Equity markets continued their strong run in the second quarter of 2017, thanks to the global economy hitting its stride and registering the fastest level of growth in six years. For the first time since 2011, the U.S. is no longer the only shining star as economic momentum picked up across the globe.
The S&P 500 index gained 3.1% in the second quarter (Q2), boosting its year-to-date return (through June 30th) to an impressive 9.3%. This was eclipsed by the MSCI EAFE Index (net), which gained 6.1% in Q2 and ended the first half of the year with a 13.8% year-to-date gain. Emerging markets led the pack though; the MSCI Emerging Market Index (net) rose 6.3% in Q2 and posting a whopping 18.4% gain over the first half of the year.
At the same time, global central banks found more confidence to embark on a path of policy normalization sooner rather than later. However they face a dilemma in that inflation, which is already below their target, is falling across the developed world. This reality manifested itself in yield curve flattening. In the U.S., the Federal Reserve raised the short-term federal funds rate by 25 basis points at their June meeting even as yields on the long-end of the curve fell as inflation numbers softened in Q2. The spread between yields on ten-year and two-year U.S. treasury bonds fell 20 basis points during the quarter, to 0.93. The Barclays Global Aggregate Bond Index rose 2.6% in Q2, resulting in a 4.4% gain over the first half of the year.
The Spouting Rock/Convex Global Dynamic Risk Fund Institutional (CVXIX) and Advisor (CVXAX) classes both gained 2.67% in Q2, with year-to-date returns of 6.01% and 6.02%, respectively. This compares to a Q2 return of 0.20% and year-to-date return of 0.30% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index.
As of 6/30/2017, the average annual return since the fund’s inception on 11/24/2014 are 3.27% for CVXIX and 3.07% for CVXAX, compared to 0.26% for it benchmark. Returns for the one-year period ending 6/30/2017 are 9.05% for CVXIX and 9.10% for CVXAX, compared to 0.49% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index.
U.S. economic growth continues along post-crisis trend
The good news for the U.S. economy is it continues to produce jobs at a steady clip. Monthly payrolls rose an average of 194,000 in Q2, compared to a rate of 166,000 in the first quarter and 187,000 in 2016. With the unemployment rate sitting at 4.4% at the end of the quarter, and unemployment claims at their lowest levels since the early 1970s, there seems to be enough evidence that the labor market is tightening rapidly. Yet, this is not apparent in wage growth, which appears to have broken the uptrend it has been on since December 2014. Annual wage growth slowed to less than 2.5% in June, down from 2.8% in February.
On the consumer front, rising auto sales were boosting marginal consumption over the past few years. This has slowed considerably since late 2016, albeit from record high levels. Vehicle sales fell to a 16.5 million annual pace in June, and are down more than 13% from the same month in 2016. Meanwhile, the housing market continues to make a slow and steady recovery, with prices rising between 5% and 6% annually. New home sales rose almost 9% year-over-year in May, but sales are more than 15% lower than their 20-year average.
Manufacturing does appear to be making a strong recovery after hitting a low in 2016. The ISM manufacturing PMI climbing to 57.8 in June, its highest level since August 2014. Industrial production is rising at its fastest pace since January 2015. Of course, part of this is due to the base effect (poor numbers last year) – business spending on capital goods remains more than 5% below where it was at the beginning of 2015.
All this is to say the U.S. economy continues along its post-crisis trend, expanding about 2% annually. The economy is now in its ninety-seventh straight month of expansion, its third longest run ever (the longest was the ten-year expansion in the 1990s), and does not look like it is in immediate danger of slowing or overheating. For a brief few months after the presidential election, the opportunity for fiscal expansion raised the possibility that the economy may break out of its recent trend. However, this looks increasingly unlikely.
Investor expectations for a fiscal boost via tax reform and infrastructure spending appears to have firmly receded, thanks to legislation bogged down within the halls of Congress. This is clear from the fact that sectors underlying the S&P 500 have seen a complete performance reversal in 2017. Technology and health care sectors, which under-performed soon after the election have soared this year, rising 17.2% and 16.1%, respectively, over the first six months. The financial sector, which got a boost post-election as investors expected reflation and regulatory easing, has faltered this year, rising 6.9% through the end of June. The U.S. dollar also experienced its worst stretch in six years over the first half of 2017, falling 5.6% through June and reversing all its post-election gains.
The Federal Reserve seems determined to stick to their rate hike schedule (three in 2017, two of which have already passed). Their path to normalization also includes balance sheet reduction, which is scheduled to start later this year. While most employment indicators point to a tight labor market, providing the justification for normalizing policy, wage growth and inflation continue to disappoint. Most committee members, including Chair Yellen, seem convinced that the slowdown in inflation is transitory, and that they need to raise rates to prevent a future surge in inflation.
