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Markets In Motion - Trade Winds and Tailwinds

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Markets In Motion - Trade Winds and Tailwinds

Macro Backdrop

Trade Winds and Tailwinds

A core behavioral finance principle is to heavily discount pundits who call for specific markets to rise or fall based on their “unique” forecasting abilities or capability to divine data differently from everyone. It’s great fun to rewind YouTube videos of these folks who represent the vast majority of guests on Bloomberg and CNBC to see how poorly many humans predict the financial future. Despite the fact that the long-term direction of equity markets is upward sloping, the “experts” and their TV producers know that investors are drawn to things that scare them. 2018-060-mapThey stay afraid through most of a post-crash risk markets expansion, only to emerge bravely at the end; “buy high and sell low.” This vicious cycle is in play now as we try to navigate the end of a long, nearly 10-year period of global credit expansion. In our data-driven, non-emotional view, there are still plenty of opportunities provided by the tailwind of cheap credit (the global 10-year sovereign yield is still around 1.50%) and plenty of liquidity.

But there are headwinds, the most violent emanating from US trade policy rhetoric (see “Self-Inflicted Wounds,” our April 2018 Markets in Motion™). Global supply chains depend on vast networks of multilateral trade agreements. It is a pro-business and conservative, free-market fact that expanding trade is best done by becoming more competitive through investments in productivity, education, and technology and not restrictive tariffs. One of the best examples of this is airplanes, where the US is an important exporter. Major parts of the most technologically sophisticated large commercial airplane, the Boeing Dreamliner, come from no fewer than 10 trade partner countries, and airplanes are the top-ranked economic export driver in no fewer than 17 states.

dreamlinerEconomics 101 teaches that if US trade protectionism spreads, the result, particularly for a country dominated by price-sensitive consumers, is an economic slowdown or higher inflation and interest rates. This political/fiscal trend is worth watching, and we will make adjustments in our Global Tactical portfolios to profit from government mistakes or mitigate risk if those mistakes lead to outright economic slowdowns.

We made two changes this month in our asset allocation. First, we lowered exposure to emerging markets debt and equity positions. It’s not a big move, as these two asset classes are still “high conviction” positions in Global Tactical Allocation (GTA). But economic slowdowns, once underway, can move faster through emerging economies than developed ones, hence the note of caution this month. We continue to own “value” equities in the US, Europe, Japan, and greater Asia and we added to our US “high quality” position as well. If we are correct in our thinking that we are in the later innings of a credit expansion (a global slowdown appears to be likely within the next two years), then quality and relative price metrics will matter. Emerging market equities, Euro region equities, and Japanese equities are all attractively priced relative to most US equity sectors. And of course this month we have ramped up our watch on the “trade war” rhetoric closely. Right now, our 8% cash level in GTA remains as a repositioning posture rather than a defensive measure; we are looking for better entry points in some sectors & regions that we like. We continue to monitor fixed income exposure and as we have warned all year, is by far the hardest of the three main asset classes.

We are positioned in our Global Tactical portfolios to capture the upside of the later innings of a long-running global credit expansion. We are constantly looking for evidence that will cause us to reposition away from our more aggressive positions. Global Tactical Allocation is not just the ability to “go anywhere,” it’s being able to pivot when the facts change.

Portfolio Positioning

2018-060chart-1

2018-060chart-2We have recently decreased our equity exposure in our portfolios in favor of a tactical cash position. While we remain constructive on equities, a better entry point may present itself in the near future.

