Precursor to Q2-2018 Market Commentary

Please note that we will be publishing a more formal Commentary and Outlook piece in the next couple of weeks, but we recognize you are meeting with clients and would like some color around the markets and our thoughts in the meantime. So, below are a few key market drivers from the first half and our resultant positioning.

Narrowness:
Through the close on July 9, only 6 stocks have made up 98% of the return for the S&P 5001. These six stocks are: Netflix, Microsoft, Amazon, Apple, Alphabet & Facebook. Bottom line: the market appears narrow given this (although the Russell 2000 has rallied the last couple months). Feels like 2015 all over again.

Protectionism and tariffs:
Implementation of tariffs and rhetoric around trade disputes have created volatility and perhaps led to a weakening in consumer and business confidence at potentially a critical time. The trade issues centered on China are particularly worrisome as it’s the second biggest economy in the world, and potentially showing signs of economic stress and deceleration.

Strong USD leading to poor international market performance:
Higher US interest rates, repatriation of overseas corporate cash and trade issues have combined to lead the USD higher. These factors have put pressure on international asset classes, particularly emerging markets equity and fixed income markets. Again, it seems a lot like 2015 all over!

Inflation:
Cost pressures for corporations are rising, with rising oil prices, rising labor costs, and rising interest rates. This puts at risk future profit margins and earnings, especially when compared to the outstanding results we expect to see throughout 2018. This is especially true given the leverage corporations have added over the recent low interest rate years.

More restrictive monetary conditions:
With unemployment full and inflation rising, we expect the Federal Reserve to continue raising rates in line with market expectations. Looking at 9-12 months, we believe this will result in short rates at least 75bps higher than current short rates. If the long end of the curve doesn’t respond, the curve will invert. If the long end of the curve does respond in parallel fashion, long rates closer to 4% could have an impact on the real economy and could also provide stiffer competition for equity valuations.

Mid-Term election year:
Historically, equities have tended to be range-bound in mid-term election years as we are experiencing in 2018. Perhaps the uncertainty around trade, the strength in the USD and weaker international markets will reverse course if it all proves to be political bluster ahead of an important election this fall.

Fundamentum Positioning:
In terms of our Tactical positioning, we reduced our overall equity exposure (both domestic and international) closer to neutral positions in all Tactical portfolios in early May, after being overweight for all of 2017. We want to make clear that moving to neutral positions does NOT make us bearish. While we have some sympathy for the “peak everything” narrative (peak margins, peak earnings, peak economic growth) and the nervousness around trade issues, we continue to believe that there is limited (but perhaps growing) evidence of a recession on the horizon. While we are troubled about the equity markets inability to rally this year given the strong earnings we are experiencing, the risk of a sizable drawdown seems modest, without economic pressures and at valuations that are only modestly high. The most likely outcome from our view for the next few months is a range-bound, choppy market. As a result, proceeds from the reduction in equities were committed to short-term high-quality bond strategies (they actually yield something now) and an options strategy that sells options on the S&P 500 Index in order to generate income. These types of options strategies may perform well in a sideways equity market. We are continually assessing economic and market data to better understand if some of the issues highlighted are short lived or the beginning signs of a slowdown. Gravitating toward neutral points until the tug of war in data is clearer has proven to be a good strategy from our experience.

Finally, we should remind investors that we manage globally diversified portfolios across many asset classes. In markets where 6 growth names dominate the performance of the S&P 500, diversification can seem like a failure. Unfortunately, some investors will chase returns and take undue risks at exactly the wrong time. The average investor needs much more coaching and hand holding when markets behave like they have thus far in 2018.

We will have a more detailed Commentary and Outlook piece to you within the next couple weeks. As always, thank you for your confidence in our team. Feel free to contact us with questions.

1https://www.cnbc.com/2018/07/10/amazon-netflix-and-microsoft-hold-most-of-the-markets-gain-in-2018.html

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