Another driving factor in their deliberations appear to be financial stability in a low-rate environment. At the June meeting, members discussed the fact that financial conditions had eased even as they reduced policy accommodation. They were concerned about elevated equity market valuations, subdued market volatility and increased risk tolerance amongst investors.
Convex’s proprietary leading economic index (CPLEI) risk rating for the U.S. fell from Buy at the beginning of Q2 to Hold-Buy in May and June – as economic data softened slightly and there was no visible progress of a fiscal agenda passing Congress. Domestic equity exposure was subsequently reduced from 58% at the beginning of the quarter to 44% by the end of May. The allocation to U.S. equities contributed 147 basis points to the fund’s second quarter return of 2.67%.
At the end of the last quarter, we wrote about cyclical recoveries that took hold in parts of Europe. These seem to have only gotten stronger over the past three months. Germany’s manufacturing PMI came in at 59.6 in June 2017, indicating the strongest pace of expansion since April 2011. The business climate index for June also hit its highest level since the series began in 1991. Manufacturing numbers in the Netherlands are also looking very strong, with the headline PMI rising to 58.6 in June, even as the corresponding PMI number for Sweden hit 62.4.
Spain, which is more dependent on consumption and less on manufacturing and exports, saw retail sales pick up momentum over the quarter even as consumer confidence rose close to record highs. Italy is attempting to pull itself out of its funk by putting its bank troubles behind, via bailouts. France also elected a market friendly and pro-EU president in Emmanuel Macron, reducing political uncertainty considerably.
All in all, the European economy is seeing real momentum with growing credit demand and business confidence hitting its highest level since 2011. The unemployment rate continues to fall (now at 9.3%) and consumer confidence is back to where it was in 2007.
The European Central Bank (ECB) is clearly taking notice. ECB president Mario Draghi sounded upbeat on the economy in a speech at the end of June and implied that the time may be near for tightening policy. For now they continue to maintain their easy monetary policy, especially since headline inflation is well below their target. Inflation has in fact softened recently, easing to 1.3% in June from as high as 2% in February.
The quarter also saw a huge setback for British Prime Minister (PM), Theresa May, who lost seats in June parliamentary elections. She continues to hold on to power thanks to a coalition with a third party, but has lost significant political capital to pursue a hard Brexit. The problem is that this creates more uncertainty just as Britain starts Brexit negotiations with the European Union. As an example of the difficult road that lies ahead, the PM faces a tough sell on her “Repeal Bill”, which is expected to be one of the most constitutionally significant pieces of legislation in British history – it aims to convert all EU legislation to British law and fill any gaps, as soon as Brexit goes into effect. There would be tremendous legal uncertainty for individuals and businesses if this does not happen.
The CPLEI risk rating for European developed markets rose to Hold-Buy in Q2, on the back of solid macro-economic numbers in Germany, Netherlands, Spain and Sweden. Allocation to developed Europe was raised from 4.5% at the end of Q1 to almost 12% by the end of May, and contributed 31 basis points to the fund’s second quarter return of 2.67%.
Over on the other side of the world, Japan is experiencing resurgence even as its Central Bank promises to maintain its highly accommodative policy stance. Industrial production rose close to 7% in May (year-on-year) while the latest manufacturing PMI of 52.4 (June) indicated the country is in its tenth straight month of expansion. Inflation looks to be on the rise, with core consumer prices rising 0.4% in May, the highest year-on-year gain in more than two years.
Japan saw its rating rise from Hold at the end of Q1 to Hold-Buy in Q2. The portfolio averaged a 5% allocation to Japan across the quarter, which contributed 20 basis points of gain to the second quarter return.
Growth in emerging markets is also picking up, though these are rebounding from lows. China is seeing renewed growth, thanks to policymakers opening up the credit spigot and allowing easier financing. This has allowed investment to pick up again, resulting in more imports of raw materials and boosting commodity producers across the world. Nevertheless, due to sustainability concerns, Convex rated China, and overall Emerging Markets, as Caution-Hold through the second quarter.
The fund did initiate opportunistic positions in selective Emerging markets that were rated Hold-Buy in Q2, including Taiwan and India. The overall allocation to these countries was increased from 2.5% in April to 4% in May, and contributed 12 basis points of gains to the Q2 return of 2.67%.
The overall risk rating for the world remained steady at Hold-Buy in the second quarter, with softer U.S. economic data balanced by stronger numbers in other developed markets. Fixed income allocation was raised from 22% at the beginning of the quarter to almost 29% by the end of May, mostly to take advantage of yield-curve flattening. Fixed income exposure contributed 46 basis points to the fund’s Q2 return of 2.67%.
As always, we shy away from making forecasts and predictions. However, there are five questions we are asking as the third quarter gets underway.