  • We are avoiding foreign currency fixed income to benefit from higher US dollar interest rates. We expect spreads between the US dollar and foreign currency interest rates to narrow, and therefore will benefit by concentrating all of our fixed income exposure in US dollar-denominated holdings.
  • We are avoiding long duration fixed income in our portfolios. Interest rates may continue to rise as economic growth remains strong, inflation reemerges, and global central banks step away from the “extraordinary measures” they employed during the financial crisis.
  • We have exposure to three US equity sectors/factors: value, technology, energy. Lower valuation equities provide us with a defensive holding, which we feel is prudent in later stages of the US credit cycle. The pace of disruption of old industries by new products and processes has continued to accelerate, and technology gives us exposure to this process of creative destruction. Global energy market fundamentals have continued to improve, and we expect inflation to increase over the course of 2018.
  • We have exposure to both broad European and hedged-currency Eurozone equities. Following several important elections, the political environment in Europe is much less uncertain. This should enable further structural reforms which will support European assets. We have hedged some of our exposure to the Euro, as we expect it to weaken vs. the dollar.
  • We have exposure to large-cap Japanese equities. They are supported by favorable valuations, accelerating economic and earnings growth, the Bank of Japan’s ongoing aggressive monetary easing, and global money managers’ underweight exposure. We have not hedged any of our Yen exposure.
  • We have significant exposure to emerging market equities, which benefit from positive capital inflows and represent attractive relative value. We expect global capital flows to remain supportive and emerging market equities to continue to “catch up” after years of underperformance. Asia, in particular, represents an excellent opportunity.
  • We hold a position in global agriculture equities. Increasing inflationary pressures and underweight investor positioning should support the industry in 2018.
  • We hold positions in broad commodities and gold. We expect inflation to rise in 2018, which will support commodity markets.

Recent GTA Portfolio Changes

  • We trimmed our allocations in emerging market bonds and equities to add to our US “value” position. These two asset classes are still “high conviction” positions in GTA. But economic slowdowns, once underway, can move faster through emerging economies than developed ones, hence the note of caution this month.

GTA Portfolio Changes
Since 2/28/20181

2018-060chart-3We have owned US financials since August 2016, expecting the sector to benefit from rising US interest rates, and have been well-rewarded for the allocation. However, the yield curve has flattened too severely in the US to support the allocation, so we have exited the position.

In the two months following the German federal election in September, which yielded a disappointing result, we exited our two European equity positions. Reforms to promote growth and stability in Europe are more difficult to achieve without a strong German government, and European equities lagged the rest of the world in the months after. Following the agreement between Angela Merkel’s CDU and the center-left SPD parties to form a coalition government, as well as an acceptable result to March’s Italian election, we have initiated two positions in European equities. We hold a position in broad European equities and a position in currency-hedged Eurozone equities. This gives us broad exposure to Europe, which hedges our exposure to the Euro, which we expect to weaken against the dollar.

As we enter the later stages of the US credit cycle, it is prudent to begin building a position in defensive US equities, so we have initiated a position in an ETF targeting companies with low valuations.

We have exited our tactical positions in US aerospace & defense and small-cap Japanese equities to consolidate our late cycle US thesis, as well as our relative valuation bias in Europe, Japan, and Emerging Markets versus the US.


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Best regards,

John A. Forlines III

Chief Investment Officer
Investment Committee Member

W.E. Donoghue Team

Global Tactical Allocation Strategies
Investment Management

1Information as of 6/8/2018. Individual account allocations may differ slightly from model allocations.
2Some Emerging Markets allocation overlaps with regional allocations.
3Excludes GTA’s 15% alternative, cash, and cash equivalent positions.
4Contains international exposure

Past performance is no guarantee of future results. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. Returns can vary dramatically in separately managed accounts as such factors as point of entry, style range and varying execution costs at different broker/dealers can play a role. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Forecasts are inherently limited and should not be relied upon as an indicator of future results. There is no guarantee that these investment strategies will work under all market conditions, and each advisor should evaluate their ability to invest client funds for the long-term, especially during periods of downturn in the market. Some products/services may not be offered at certain broker/dealer firms.

The investment descriptions and other information contained in this Markets in Motion are based on data calculated by W.E. Donoghue & Co., LLC (W.E. Donoghue) and other sources including Morningstar Direct. This summary does not constitute an offer to sell or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities. This report should be read in conjunction with W.E. Donoghue’s Form ADV Part 2A and Client Service Agreement, all of which should be requested and carefully reviewed prior to investing.

