Investing in a Time of Transition

By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management

Our outlook continues to be constructive, though we think that the post-election rally has priced in a lot of good news. As a result of the rally, some areas of the market are potentially overdone. Meanwhile, we are finding other areas of the markets that we think have been overlooked.

While we anticipate first quarter U.S. GDP will be soft, we think that GDP growth will accelerate towards 3% during the second quarter and we are maintaining our expectation for 2.2% calendar year 2017 real GDP Growth. We are maintaining this level of expected growth despite what appears to be a delay in fiscal stimulus, regulatory changes, and tax reform coming out of Washington. The good news to us is that old-fashioned private sector growth appears to be taking hold.

We are finding pockets of opportunity domestically, though we think that the broad U.S. equity market is fairly-valued. Equity valuations in Europe and Japan look more interesting, though emerging markets appear to be unattractive from a risk/reward standpoint to us.

We think the U.S. Federal Reserve (Fed) will tighten monetary policy by both raising interest rates more quickly and more persistently than the market expects, and by pas-sively letting its balance sheet shrink. As global growth and inflation pick up, the natural level of interest rates in-creases as well. As long as the Fed simply follows the natural rate higher, the economy can continue to grow.

We think that short-term interest rates will move significantly higher from here, along with Fed policy, while long-term interest rates should be range bound at a rate a bit higher than the current level. As the Fed lets its balance sheet shrink, we expect some areas of the fixed income market, such as mortgage-backed securities, to underperform the broad fixed income market as that space adjusts to the new reality. We are finding more attractive investment opportunities elsewhere in fixed income.

We expect volatility to increase as the Fed tightens monetary policy and the markets realize that other areas of policy change, such as regulatory and tax reform, may come more slowly than some would hope. As a result, we have made adjustments in our alternative allocations that should help dampen overall portfolio risk, while potentially generating return from increased market volatility.

In summary, with an eye towards risk management, we are positioned to benefit from solid global economic growth, rising short-term interest rates, and a strengthening U.S. dollar. We expect volatility and market dips. So long as fundamentals remain solid, we see potential dips as buying opportunities.

Our outlook continues to be constructive, though we think that the post-election rally has priced in a lot of good news. As a result of the rally, some areas of the market are potentially overdone. Meanwhile, we are finding other areas of the markets that we think have been overlooked.

While we anticipate first quarter U.S. GDP will be soft, we think that GDP growth will accelerate towards 3% during the second quarter and we are maintaining our expectation for 2.2% calendar year 2017 real GDP Growth. We are maintaining this level of expected growth despite what appears to be a delay in fiscal stimulus, regulatory changes, and tax reform coming out of Washington. The good news to us is that old-fashioned private sector growth appears to be taking hold.

The labor market is key to the health of the U.S. economy and monthly jobs creation can be volatile, so we prefer to look at the 6-month moving average. As exhibit 1 shows, jobs creation remains healthy despite the dip in March. As the unemployment rate continues to fall with the economy at full employment, we should expect monthly jobs creation to taper, but remain at a healthy level.

exhibit-1

We also prefer to look at other indicators of labor market strength, such as weekly jobless claims and the pace of voluntary departures, known as the quit rate. When corporate views turn pessimistic, layoffs, as represented by weekly jobless claims, increase. Conversely, claims decrease when companies turn more optimistic. Similarly, when workers are more pessimistic, they tend to not quit their jobs, but the quit rate picks up as workers become more confident in their ability to find new and better jobs.

As exhibit 2 shows, the data seems to confirm our confidence in a strong jobs market with layoffs declining since 2009 and quits increasing since 2013.

exhibit-2

Not only are weekly jobless claims down year over year, they are down to levels not seen since 1973 (exhibit 3).

To put that into perspective, the 1973 labor force was approximately 90 million people. Today, the U.S. labor force is roughly 160 million strong. The size of the current labor force is nearly double what it was 44 years ago, but layoffs are at the same low level. We think this situation reflects strength in the U.S. economy, which should lead to more jobs creation in the future. Therefore, we expect consumer spending to be exceptionally strong going forward as the economy adds more jobs and more income, which is already at an all-time high.

exhibit-3

Alongside improvements in the labor market, we are seeing improvements in business optimism and investment.

As exhibit 4 shows, the ISM Manufacturing Purchasing Managers Index growth rate has softened but continues to impress. Additionally, the Conference Board’s U.S. Leading Index of Ten Economic Indicators continues to make positive gains as well. We are seeing this optimism translate to investment as shipments and production of business equipment are on the rise as exhibit 5 suggests.

exhibit-4

exhibit-5

Importantly, this strength is not just in the U.S., euro zone business activity has surged to its highest level in years, per the latest IHS Markit survey (exhibit 6). Euro zone job creation is at levels not seen in nearly a decade, while new orders and business optimism are moving higher, which bodes well for economic activity.

exhibit-6

INVESTMENT IMPLICATIONS: EQUITY

We are finding pockets of opportunity domestically, though we think that the broad U.S. equity market is fairly valued. Equity valuations in Europe and Japan look more interesting, though emerging markets appear to be unattractive from a risk/reward standpoint to us. Given the positive economic signals we are tracking, we think that the U.S. economy will continue to grow at a steady pace. We think that increasing U.S. nominal GDP will support increased corporate revenues (exhibit 7), which can propel earnings higher. Note that we expected all of this to occur even without the new Presidential administration’s push for regulatory and corporate tax reform. Additional tailwinds from these reforms can propel earnings even higher.

exhibit-7

In particular, we find attractive valuations and potential earnings growth in the information technology, consumer discretionary, and health care sectors, while we are generally underweight consumer staples, energy, industrials, and materials.

