Dear clients, friends and family:
Following is the 2018 first quarter performance for CMG’s Tactical Investment Strategies along with our thoughts on each strategy over the past quarter. Market index performance is presented at the bottom of the chart.
CMG Tactical Fixed Income Strategies
The CMG Tactical Fixed Income Strategy (“CMG FI”) returned -1.63% for the first quarter, net of fees. It was a challenging quarter for bonds as concerns over inflation and rising interest rates hurt returns across the fixed income universe. January in particular was a difficult month as treasury bonds declined significantly. The strategy was allocated to emerging market debt, high yields and convertible bonds during the month. Each of these positions outperformed other segments due to their shorter duration (lower sensitivity to interest rates) and also benefited from a tailwind that boosted hybrid fixed income assets like convertibles and high yields. Volatility in fixed income markets was further exacerbated in February as equity markets reversed their strong start to the year, impacting convertibles and high yields where those positions were spared in January. The strategy held convertibles and high yields at the start of the month before rotating into investment grade international bonds (developed) and cash. By the end of the month, the strategy rotated back into convertibles while still holding 50% of the portfolio in cash. By March, the carnage in the fixed income market subsided and the strategy generated positive returns from investment grade international bonds and convertibles, which were incidentally, the two best performing bond classes for the quarter. The strategy avoided long-term government bonds, the worst performing segment, entirely during the quarter.
The CMG Managed High Yield Bond Program (“CMG HY”) returned -1.14% for the first quarter, net of fees. The strategy began the quarter fully invested in high yields. Equity markets rose in January while fixed income markets, particularly government bonds, declined. High yields were roughly flat during the month and the strategy generated a slight loss during the month. In February, interest rates spiked and high yield bonds sold off. The effective yield on the BofAML US High Yield Master II, a widely cited tracking index of high yield bonds, jumped from 5.82% at the end of January to 6.36% on February 9. The strategy moved to a defensive cash position in the first week of February during the sell-off. The strategy remained in cash for the remainder of the first quarter. High yield bonds continued to struggle for the remainder of the quarter, suffering their biggest first quarter loss since 2008. However, they appear to have put in a short-term low around a 6.40% yield and prices have since firmed up as the effective yield has come back down to 6%.
High yield bond returns will continue to be shaped by two key dynamics this year: investors concerned with rising interest rates and the supply / demand dynamics of new issuance. High yield bond funds have seen significant outflows this year, with negative net flows for 10 out of 13 weekly periods. The two largest junk bond ETFs, JNK and HYG, have lost over $6 billion this year. While fears over interest rates have pushed investors out of funds, those same concerns have impelled issuers to be more opportunistic with new issuance. According to JP Morgan, new supply year to date is approximately 25% below the same period last year. Limited supply in the face of the sell-off helped support prices but it is likely that investors will demand better terms moving forward, particularly with respect to covenants. What has been for years a sellers’ market may have reached an inflection point – one where buyers once again have power and can dictate terms.
CMG Tactical Equity Strategies
The CMG Opportunistic All Asset Strategy (“CMG Opportunistic”), returned -1.25% for the first quarter, net of fees. The Jefferson National Tax-Deferred Variable Annuity portfolio returned -0.94% for the first quarter, net of fees. CMG Opportunistic was aggressively positioned to start the quarter as equity markets traded higher at the beginning of the year. The strategy was 98% invested in equities, the largest and most equity oriented allocation in well over a year. During January, the portfolio held positions in domestic mid and large cap equities but the majority of the portfolio was tilted to international stocks. Over 60% of the portfolio was in international equities, split roughly evenly between developed and emerging market positions. Equity markets stumbled in February on inflation concerns and rising interest rates and the strategy began reducing risk during the month as our proprietary relative strength readings favored cash (or short duration 1-3 month T-bill positions that are not inflation sensitive) over equity and traditional fixed income positions like government bonds and corporates. By the end of the month, the strategy had moved 20% into defensive positions. The strategy reduced domestic equity exposure while maintaining its international positions. The volatility continued in equity markets throughout March albeit the concerns driving market gyrations shifted from inflation and interest rates to the impact on growth of an escalating trade conflict between the U.S. and China. As a result, during March, the portfolio further reduced equity exposure to its most defensive position in several years with over 70% of the portfolio in cash and/or short duration fixed income positions. The balance of the portfolio remained invested in international equities, which held up better in March than domestic stocks.
