By Court Hoover, JAForlines Global
The first half of 2017 surprised investors who expected the “Trump reflation rally” to drive interest rates higher and US equity market outperformance. This thesis quickly crumbled, along with hopes for a speedy implementation of the Trump administration’s policy agenda, causing interest rates to reverse course and foreign equities to outperform. Our portfolios were well-positioned for this head-fake, with an allocation to long duration US Treasuries and large international equity allocations. As a result, all of our portfolios have significantly outperformed their benchmarks year-to-date, and our JAforlines Global Tactical Allocation mutual fund (RMAIX) has achieved a 5-star rating from Morningstar.*
*The American Independence JAForlines Global Tactical Allocation Fund Class I received a 5-Star rating for the 3-year period ending June 30, 2017 out of 247 funds.
Looking to the second half of the year, another challenge faces investors: the impending unwind of the Federal Reserve’s massively inflated balance sheet. Janet Yellen has charted a fairly steady course towards tighter policy this year, despite disappointing economic data in the first half. We expect US economic growth to accelerate in the second half, which should strengthen her resolve to follow through with balance sheet reduction as advertised.
In addition, the ECB has signaled its intention to taper its asset purchases. ECB Chairman Draghi even said recently that “the threat of deflation is gone and reflationary forces are at play.” Together, the world’s two most powerful central banks have signaled that the global reflation which began in mid-2016 remains in place. We have therefore reduced duration across our portfolios in order to protect against another move upwards in interest rates.
• We are avoiding foreign currency fixed income to benefit from higher US dollar interest rates. We expect spreads between US dollar and foreign currency interest rates to narrow, and therefore will benefit by concentrating all of our fixed income exposure in US dollar denominated holdings.
• We are avoiding long duration fixed income in our portfolios. Interest rates should rise in the second half of the year as economic growth accelerates and global central banks step away from the “extraordinary measures” they employed during the financial crisis.
• We have exposure to five US equity sectors: financials, technology, biotech, energy, and aerospace & defense. Financials benefit directly from a higher interest rate environment in the US, as well as a more favorable tax and regulatory environment which is likely to develop. The pace of disruption of old industries by new products and processes has continued to accelerate, and technology and biotech give us exposure to this process of creative destruction. Revived economic growth will support global energy markets, and energy equities are under-owned by asset allocators, creating an excellent buying opportunity. Global military spending will increase in coming years, as US hegemony fades and a multi-polar world emerges—the aerospace and defense industry will be a beneficiary.
• The immediate threat of populist and nationalist politicians in Europe has subsided. Regaining power are centrists determined to implement reforms necessary to ensure the long-term stability of the Eurozone. This will support European equites, benefitting our positions in Eurozone equities and the European financial sector.
• Japanese equities are supported by the Bank of Japan’s ongoing aggressive monetary easing. The Bank of Japan is likely to be the last major central bank maintaining an aggressively easy policy stance, which should support Japanese equities and put downward pressure on the Yen.
• Emerging market equities benefit from positive capital inflows and represent attractive relative value. We expect global capital flows to remain supportive and emerging market equities to continue to “catch up” after years of underperformance.
• Gold’s status as an alternative currency should support it as geopolitical risks and policy uncertainty remain elevated. Furthermore, as an asset with low correlations to most others, it helps lower overall portfolio volatility.