The Global Tactical Allocation Composite (“Composite”) was created on July 1, 2009. The Global Tactical Conservative Composite (“Composite”) was created on February 1, 2014. The Global Tactical Income Composite (“Composite”) was created on February 1, 2014. The Global Tactical Growth Composite (“Composite”) was created on February 1, 2015. W.E. Donoghue acquired 100% of the assets of JFG on December 29, 2017. Composite returns are calculated gross of investment management fees, net of investment trading expenses and underlying fund costs but do not reflect the effect of income taxes on the investment returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. Performance reflects the reinvestment of dividends, income, and capital appreciation. Composite returns are calculated monthly, which are described in greater detail in the firm’s Form ADV Part 2A, using the time-weighted total rate of return methodology. Monthly returns are geometrically linked to calculate quarterly and annual returns. As fees are deducted quarterly, the compounding effect will be to increase or decrease their impact by an amount directly related to gross portfolio performance, and dependent on direction, magnitude, and order of returns. For example, on a portfolio with a 2% annual fee, if gross performance is 10%, and performance is equally distributed across all four quarters, the compounding effect of the fees will result in a net annual performance of 7.81%. No leverage, derivatives, or shorts are used. Past performance is not indicative of future results. There can be no assurance that the purchase of the securities in this portfolio will be profitable, either individually or in the aggregate, or that such purchases will be more profitable than alternative investments. Investment in any Global Tactical Portfolio, or any other investment or investment strategy involves risk, including the loss of principal; and there is no guarantee that investment in W.E. Donoghue’s Portfolios or any other investment strategy will be profitable for a client’s or prospective client’s portfolio. Investments in W.E. Donoghue’s Portfolios, or any other investment or investment strategy, are not deposits of a bank, savings, and loan or credit union; are not issued by, guaranteed by, or obligations of a bank, savings, and loan, or credit union; and are not insured or guaranteed by the FDIC, SIPC, NCUSIF or any other agency. The composite strategy provides diversified exposure to various asset classes such as equities, fixed income, and alternatives utilizing liquid exchange-traded products. Diversification does not guarantee a profit or protect against a loss.

The Blended Benchmark Growth is a benchmark comprised of 65% MSCI ACWI, 25% Citi World Government Bond Index, and 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Growth returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark's constituents is available upon request.

The Blended Benchmark Moderate is a benchmark comprised of 50% MSCI ACWI, 40% Citi World Government Bond Index, and 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Moderate returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark’s constituents is available upon request.

The Blended Benchmark Conservative is a benchmark comprised of 35% MSCI ACWI, 55% Citi World Government Bond Index, and 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Moderate returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark’s constituents is available upon request.

The Blended Benchmark Income is a benchmark comprised of 90% Bloomberg Barclays Global Aggregate Bond Index, and 10% MSCI ACWI, rebalanced monthly. The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. There are four regional aggregate benchmarks that largely comprise the Global Aggregate Index: the US Aggregate (USD300mn), the Pan-European Aggregate, the Asian-Pacific Aggregate, and the Canadian Aggregate Indices. The Global Aggregate Index also includes Eurodollar, Euro-Yen, and 144A Index-eligible securities, and debt from five local currency markets not tracked by the regional aggregate benchmarks (CLP, MXN, ZAR, ILS and TRY). A component of the Multiverse Index, the Global Aggregate Index was created in 2000, with index history backfilled to January 1, 1990. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Blended Benchmark Income returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark's constituents is available upon request.

The information contained in this presentation related to JAForlines represents the strategies and performance achieved prior to the acquisition. W.E. Donoghue & Co., LLC is a registered investment advisor with the United States Securities and Exchange Commission in accordance with the Investment Advisors Act of 1940.

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