1. Can Congress pass a budget, raise the debt ceiling and move on to taxes?
According to the original timetable set by Congressional leaders at the beginning of the year Congress would be deliberating a tax bill at this point, having finished health care in the spring. However, the Senate is currently mired in deliberation on health care, and procedurally, they cannot move on to taxes until this is done. Also, Congress has to pass a budget for 2018 by the end of September (when the current fiscal year runs ends), which would act as the vehicle for tax legislation. Yet, Republicans have delayed this due to deep differences over whether tax cuts should be allowed to increase the deficit or be offset by new revenue and/or spending cuts. This means any debate of potential tax legislation will not even begin until September, at the earliest.
The month-long Congressional recess in August means that in reality, they have only a few weeks to complete health care, extend the Children’s Health-Care program, continue federal flood insurance, pass a budget that will keep the government funded and allow tax legislation to move ahead, and crucially, raise the debt ceiling. A significant part of the Republican caucus is opposed to raising the debt ceiling and this could complicate matters further.
2. Will the U.S. impose new tariffs, and will trade partners retaliate?
As the rest of the world looks to negotiate free trade agreements, the U.S. is contemplating raising tariffs for a range of goods in bid to boost the domestic manufacturing industry. Unlike any of the other fiscal proposals, which need to go through Congress, the administration has significant flexibility when it comes to trade. They are already using little-known, and little-used, provisions of existing U.S. law for aggressive enforcement and to restrict imports.
The administration is currently assessing whether steel imports from China constitute a national security risk. The problem is China is not even one of the top 10 sources of steel for the U.S. – Canada, Brazil, South Korea and Mexico make up the top four. So potential tariffs will impact U.S. allies more, raising the possibility of widespread retaliation, as opposed to just retaliatory actions from the Chinese. We have written on the ineffectiveness of tariffs that were imposed in the past.
3. How will the Federal Reserve proceed if inflation does not pick up?
At the June FOMC meeting, a few members expressed the worry that slowing inflation would be persistent, and not transitory. If this is indeed the case, one would think that the Federal Reserve would ease up on its projected rate hike path. Yet, it was clear from the minutes that participants are also worried about financial stability in the face of low interest rates. This will be a movement away from their primary dual mandates of full employment and stable inflation.
The question is what framework the Federal Reserve will use if it indeed wants to reduce instability from elevated asset prices, without negatively impacting the economy at the same time. Policy makers already depend on unobserved variables such as natural rates of interest and unemployment, and potential output, which sometimes lead to problems when it comes to communicating policy. Including financial stability in the mix, without any clear definition of what this implies, will only raise policy uncertainty.
4. Will the ECB tighten policy if Europe sustains its recovery?
As we wrote earlier, the European recovery continues apace. If this extends well into the fall, and inflation picks up again, the question is whether the ECB jumps the gun and starts to tighten policy sooner than they should, resulting in a policy error (as in 2011). For now, it looks like the ECB is committed to maintaining accommodative policy in the near-term.
Another issue relates to tapering and not in the conventional sense. The ECB may have no choice but to taper as 2018 begins due to a shortage of collateral and it will be interesting to see how they deal with this issue.
5. Has the China risk really eased?
On the face of it, it would appear that the China risk has eased, given that several economic indicators from the country point upward. Also, since early 2016, when there was serious downward pressure on their currency, a few factors have worked in their favor.
The Federal Reserve’s tightening policy has proceeded at a slow pace and the dollar has not appreciated significantly (it has given up all of its post-election gains this year). The Chinese government also instituted stricter capital controls to prevent outflows, reducing pressure on the currency. Crucially, as we wrote in the previous section, Chinese policymakers have also reversed policy and returned to massive lending in an effort to boost growth. As a result, investment has picked up again and this is most noticeable in inventories – China was drawing down its stock of inventories at an annual rate of almost 200 billion yuan in early 2016, but by the end of the second quarter of this year, it was back to accumulating inventories at a rate of 1 trillion yuan. China’s total debt-to-GDP rose above 304 percent in May of this year but the absolute number is not quite the problem. It is the speed at which debt is being raised – return on investment continues to fall and as we wrote more than a year ago, it leaves China with a chronic ailment that requires ever more credit to sustain growth.
The Convex proprietary risk rating for the world stands at Hold-Buy as we move into the third quarter. We continue to monitor economic prospects of thirty different countries across five regions of the globe and remain vigilant about potential risks.
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As of 6/30/2017, the Spouting Rock/Convex Dynamic Global Macro Fund average annual returns since the fund’s inception on 11/24/2014 are 3.27% for CVXIX and 3.07% for CVXAX, compared to 0.26% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury . The returns for the one-year period ending 6/30/2017 are 9.05% for CVXIX and 9.10% for CVXAX, compared to 0.49% for its benchmark.
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