Equity markets remain choppy and range-bound after reaching new highs this year. Our relative strength readings continue to favor risk-off assets, primarily cash, and are likely to remain there until a sustained trend in equities re-emerges. For the better part of two months, equities have taken one step forward and two steps back, painting a poor technical picture, one suggesting that short-term resistance is strengthening. Despite a challenging quarter, we are pleased with the strategy and our model’s ability to respond to the change in equity risk and move from an aggressive to a defensive position in such a short window of time. The ability to change asset allocations in response to changing market conditions is the essence of the value proposition for tactical strategies and why they play such an important and complementary role to traditional long-only portfolios. The strategy held the following allocations (individual portfolio allocations may vary) to equities, fixed income, commodities and cash at the end of January, February and March:
The CMG Tactical Equity Strategy (“CMG TE”) returned +0.38% for the first quarter, net of fees. CMG TE generated positive returns during a volatile quarter for equity markets. Overall, emerging markets outperformed developed equity markets. The strategy can have up to ten positions with half allocated to domestic equity and half to international markets, both developed and emerging. In January, the strategy generated strong returns as the rising tide in equities lifted global equities across the board. Within domestic equity allocations, the strategy held allocations to U.S. large caps with a bias towards value, small cap growth and sector allocations to consumer services, consumer discretionary and information technology. Developed international allocations were in Norway, Japan, France and Singapore while emerging market positions were invested in Thailand and South Africa. February marked a U-turn for equities with domestic equities leading the decline. The portfolio was primarily comprised of the same positions in February and as equity markets declined and relative strength waned, the strategy raised cash. By mid-month the portfolio was 40% in cash. In early March, the portfolio sold additional positions to cash, raising the balance to 80%, with no exposure to domestic markets. The strategy held only two positions for most of March, Japan and Singapore, helping to limit losses.
The CMG Beta Rotation Strategy (“Beta Rotation”) returned +1.88% for the first quarter, net of fees. Beta Rotation performed well during the quarter generating positive returns from both equities and utilities positions. The strategy is designed to enhance the role of the equities in a client portfolio by allocating fully to one of two positions based on our proprietary relative strength indicator. During periods when equity markets demonstrate a strong price trend, the strategy will allocate to the Vanguard Total Market ETF (VTI). During periods when equity market trends are not as strong, the strategy will allocate to the Vanguard Utility Sector ETF (VPU). During rare periods of negative equity market price trends, the strategy also has the ability to move to the safety of cash. January was a strong month for equities and the strategy was allocated to equities for the entire month, capture strong upside. The strategy held equities through most of February (aside from a couple of days mid-month when the portfolio moved to utilities) and into mid-March. Utilities, which are sensitive to interest rates due to their high debt loads, struggled in January and were one of the few sectors to post negative performance during an otherwise broad-based equity rally. However, as the equity markets turned negative, utilities outperformed as rates topped out and, due to their historically lower beta, was attractive to equity investors looking to lower risk but not get out of the market entirely. The strategy captured significant upside in utilities in March, helping to post positive performance during the quarter. We are particularly pleased as both the underlying instruments the strategy trades, VTI and VPU, were negative for the quarter.
The CMG Tactical Rotation Strategy (“Tactical Rotation”) returned -0.39% for the first quarter, net of fees. Tactical Rotation began the year positioned 50% to domestic equities (SPY) and 50% to commodities (PDBC). Equities and commodities performed well in the fourth quarter of last year and their momentum continued at the start of the year. The strategy had avoided commodities for most of 2016 but inflation concerns have highlighted the diversifying effects of commodity exposure, pushing commodity funds higher during the quarter, outperforming the other four asset classes. The strategy remained allocated 50% to domestic equities (SPY) and 50% to commodities (PDBC) for the entire quarter and avoided the two worst performing asset classes, bonds and REITS. REITS, in particular, had a very difficult quarter down over 8% on rising interest rates. It was the worst performing quarter for REITS since the second quarter of 2015 and the second worst quarter in four years. The strategy remained 50% allocated to commodities (PDBC) heading into April and traded out of domestic equities (SPY) and into cash for the remaining 50% of the portfolio.
The Scotia Partners Dynamic Momentum Program (“Scotia Dynamic”) returned -10.42% for the first quarter, net of fees. Scotia Dynamic began the year with a positive return in January, albeit one that was generated by sectors that were not market leaders. After a strong fourth quarter and an explosive start to the year, many sectors were overbought on a short-term to intermediate-term basis, limiting the opportunity set for the strategy. As a result, the strategy was primarily exposed to healthcare, biotech, basic materials and precious metals during January. Equity markets sold off in February and March leading to negative performance in the strategy. In early February, primary detractors from performance were biotech and technology after which point the strategy moved to a cash positions for over two weeks, one of the longest periods in recent memory. Equity market declines pushed all sectors into the red with few opportunities for positive momentum trades. In March, equities continued to struggle and the strategy faced a challenging environment in the face of several hundred basis point daily moves across most of the market. Positive contributions to performance came from positions in precious metals and electronics but were outweighed by negative performance in allocations to energy services, biotech and small caps.
