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Markets in Motion - Matter of Fact(ors)

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Markets in Motion - Matter of Fact(ors)

2019-06-chart-1We noted last month to expect and plan for volatility and opportunity in markets through 2020. Rarely is there instant gratification in this business, but that’s exactly what we got in May. A deeper dive into our positioning illustrates the importance of adjusting to credit and market cycles using factors—which are simply the “drivers” for sector and individual company performance. There are some overlaps, but there’s only a handful that matter in equities: Quality, Value, Momentum, and Size are the main ones. In addition, there is one more in our arsenal as tactical allocation managers, and that is Volatility. The chart to the right provides a framework for the entire cycle; the trick is to remember that cycles are generally different each go around and that sometimes factors don’t work like they are supposed to. Hence our insistence on monthly portfolio meetings, where we have a chance to assess what’s working/not working and why/why not.

Bad News is Good News?

In factor investing, it’s important to look at the current interest rate and liquidity environment as a precursor to factor positioning. 2019-06-chart-2As of June 2019, Interest rates have plunged as concerns about trade wars and their effect on growth led traders to press bets for multiple Fed cuts this year. Fed Fund Futures are pricing in an 86% probability of a July cut—contrast that to December 2018, where the Federal Reserve was discussing multiple rate hikes for 2019! Such a radical shift in such a short time, implies that Minimum Volatility strategies should be part of a position—more short-term bonds, minimum volatility equity ETFs. Simultaneously, with the recent correction in equity markets, the S&P 500’s dividend yield and the yield on the 10-year Treasury Note have fully converged. This makes equities significantly more attractive relative to risk-free rates. If the Fed is going to support growth with lower policy rates without a major economic slowdown, equities should outperform. But what kind, what further factors should be considered?

There are two major tail risks — Trade Wars & Recession.

In answering this important question, until a trade resolution is reached, equity markets will continue to be volatile and are seemingly at the mercy of the latest headline (or Tweet). As noted above, we have incorporated some “anti-volatility” tools within our Portfolios. The far larger risk—recession—have increased on the margin. The inversion of the 3-month T-Bills vs. 10-year Treasury yield curve and the amount of time it’s been inverted has been alarming. But an inverted yield curve by itself is not alone a sure sign of recession. Significantly, the 2-year Treasury vs. 10-year Treasury yield curve has actually steepened in recent days as the market prices in rate cuts this year and credit conditions are accommodating. There’s also the matter of the 2020 US Presidential election, where the current Administration will want to forestall a recession, both through subtle and not-so subtle pressure on the Fed and by being seeking compromises on trade. There are two further factors that we are currently employing in this environment—a strong conviction on Quality equities, which work well in either a sharp uptrend in equity prices or pre-recessive market weakness; and Momentum stocks, which will work extremely well if the odds of a recession prior to 2021 continue to go lower.

This month’s positioning, we increased our exposure to equities to bring our positioning to NEUTRAL, with an overweight in US equities and with some re-positioning around the factor analysis above. We will have the beginning of earnings season beginning in mid-July, so we will get more input on the risks discussed as well as the first look at forward 2020 earnings forecasts.

2019-06-chart-3

Recent Portfolio Changes

  • We exited our position in Foreign Large-Cap (developed ex-US) equities. With the odds now favoring an indefinite conflict between the US and China, innocent bystanders will fare worse than the two principals. The macroeconomic impact of the trade war on individual countries will depend on two factors: 1) their economies dependence on trade and 2) the policy space governments and central banks have to ease in response. The US is the least trade dependent of developed countries and has the most room to cut interest rates. Thus, we are exiting our position in favor of US equity exposure.
  • We trimmed Ultrashort Term duration exposure to add to equities. The S&P 500’s dividend yield and the yield on the 10-year Treasury Note have fully converged — stocks are “cheap” relative to bonds.
  • We initiated a position in US Momentum and added to our Quality and Minimum Volatility positions. We added and consolidated our equity exposure to focus on late-cycle factors.

Portfolio Changes
Since March 11, 20191

Fixed Income (US)

We continued to be overweight in our position to Ultrashort Maturity Bond. Huge moves in interest rates have left government bonds at extreme overbought levels — reflecting a very bearish view of economic growth. We continue to see duration as a risk and favor ultrashort duration at the expense of allocations to long-dated fixed income. We’ve trimmed this position as bonds have become “cheap” relative to equities.

We trimmed but retained our positions in Preferred Stocks. We remain convicted in our position, and believe they have a positive tailwind in place, but trimming risk at overbought levels is prudent.

Continue to avoid long duration fixed income in our portfolios: As we said earlier, we favor ultrashort duration at the expense of allocations to long-dated fixed income. Interest rates will continue to move higher leading to uninspiring total returns to duration.

Fixed Income (International)

We maintain our positions in Emerging Market Bonds. We continue to maintain Emerging Market Bonds — it’s attractive yield and the current tailwinds for emerging markets will continue to provide the diversification benefits to the portfolio but trimming risk at overbought levels is prudent.

Equity (US)

We exited our positions in Healthcare & Industrials and maintain a position in Quality Factor equities. We continued to consolidate exposure in our US equity book. 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.

Equity (International)

We maintain 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 trade war with China could have on Asia.

We maintain a position in Global Minimum Volatility equities. Equities are vulnerable to volatility over the coming months on risk of trade tension escalation or monetary policy easing disappointment. Minimum volatility equities should outperform in this environment.

Alternatives

We maintain a position in Energy MLPs. We are concentrating our alternative exposure around our convicted view in Energy MLPs. The asset class has an attractive yield and has held up well amid the most recent sell off in the barrel of oil. From here, spot oil prices are biased towards the upside - global spare capacity is too thin to absorb/respond to a loss of all output from Venezuela and Iran simultaneously.

We maintain a position in Gold. We added the precious metal as a hedge against volatility. When risk assets are trading lower, gold holds value relative to other asset classes.

 


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Please do not hesitate to contact us with any questions!
Best regards,

John A. Forlines III

Chief Investment Officer

Robert Shea

Co-Chief Investment Officer


1Information as of 6/5/2019. 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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