Dear clients, friends and family:
Following is the 2015 fourth quarter and year end net performance for CMG’s Tactical Investment Strategies along with our thoughts on each strategy over the past quarter. In addition, we have provided the net performance for the CMG Managed Blends and the CMG Classic Blends. We have also reflected the net performance for our tax-deferred variable annuity tactically managed programs. Market index performance is presented at the bottom of the chart.
Additionally, we would like to provide a brief update on our strategies in the context of a particularly volatile start to the year. We have seen a move to safer asset positioning across most of our tactical strategies. The CMG Opportunistic All Asset Strategy has moved to a conservative risk position. Portfolio allocations to fixed income and defensive equity positions like utilities have helped the portfolios perform well during the market sell-off. Performance for the strategy is modestly down, providing significant relative outperformance compared to equity market indices. The CMG Managed High Yield Bond Program and the CMG Tactical Rotation Strategy are also in defensive positions with little or no market exposure at all.
Within the total portfolio construction process, we believe it is important to include a number of non-correlating risk diversifiers (equity, fixed income and tactical exposure), that performance evaluation should be considered over a three to five year period vs. months and quarters, and that one should compare equity performance against an equity benchmark, bond against a bond benchmark and tactical against a tactical benchmark. Asset classes are non-correlating for a reason and should be viewed from that perspective. Of course, past performance does not predict or guarantee future returns.
CMG Tactical Fixed Income Strategies
The CMG Managed High Yield Bond Program (“CMG HY”) returned -0.85% for the fourth quarter and finished the year -3.59%, net of fees. The same strategy managed inside the Jefferson National Tax-Deferred Variable Annuity returned -0.85% for the fourth quarter and -3.24% for the year, net of fees.
The strategy began the quarter in a defensive position and was not invested long in high yield bonds. The high yield market remained volatile during the quarter due to speculation around the timing of an interest rate hike and the declining price of oil (energy companies now make up a large portion, approximately 14%, of the high yield market). The strategy traded several times during the quarter, investing long in high yields in mid-October, moving to cash in mid-November, before re-establishing a long position in mid-December. The strategy moved back to a defensive cash position in the second week of January and has since, as of this writing, moved back to a long position in high yields.
Forecasts for high yield bond returns for 2016 range from -3 to +6% based on an annual survey by LCD, a unit of S&P Capital IQ, with most forecasts from the major banks in the +4-6% range. Regarding default rates, the average forecast is in the 3% range with some banks predicting defaults as high as 5.5%. Energy and energy related (services, pipelines, etc) is the wild card in this forecast and the health of energy related credits is tied to the price of oil. Forecasts for energy related high yields are 10% or more, which is in line with the peaks in defaults in the last three major blowouts in credit spreads. Most recently, during the financial crisis, defaults peaked at around 12%. Whether we reach those levels or not, defaults are going to rise and high yields will be more volatile than in the past several years.
CMG Tactical Equity Strategies
The CMG Opportunistic All Asset Strategy (“CMG Opportunistic”), our broadly diversified mutual fund and ETF allocation strategy, returned +1.97% for the fourth quarter in the TCA (Trust Company of America), TDA and ETF portfolios, net of fees. The Jefferson National Tax-Deferred Variable Annuity portfolio returned +2.74% for the fourth quarter, net of fees. The TCA, TDA, ETF and Jefferson National Variable Annuity portfolios returned -5.19%, -6.60%, -5.63% and -5.84% in 2015, net of fees, respectively.
The strategy began the quarter in a conservative risk position after a challenging third quarter. The portfolio was balanced between equities and fixed income positions and close to a 20% position in cash. As the equity markets rebounded, the strategy rebalanced the portfolio into equity positions from fixed income and cash. Within the equity allocations, the strategy added risk as the quarter went on, rotating out of defensive low beta positions in healthcare and utilities into technology, real estate, industrials and large cap equities. In October, the fixed income positions as a percentage of the portfolio peaked at 44.92% with allocations in convertible and corporate bonds rotating to equity positions by the end of the quarter. Fixed income positions in the portfolio at the end of the year were split between municipal bond and long government bond funds. After increasing risk from September to November, the strategy moved to a moderate risk position to finish the year, holding 17.94% in cash. The strategy held the following allocations (individual portfolio allocations may vary) to fixed income, equities and cash at the end of October, November and December:
For a more detailed summary of current allocations for each specific portfolio and allocation changes over the past month, please visit our website at the following links to view the monthly update for each portfolio: TCA, TDA, ETF, and Jefferson National.