Market Commentary and Outlook
It’s been a great party but as with any good soiree, the day after is time to clean up. For over a decade markets have feasted on low interest rates, accommodative fed policy and stable trade pacts. Equity markets set new highs, ample liquidity has pushed real estate back to pre-crisis highs (and beyond in many regions) and unemployment is at multi-year lows. After tax cuts passed last year and the roaring start to the year for equity markets across the world, it looked as if the party might roll on forever.
What a difference a couple of months makes. The concerns we shared in our last newsletter, rising interest rates and trade conflicts, revealed themselves during the first quarter showing that volatility and risk are alive and well. Five hundred to 1000 point swings in the Dow became daily occurrences and lead to the blow-up of volatility-based investment products that employ the “pennies in front of steamroller” investment approach. Inflation and trade war concerns knocked markets around for the better part of February and March and April is bringing more of the same. All indications point to a change in the state of mind of the market: things are going to be tougher and the technical charts are telling us we are heading into choppy waters. The upward trendline on U.S. market indices has been broken and there is now ample resistance to this market reaching new highs. Like a mountaineer attempting to summit, each failed attempt saps him of strength, lowering the prospect of reaching the peak on another attempt. It will take a lot of energy to break through and reestablish another cyclical bullish upswing in the intermediate term.
Investors found few safe havens during the market declines. Domestic and international stocks fell in tandem and few sectors were spared. Facing a headwind, fixed income allocations failed to offset equity losses in portfolios. Cash and commodities, underappreciated for years, served as bulwarks against portfolio losses and will remain critical components for asset allocators moving forward. What has, to some extent, been lost during the drama of the first quarter is the economy is doing well – not great but certainly not about to decline or go in a recession. That view, as we have recently seen, can change quickly, but it is going to take more negative data and/or news to get there. We continue to believe that rising interest rates and trade conflicts are the biggest headwinds for markets and how risks associated with them evolve will in large part determine whether markets can move higher.
An Expensive Pony
If you drive anywhere in this country, you have likely noticed our infrastructure looks a little run down – like last century run down. I know for a fact that certain roads and bridges in our area have not been touched in over 30 years. Other aspects of our infrastructure look much the same. I get it – it’s not easy. To fix 50+ years of underinvestment takes a lot of work. In fact it takes a lot more work than just cutting taxes and hoping for the best. The reality is that our country has an investment problem, public and private, and our leaders, in Congress and in the C suites have turned into one-trick ponies.
The tax cut approach has never really worked for most of America and it overshadows other good ideas that could make the economy grow, increase worker productivity and at the same time increase standards of living. Investments in education and teachers, nationwide broadband, better and more easily transferable healthcare and a real commitment to a new energy future (not doubling down on coal) are just some examples that would boost economic growth.
Corporations received a huge windfall from the tax cuts last year, and as we anticipated, rather than spurring investments or hiring, most of the windfall is going to executive bonuses, dividends and buybacks. American companies have announced $171 billion of stock buybacks, a record high for this point in the year according to Biryini Associates, and more than double the $76 billion that corporate America disclosed at the same time last year. Further, JP Morgan estimates that gross share buybacks will reach a record $800 billion in 2018, up from $530 billion in 2017.
Much like their counterparts in Congress, there is a lack of commitment to investment. While that may help short-term profitability, it ultimately sows the seeds of a more difficult economic future, one where those investments are going to be more expensive to finance. If corporate America can’t find attractive investments at a 3% ten year, what are they going to do at higher rates? If Congress can’t find a way to rebuild our country at near record low rates, what incentive will they have as the cost goes up? One of the drivers of interest rates over the quarter was the reaction to the budget deal that projects trillion dollar deficits for the foreseeable future. Combined with tax cuts, over the next ten years, we could see over 10-20% added to our national debt. If the economic growth doesn’t show up, it could be an expensive one-trick pony indeed.
The more immediate issue is that recent budget decisions have put additional upward pressure on interest rates and the headwind facing bonds blows stronger. Here are some other data points to consider as the supply of debt coming to market continues to increase and put pressure on rates:
- According to the Congressional Budget Office, the U.S. budget deficit will surpass $1 trillion by 2020, two years sooner than originally estimated.
- The U.S. budget deficit was $215 billion in February alone, the largest in six years.
- The Treasury Department, in March, auctioned its largest supplies of debt since the financial crisis. Sales of shorter-term debt in particular are rising as the government’s financing needs have increased due to the tax overhaul.
- China holds over $1.7 trillion of U.S. debt and between December and January of this year, the Chinese reduced their holdings by 1.4%. The Chinese are considering scaling back more in response to U.S. tariffs.
