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Markets in Motion - The Sea Change

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Markets in Motion - The Sea Change

The Sea Change

I wanted to start this month’s Markets in Motion by reaffirming for folks that our Global Tactical Allocation (GTA) strategy is a Relative Value discipline, a core-active strategy that weighs and allocates among the three main asset classes (equity, fixed income, and alternatives). We then further weigh the sectors and regions where we deploy our factor-centric ETF positions. Our “style” is a conservative yet opportunistic form of credit macro, which has worked extremely well as a diversified strategy since the late 1940’s.

mim-2018-09-img-1After a tremendous 2017, where we achieved what we targeted as the right balance between risk and reward in our flagship GTA strategy, like the majority of global investment managers we find ourselves at a crossroads in 2018. We always get a few things wrong in a year, and we are only a few basis points down for the year. But it feels much worse because we haven’t been rewarded for the stuff we got right, like pivoting correctly on our dollar exposure mid-year and being correct on our oil price range.

We’ve been here before though, like in Q4 2016 where our conservative approach in the run-up to the US election that hurt short-term performance. We pivoted then, believing that the 2009 credit expansion would be extended by pro-business forces in the new Administration. Like 2009, we are pivoting now. The “script” we were following for this late Credit cycle expansion was that Commodity, Emerging Market, and International exposure would follow the US-led GDP growth, and it would surge and appreciate accordingly. Most credit cycles end in a broad inflationary boom, but that doesn’t appear to be happening this time. In fact, this particular boom is more like 1992-2000 where Emerging Services, Technology, and Financial companies left the industrial complex mostly in the dust. Then, as now, US Technology is forging into a profound leadership position in the global economy, but this go around Healthcare is right beside it. This combined with strong US-centric fiscal, tax, and regulatory policy will create demand for other evolving US sectors (think smart robotics in industrial processes and AI-driven database inputs in finance and transportation as just a few examples).

What HAS changed is that the Relative Value calculus favors these sectors, even after two years of outstanding performance. Fortunately, we have always included Technology and Healthcare as subjects for research and long-term positioning in our portfolios. In short, Value and Growth factors are converging in the US, and in the span of six months, they have deteriorated almost everywhere else. First up this year was the EU, where we eliminated exposure in April. The EU has massive political issues and uncertainty affecting growth. Second, we pared Asia-centric emerging markets because of another possible China reset similar to 2015. There’s above-US base GDP growth in a number of Asian countries, but it can’t be sustained unless China does more to stimulate its economy than merely devalue its currency.

mim-2018-09-img-2Finally, to repeat, we’ve been here before. We’ve been at this a long time, and we trust our process. We believe in the GTA methodology, its inherent flexibility, and its ability to deliver solid returns across all Credit cycles. This month, we added to our US exposures in both Technology and Healthcare, added a position in US small-cap value (giving us broader exposures to currency-neutral Industrial and Financials), eliminated integrated oil equities while maintaining our high-yielding hedge that keeps some energy exposure, halved our remaining Emerging Market Bond and Equity positions, and in alternatives we eliminated Gold in favor of high yielding mortgage exposure. The theme is that in the absence of a commodity boom, we want to get paid cash dividends for any remaining inflation hedges.

mim-2018-09-img-3

  • mim-2018-09-img-4We are avoiding foreign currency fixed income to benefit from higher US dollar interest rates. We continue to expect spreads between the US dollar and foreign currency interest rates to narrow, and therefore we believe we 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 maintain a short-term position to US 7-10 Year Treasuries to take advantage of extreme investor positioning and to provide some hedge if fiscal and policy storms get worse.
  • We have exposure to four US equity sectors/factors: Value, Small-Cap Value, Technology, Healthcare & Medical Devices. Lower valuation equities provide us with a defensive holding, which we feel is prudent in the later stages of the US credit cycle. Small-Cap Value gives us broader exposures to currency-neutral industrial and financials. 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. Aging demographics and strong corporate balance sheets in the healthcare sector should provide tailwinds for medical devices.
  • We have neutral exposure to Emerging Market Equities, which is a departure from our going-in 2018 forecast. A major concern is that China’s economy continues to struggle and that the Chinese are far more preoccupied with tariff and trade wars than in stimulating their economy.
  • We have exposure to Small-Cap Japanese equities. They are supported by favorable valuations, accelerating earnings growth, an extraordinarily cheap currency, and the Bank of Japan’s ongoing aggressive monetary easing.
  • Given our revised outlook on inflation, which we think will be modest for the balance of 2018, we have cut some exposure to commodity markets and eliminated our Gold position.
  • We hold a position in Mortgage REITs. In the absence of a commodity boom, we want to get paid cash dividends for any remaining inflation hedges. Our two major alternatives positions are both high yielding.

GTA Portfolio Changes
Since June 30, 20181

We exited our positions in Europe and Large-Cap Japan. Economic slowdowns are a big deal this late in the cycle. The ECB signaling on Italy, the BREXIT turmoil, and Germany’s new political headaches have all led us to believe there are no short-term upside catalysts for Euro equity exposure. Japan’s negative GDP print in the first quarter has led us to be cautious around Japan’s exporter economy.

We initiated a position in US 7-10 Year Treasuries. Investor positioning has gotten extreme, so we have initiated a trade to take advantage. We do not see long-term prospects, but it has compelling value and provides some hedge if fiscal and policy storms get worse.

We’ve added to our position in US Value Equities. 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.

Recent Portfolio Changes

This month, we added to our positions in Technology and Healthcare equities. As we’ve mentioned, they both have growth and value factors, and we believe will do well for the remainder of the current credit cycle.

We initiated a position in US Small-Cap Value Equities. This position underscores our relative value thesis, has low sensitivity to trade tensions, and has strong tailwinds from corporate tax policy.

We initiated a position in Mortgage REITs. In the absence of a commodity boom, Mortgage REITs offer an attractive yield even in a gradual rising rate environment.

We trimmed our position in Emerging Market equities and bonds. Despite our long-term Relative Value preference in emerging markets, we acknowledge the impact of trade tensions and have trimmed our exposure to neutral.

We exited our position in Energy Equities. Energy equities have de-coupled from the barrel of oil and no longer warrant an overweight position in the portfolio.

We exited our position in Gold and trimmed our position in Broad Commodities. We’ve kept some exposure to oil as noted above but have eliminated Gold. The US dollar and the slowly rising US rate environment (due to the outperformance of US economy) implies that Gold will continue to underperform in the latter stages of the credit expansion.


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Please do not hesitate to contact us with any questions!
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 8/15/2018. 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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