The Scotia Partners Dynamic Momentum Program (“Scotia Dynamic”) returned -3.16% for the fourth quarter and finished the year -2.95%, net of fees. It was an up and down quarter for the strategy echoing the volatility of equity markets. The strategy generated positive returns in October with allocations to precious metals and electronics. In November, allocations to electronics, biotech and healthcare contributed to positive performance. In December, the strategy was negatively impacted by allocations to biotechnology and precious metals specifically. By the end of the month, the Scotia Dynamic model signaled a move to a long-term bearish market trend that acts to reduce maximum allocation to a single position in the interest of risk management. When the long-term equity market trend turns bullish again, the strategy will look to be more fully allocated again.
The CMG Tactical Rotation Strategy (“Tactical Rotation”) returned -2.03% for the fourth quarter and finished the year -8.03%, net of fees. Tactical Rotation began the quarter positioned 50% to bonds (BND) and 50% to cash. Equity markets rallied after a volatile summer when the Fed held off on hiking interest rates in October. After a difficult summer for all asset classes (not named cash), equities and REITS did not appear primed for a large rally. The strategy remained in a defensive position during October and did not capture the upside in equities. For November, the strategy remained 50% invested in bonds (BND) and allocated the remaining 50% of the portfolio from cash to REITS (VNQ). November proved to be a challenging month with domestic equities the lone bright spot after posting a slightly positive return for the month. Bonds and REITS were down modestly ahead of the December rate hike by the Fed. For the month of December, the strategy was allocated 50% to domestic equities (SPY) and 50% to international equities (EFA). Markets stumbled to finish the year after digesting the first rate hike in years with only REITS posting positive performance for the month. Commodities continued their free fall in the fourth quarter and finished the year down -27.41% (DBC). The strategy avoided allocating to commodities for the entire year.
Market Commentary and Outlook
As the calendar turns from one year to the next, most people think about resolutions and new beginnings – a clean slate and a fresh start. Investors do much the same, leaving behind last year’s themes and focusing on what is likely to make money or headlines (or both in the coming year). As we finished 2015, there was a sense that markets were running on fumes as investors and managers were looking to post a positive return for the year, relieved that the Fed had finally hiked rates, and awaiting what the New Year will bring. If markets felt complacent and exhausted at the end of last year, 2016 has started with investors in an outright panic. While some of the selling pressure for the worst January on record for stocks (as of this writing) is overdone in the short term (or oversold in technical terms), we believe the risks are greater than most believe.
There were three major themes that had the market’s attention at the end of 2015 and with the Fed raising rates in December, the focus to start 2016 has been on the other two: China and oil. The Chinese stock market continues to exhibit the extreme volatility that we saw last year as Chinese regulators fumble with narrow policy fixes that only exacerbate the problem. Most commentary has focused on the relative small size of the Chinese stock market compared to the overall economy and has sought to calm investors – this is part of the transition of a controlled economy to a market based system. The economy, most say, is doing OK. There is much truth to that. Although it was the slowest rate since 2009, China’s economy grew at an annualized rate of 6.8% in the fourth quarter, still a robust number. However, we believe the situation in China to be more uncertain than most believe. Since the financial crisis, China, and in particular the Chinese President Xi Jinping, has been looking to centralize control of the economy, purge corruption and rebalance the economy from an investment driven manufacturer to a more balanced one with a greater contribution to growth from services and consumption. It has been taken for granted that because China is a centrally controlled country, the economic adjustment will be easier to make – no messy elections, no fussy central bank, and a free hand to stimulate and create jobs. We don’t believe that it will go as smooth as most expect. The recent loosening of the management of the yuan is an example of how state control can be powerless.
After loosening capital controls in 2015 (in response to a surging dollar – the yuan was semi-pegged to the dollar), the IMF accepted the yuan into its SDR (Strategic Drawing Rights) basket of currencies and acknowledged the positive economic reforms taking place in China. However, floating your currency brings challenges – most significantly a decline in control. In the second half of 2015, capital outflows reached an annualized rate of $1 trillion. China has huge foreign exchange reserves (approximately $3 trillion) as a result of its trade surplus to defend its currency, but the rate is alarming nonetheless. Add in $10 trillion in new debt in the past eight years (with approximately $100 billion denominated in dollars) and the risk of a hard landing looks much higher. There is now an expectation that the yuan will fall further as the state looks to stimulate the economy and Chinese citizens look for other places to put their money. This serves as a great example of the challenge for Chinese leaders – liberalizing the economy without liberalizing (or losing control) of the political system. We believe investors continue to underappreciate the enormity of this task and the risk it brings to the global economy.
