 26th up 7.45% in less than a calendar month.
It wasn’t until the employment and consumption data indicated wage pressures that led to an immediate increase in expected inflation which caused the yield on the 10-Year Treasury note to rise from 2.69% to 2.84% in less than a week. The prospect of an overheating economy, and consequentially a more aggressive Fed in raising rates, caused stocks to sell-off in tandem with bonds. Volatility is back, as the long dormant VIX Volatility Index soared and burned last year’s popular “short volatility” trade. Markets can remain calm for only so long.
The major equity indexes, including the S&P 500, tested and found genuine support at their 200-day moving averages, but continue to look for direction as bulls and bears arm-wrestle for control of the next move. Only the technology-heavy Nasdaq 100 could find a new high after the late January surge, and led the S&P 500 and the Dow Jones Industrial Average with a 2.89% return for Q1. The more trade-war insulated US Small-Cap equities (as represented by S&P 600) returned .23% and outperformed US Large-Cap (as represented by S&P 500, -1.22%) and US Mid-Cap (as represented by S&P 400, -1.15%) by a significant margin. International equity markets were mixed, with Emerging markets (as represented by the MSCI Emerging Markets ETF ticker EEM) up 2.46%, while Developed International markets (as represented by the MSCI EAFE ETF ticker EFA) ended the quarter -.90%.
US Equity sectors were mixed with clear winners and losers for the 1st quarter. Amazon.com, Inc (ticker AMZN) helped Consumer Discretionary (SPDR ETF ticker XLY, 2.94%) edge out Technology (SPDR ETF ticker XLK, 2.62%) to lead all sectors. Incidentally, AMZN is a big reason why household retail companies in the Consumer Staples sector (SPDR ETF ticker XLP, -6.97%) lagged all other sectors including the interest rate sensitive Real-Estate sector (SPDR ETF ticker XLRE, -5.09%). A 7.48% return for the West Texas Intermediate crude oil benchmark to $64.94 per barrel was insufficient to boost the Energy sector (SPDR ETF ticker XLE, -6.05%) into the green for the quarter.
High yield debt as represented by Merrill Lynch High-Yield Master II Index ended -.92% for the 1st quarter. As yields have risen rather quickly this period weighing on bond prices, yield spreads over treasuries with equal time to maturity have not increased dramatically. This is reflective of the persistence of low default rates and solid demand in liquid credit markets, but there will be a tipping point where investors demand a higher risk premium for the relative risk.
Hanlon Tactical Portfolio Commentary
While credit risk has not materially increased for high-yield borrowers in terms of increasing default rates, investor sentiment is starting to turn on corporate bond markets in general. At some point in a rising interest rate environment, refinancing can become especially difficult for below investment grade borrowers. It was along this line of rationale that we have lessened our exposure to longer duration high-yield bond funds during the 1st quarter. Although we still like the sector long term, the near-term risk/reward is less favorable with a late-January low in spreads seemingly in the rear-view mirror.
In reducing our traditional high-yield fund exposure, we added a Senior First-Lien Floating-rate Bank Loan Fund position to reduce duration while maintaining an attractive yield. Our quantitative research has caused us to remove Long-Term Corporate Bond funds and implement allocations to Developed and Emerging Market local currency sovereign debt during the 1st quarter. We also increased our model exposure to Convertible Debt Securities that have an added component to help capture equity market upside.
The equity component of the Hanlon Tactical models started and remained fully invested throughout the first quarter. The long term bullish technical trend is still intact despite volatile gyrations in February and March. Fundamentally, valuations are still reasonable based on earnings growth and eagerness of corporations to return cash to shareholders. As always, we remain vigilant in monitoring market health when evaluating tactical opportunities and risks.
Hanlon All-Weather Portfolio Commentary
Risky assets performed poorly in general during the 1st quarter, with fixed income outperforming equity positions in Hanlon All-Weather models. Developed International sovereign debt fared particularly well with the iShares International Treasury Bond ETF (ticker IGOV) leading all holdings with a quarterly return of 3.39%. The IGOV ETF benefitted from being invested in the local currencies, which fared well compared to the struggling US dollar. Emerging Market equities outperformed US and Developed markets as iShares Core MSCI Emerging Markets ETF (ticker IEMG) returned 2.64%.
We will always do what’s in the best interest of our clients consistent with our principals of Passion, Integrity, Vision, and Care. We will continue to monitor for opportunities, look-ahead for market dangers and make corresponding defensive moves in the Tactical allocations to seek downside protection and upside participation in 2018 and beyond. For investors seeking a complete portfolio asset allocation solution, our All-Weather models are the answer. As always, we thank you for the opportunity to be of service.
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