- Per the National Association of State Budget Officers, 27 states saw revenues fall below expectations last year. These states will need to borrow more in a market already overflowing with new issuance.
- Teacher Populism: Cuts to education have been one way to balance budgets but appear to have reached a limit. Teachers in West Virginia, Oklahoma, Kentucky, Arizona, Louisiana and Colorado have gone on strike this year. Governments in many of these states have a tough choice: raise taxes or raise more debt.
Trade Wars and Real Wars
Although the first leg of the market drawdown this quarter was precipitated by a spike in interest, it was the escalating rhetoric on trade that left a more lasting mark on investors’ psyche. What started with the administration’s roll-out of steel tariffs evolved to several rounds of tariffs targeting China over the past months. There was a decidedly different tone and calculation to each of the tariffs: the steel tariffs were introduced on the grounds of questionable national security concerns while the tariffs against China were targeted at very specific sectors like electronics, medical equipment and televisions. The difference between how they were rolled out plainly shows the bipolar nature of the Trump administration. For the first year of this presidency, markets were willing to ignore a certain amount of bluster assuming that policy would not change much. This quarter brought reason for a reassessment of that view. Although Trump appears fluid on most policy issues, he has for most of his life held anti-trade views, frequently venting about the poor quality of trade deals as if the trade deficit was the only score that matters. That has markets rattled and it is likely to spur bouts of volatility over the coming months.
A trade war would have an immediate impact on economic growth and trade, but it is the long-term impacts on the U.S. that could have more lasting consequences. The current skirmish with the Chinese also highlights a global dichotomy on trade: developed counties are downbeat on trade while emerging markets are increasingly optimistic. Public policy polls bear this out as the recent McKinsey survey of global business leaders lists changes in trade policy as the number one risk to global growth. While rising interest rates are number two, both doubled (in terms of respondents citing them as a risk) from the previous survey in December. One estimate from UniCredit Bank suggests a trade war would reduce global growth by 0.50% – 1.0% a year and could spark a recession. While significant, how does that compare to the cost of the U.S. relinquishing its leadership on global economic affairs?
Relying on national security justifications to pass steel tariffs is one example of this. While WTO rules permit members to impose tariffs under this premise, it is a highly cynical approach to trade – every country, including China, could use national security to justify trade protectionism. Additionally, the steel tariffs targeted allies that were puzzled by the administration’s mixed signals. Tariffs against China targeting intellectual property theft actually have a fair amount of support amongst allies in Europe and Canada but the lack of coordination with allies has undermined their effectiveness. The Trans Pacifica Partnership, which Trump abandoned, actually has some of the strictest intellectual property protections of any trade deal. It is no wonder that the global community is puzzled by such a duplicitous economic policy and is looking to diversify away from the U.S. Canada and Mexico, concerned about NAFTA, have both joined the TPP and Mexico most recently agreed to a new trade deal with the EU (the largest common market in the world) that virtually eliminates tariffs between them. Clearly, both countries are looking for leverage and planning contingencies if NAFTA negotiations don’t go well.
As much as the world is weighing how to engage with an “America First” policy, the biggest geopolitical risk this quarter is Trump decertifying the Iran deal on May 12. The additions of Mike Pompeo at state department, John Bolton as national security advisor and the outsourcing of Middle East policy to Saudi Arabia and Israel increases the likelihood of a larger conflict with Iran. While that would be devastating for an already war-torn region, the global fallout of the U.S. withdrawing from a well-negotiated deal could have major ramifications for U.S. global leadership for years. Most immediately, it would undermine the positive overtures between the Koreas. Indeed, it appears that Kim Jong-un may have timed his trip to South Korea precisely because it puts pressure on the U.S. If the Iran deal falls apart and negotiations with North Korea don’t go well, the U.S. may well look like the rogue. Internationally, this drives up the status of Russia and China and undermines trust in the US as a global leader.
Recently departed Secretary of State Rex Tillerson left the state department in shambles. Dismissed under his tenure as overly bureaucratic, our diplomatic corps has been hollowed out and is contracting at a time when China is investing a huge amount of political capital to sell its brand around the globe. This was the job our diplomats did very well, often to the significant benefit of business, for over a half century. Now it is the Chinese building roads, infrastructure, making investments and influencing young minds in the emerging and frontier countries. They are seeing the American brand less and less. A further sign of China’s outsized role was the launch of the first ever Yuan denominated crude oil futures contract by the Chinese. A weakened, isolated or less trusted U.S. may no longer get financing at the same attractive rates in what is still a dollar-centric world. Yet another tailwind for rising rates and inflation and a good reason to diversify equity holdings into international and emerging markets.
With kind regards,
IMPORTANT DISCLOSURE INFORMATION
Investing involves risk. Past performance does not guarantee or indicate future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc. (or any of its related entities, together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
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