Oil continued its plunge into year end and collapsed to below $30 a barrel in early January. While $30 seems like a godsend to consumers after the lofty levels of 2008 (remember $140 oil?), it is a double-edged sword. Economists estimate that each 10% decline in oil prices typically boost growth by 10 to 50 bps. Consumer driven and oil importing economies, like the US, Europe and Japan, are likely to benefit the most and economists are optimistic that those savings at the pump will be recycled at the local mall. However, for oil producing countries, the pain could be acute with severe political ramifications. While the Saudis are not alone (Russia and Brazil are two other great examples) in their reliance on oil to balance their budget, they are a unique case on multiple levels. Saudi Arabia, as the world’s largest oil producer, also drives the OPEC agenda and despite the collapse in prices, the Saudis have refused to cut production as many in the cartel have prodded for. The reasons for holding production at current levels are myriad: maintaining market share before a rumored IPO of Saudi Aramco (it is estimated that it would be the most valuable company in the world by a factor of 10), attempting to drive out shale producers in the US, frustrating its regional rival Iran at a time when they are trying to bring oil to market or seeking to uphold the level of government support to citizens with few other options in a non-diversified economy. I would argue that maintaining stability is the primary concern: the government relies on oil for 90% of its revenues and the budget exceeded 15% last year. Saudi Arabia is not unique in their budgetary reliance on oil – most of the Middle East cannot balance their budgets with oil in the $60-$80 range, much less at current levels. It is likely that oversupply will continue to rise as Iraq pumped record levels in December and Iran has yet to hit the market; all while China is slowing down (expect China to acquire reserves and leave them in the ground for now). However, we don’t believe oil prices will stay at these levels for long as each commodity bust sets up the next boom (exploration companies shut down rigs and supply comes back in line with demand and then potentially below demand, setting off the next cycle up).
In our 2016 outlook, we highlighted several risks we see this year, namely a global recession that could spill over into the US, an emerging market debt crisis and a rise in high yield defaults. After the rebounding from the depths of the financial crisis, markets rallied into 2014 before sputtering in 2015. Stock and bond markets have essentially gone nowhere in the past 12 months and we believe we are seeing a change in the market. Whether this sell-off turns into a secular bear market or not, the risk to investors is high. Central bank policy is operating at two speeds that cannot be reconciled: the US is tightening (don’t hold your breath on the next several rate hikes – we probably won’t get four in 2016) while Europe, Japan and China are easing aggressively. The dollar continues to trend higher in part driven by a global demand from countries that need to pay back dollar denominated debt. Commodities indicate a period of slow growth or stagnation ahead. Steve addresses the economic risks in great detail in his 2016 outlook (On My Radar: 2016 Outlook), but I would like to address what I believe is an even greater risk, not in 2016 but in the next five to ten years.
The world has become so dynamic, so complex and interconnected that it has become almost impossible for governments to rise to the task of governing. Specifically, in liberal democracies, the financial crisis has eaten away at the middle – the moderate (left and right) part of the political spectrum that typically seeks compromise over ideological purity. This part of the populace is under assault in the US and Europe predominantly and it is much easier for politicians of the extreme (left or right wing) to catch voters’ ears. It is easier to blame outside forces, scapegoat the other politician and inflame ideologues than it is to govern. Add in unlimited campaign cash in the US that freely moves from state to state and you find little room for cooperation. This is tremendously disappointing, dangerous and echoes the tensions we saw over a 100 years ago, before the start of the Great War. From a policy perspective, central banks have shouldered most of the heavy lifting, applying both conventional and unconventional policies to spur growth. However, if global economic growth is going to accelerate, the political class will have to pick up the baton from the central bankers. The current political climate is simply not conducive to the types of difficult compromises that are needed to put the US and global economy on a better path. Looking out five to ten years, return expectations for stocks and bonds (On My Radar: 2016 Outlook) are already paltry and they are likely to be even worse if the can is kicked down the road further by the political class.
With kind regards,
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of 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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