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Markets in Motion - New Year's Rally, Better Late Than Never

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Markets in Motion - New Year's Rally, Better Late Than Never

New Year’s Rally, Better Late Than Never

Santa was late this year, and the rally we experienced after the Christmas Eve lows has been incredibly strong. Even more impressive than the 10% S&P 500 rally has been the huge surge in credit, where spreads have narrowed dramatically over the last two weeks. Bonds, leverage loans and energy MLP’s have all had big moves upward, along with stocks and crude oil. The tailwinds for the sharp bounce in global risk markets from massively oversold conditions were a weaker US dollar, lower interest rates, and perhaps most importantly, a 180-degree shift in tone from the Federal Reserve (see chart).

2019-01-chart-1

Financial markets were punished in December, capping their worst 3-month stretch since Q4 of 2008. Since our last Markets in Motion, we have been delivering a calming message during our conversions centered around our constructive macro thesis and a view that the “panic” extremes witnessed in conditions like sentiment and money flows were flashing that a significant risk bounce was imminent. In January, we have been recapping these “panic” conditions and communicated that we used the sharp rebound in risk markets and our performance to raise cash.

The performance divergence indicates a significant change in perception. While we continue to be constructive on the economy, financial markets are still showing uncertainty. To set a portfolio course going forward, we want to make sure our optimistic economic thesis is valid, so our research efforts are rigorously ongoing. If we continue to see positive data, we then must determine if and when the markets will care. We feel the best prudent course of action is to trim our tilts towards a slightly more conservative approach versus our benchmark, even if we are confident about our fundamental outlook.

2019-01-chart-2For risk assets, we are biased to think the foundation is still solid enough to avoid significant downside: US GDP > 2%, a repricing of Fed expectations, capitulation and panic money flow, sentiment readings coming into 2019 and an undemanding multiple. Granted, that is not the intoxicating backdrop for a year like 2013 or 2017, but also not the ingredients for a proper bear market.

The conditions we witnessed in December point to higher market levels over intermediate and long-term timeframes, but we also think a retest (new lows with positive divergences) is possible in Q1 2019.

The above view is implicitly short at least two “puts” which we will be keeping a very close eye on:

  1. The US economy doesn’t slip into recession in the next 12 months
  2. The Fed isn’t making a genuine policy error

Two biggies after we have just witnessed the largest drawdown of the post-crisis era. In addition, we are somber about the reality that the next phase of the cycle is apt to look very different from recent years. Central Banks dynamics/policy constraints, a clear deceleration in growth and escalating political/geopolitical risks are conspiring to create an exceedingly difficult investing climate.

At some point, something has to give—either US growth proves to be durable and serves as ballast or, the markets are correctly ahead of the data, and things are inflecting in a major way. We are biased to go with the former but will not sit complacently and completely dismiss the warnings delivered by financial markets in 2018.

All of the above narratives are pointing us to a NEUTRAL positioning around our highest quality global equities positions and HIGH cash levels coming out of our January meeting.

Portfolio Positioning

2019-01-chart-3

  • Increasing our exposure to Cash Equivalents: After a 10% bounce in the S&P 500 and what we believe are “extreme” oversold conditions, high cash levels are warranted.
  • 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. Thus, we continue to avoid long duration fixed income in our portfolios.
  • Consolidating our exposure to three US equity sectors/factors: Quality, Technology, Health Care: Quality equities possess pricing power, exhibit strong profitability, and have additional sustainable competitive advantages which allow businesses to remain viable over time. We feel this holding is prudent in the 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. Aging demographics and strong corporate balance sheets in the health care sector should provide tailwinds for the industry – its defensive nature also acts as an important asset allocation tool.
  • Increasing exposure to Emerging Market equities: The fundamental picture remains strong and the most important risk to emerging markets—a big Chinese growth slowdown or collapse in its currency—is unlikely. We continue to believe that these risks are now mainly contained, or largely priced in which should bode well for equity markets.
  • Adding exposure to Developed Market (ex-US) equities: We consolidated our international equity exposure to remove a majority of our tilts and underweight positioning. Our two remaining tilts are moderately overweight emerging markets and underweight Eurozone equities.
  • Increasing our position in Energy MLPs. The oil rout that began in October appears to have run its course, which will be a tailwind for energy infrastructure.

GTA Portfolio Changes
Since October 31, 20181

We exited our position in US Small-Cap Value equities and added to US Health Care. We reduced our US equity exposure and consolidated into a more favorable sector.

We added to our position in Emerging Market equities. The most important risk to emerging markets—a big Chinese growth slowdown or collapse in its currency—is unlikely. We are still watching the effects the tariff and trade wars with China could have on Asia, but our overall outlook is a little more positive, and we believe that these risks are now mainly contained, or largely priced in which should bode well for equity markets.

We exited our position in Small-Cap Japanese equities. Japan’s monetary policy remains loose, but its earnings outlook is murkier. Our Japanese equity stance is now neutral. We lowered our allocation to fixed income – exiting our positions in 7-10 Year Treasuries and High Yield Bonds. We entered 7-10 Year Treasuries to take advantage of a  counter-trend rally, in an otherwise cyclical bear market for bonds, given oversold, lop-sided technical conditions and bearish sentiment. That has played out, and we continue to believe government bond yields will grind higher. High Yield had been an important allocation during this current economic expansion. But, with tight credit spreads and potential default risk rising, the asset class no longer offers an attractive risk premium.

We initiated a position in Energy MLPs. Oil seems to have found a bottom, which will be a tailwind for energy infrastructure.

Recent Portfolio Changes

We exited our positions in Medical Devices and Value, as well as trimmed our position in Technology. We initiated a position in Quality factor equities. We consolidated exposure in our US equity book and moved to neutral positioning vs. the benchmark. Quality equities hold financially strong companies with solid balance sheets and stable earnings – which is prudent in the later stages of a credit cycle.

We exited our position in Global Consumer Staples, added to Emerging Market equities and initiated a position in Developed Market Equities (ex-US). We added and consolidated exposure in our International equity allocations. Our portfolio remains underweight Eurozone equities, and it is now overweight Emerging Market equities.

We exited our position in Mortgage REITs and added to our position in Energy MLPs. We are concentrating our alternative exposure around our convicted view in Energy MLPs.

We increased our position to cash equivalents. After a 10% bounce for the S&P 500 from “extreme” oversold conditions, high cash levels are warranted.


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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 1/8/2019. Individual account allocations may differ slightly from model allocations.
2Some Emerging Markets allocation overlaps with regional allocations.
3Excludes GTA’s 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% FTSE 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 FTSE 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% FTSE 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 FTSE 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% FTSE 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 FTSE 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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