Furthermore, while the Fed has begun to tighten monetary policy in the U.S., the European Central Bank (ECB) and the Bank of Japan (BoJ) continue to inject large amounts of monetary stimulus into their economies. Year-over year, the ECB has increased the size of it balance sheet by 40%, while the BoJ has increased by 20% and the Fed balance sheet has been flat (exhibit 8).

exhibit-8

This injection of stimulus should help support economic growth and unlock what we believe to be attractive relative valuations.

For example, while both the U.S. stock market and broad emerging markets are trading at a premium to their historical valuations, stock prices in both the euro zone and in Japan are trading at a discount to their historical averages (exhibit 9). We think that the improving economic activity mentioned above, combined with additional monetary stimulus and attractive valuations, make European and Japanese equities attractive.

exhibit-9

FIXED INCOME

We think the Fed will tighten monetary policy by both raising interest rates more quickly and more persistently than the market expects, and by passively letting its balance sheet shrink. As global growth and inflation pick up, the natural level of interest rates increases as well. As long as the Fed simply follows the natural rate higher, the economy can continue to grow.

We think that short-term interest rates will move significantly higher from here, along with Fed policy, while long-term interest rates should be range bound at a rate a bit higher than the current level. As the Fed lets its balance sheet shrink, we expect some areas of the fixed income market, such as mortgage-backed securities, to underperform the broad fixed income market as that space adjusts to the new reality. We are finding more attractive investment opportunities elsewhere in fixed income.

We think that long-term interest rates, such as the 10-year Treasury yield, are likely to be range-bound below 3%, which is significantly lower than the long-term average.

Though global economic growth is solid, we do not expect economic growth and inflation to be strong enough to push long-term interest rates significantly higher. Furthermore, strong global demand from institutional investors for high-quality sovereign debt will likely provide a ceiling for long-term interest rates.

If the economy maintains its current positive trajectory, we think the Fed will raise interest rates three more times this year and the 10-year Treasury will move closer to 3%. In that scenario, the yield curve, as represented by the difference between the 10-year Treasury and the 2-year Treasury, will flatten, but not enough to risk choking off the creation of credit and causing a recession.

exhibit-10

Similar to our expectations that certain areas of the equity markets that have rallied strongly will begin to lag, areas of the bond market that exhibit more credit risk may also struggle. As exhibit 11 illustrates, the premium, or spread, that investors earn for owning both investment grade and below investment grade bonds has declined, which reduces the attractiveness of these bond sectors.

exhibit-11

In fact, we see increased uncertainty as the Fed considers letting its balance sheet shrink. Though we question how far the Fed can and will go in reducing the size of its balance sheet as increased global demand for the U.S. dollar may require a large endpoint, any significant balance sheet decrease can disrupt the fixed income markets.

Even a temporary disruption as the markets adjust to the new reality can have significant impacts given how tight spreads have become.

We think that corporate bonds and especially mortgagebacked securities (MBS) are the most vulnerable. During Quantitative Easing, the Fed started purchasing MBS to the extent that the Fed now owns more than 30% of the market. The Fed backing out of the MBS market will likely have adverse effects on the space. Thus, we have reduced exposure to corporate bonds and mortgage-backed securities in recent weeks.

We think that better opportunities exist in some fixed income sectors, such as taxable and high yield municipal bonds, as well as some investment grade credit sectors, including asset-backed securities. At this time, senior loans is the one high yield sector which may be attractive to us.

ALTERNATIVE INVESTMENTS

We expect volatility to increase as the Fed tightens monetary policy and the markets realize that other areas of policy change, such as regulatory and tax reform, may come more slowly than some would hope. As a result, we have made adjustments in our alternative allocations that should help dampen overall portfolio risk, while potentially generating return from increased market volatility.

Exhibit 12 on the following page shows the level of the VIX Index, a proxy for equity market volatility, since 1990. Periods of low volatility have been followed by periods of higher volatility, and the level of the VIX has been near historic lows of late. We expect a move to higher volatility in the future, though higher volatility does not necessarily mean a significant market decline.

exhibit-12

We recently added two different options writing strategies that we think stand to profit from a higher volatility regime.

These ETFs generate returns by selling put options or call options on the S&P 500 Index. As volatility increases, so does the potential options premium generated from these sales. Both ETFs reinvest the premiums they receive to potentially increase the funds’ net asset value (NAV) over time.

In addition to those purchases, we added to our existing positions in convertible bonds. Convertible bonds offer an attractive yield, as well as potential for capital appreciation.

Still, overtime they have exhibited only about 70% of the volatility of the broad equity market.

Through our other non-traditional investments, we are finding a host of return enhancing and risk management opportunities further afield. From broadly diversified ETFs that blend allocations to REITs, MLPs, dividend-paying equities, and corporate bonds, to more focused, outside of the mainstream holdings, such as high yield municipal bond ETFs, ETFs focused on preferred stocks, and high quality floating rate fixed income ETFs, these allocations to non-traditional investments should serve to generate an attractive return while reducing overall portfolio risk through low correlation and volatility reduction.

In summary, with an eye towards risk management, we are positioned to benefit from solid global economic growth, rising short-term interest rates, and a strengthening U.S. dollar. We expect volatility and market dips. So long as fundamentals remain solid, we see potential dips as buying opportunities.

THE CASH INDICATOR

The Cash Indicator (CI) has declined to its lowest levels since last summer. At these subdued levels, the CI is another indication that a downward move in the equity markets is likely a buying opportunity to take advantage of, rather than a cause for panic.

exhibit-13

This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.

DISCLOSURES

Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.

The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable. Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.

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