Quarterly Review – Q1, 2017

The first quarter of 2017 began where 2016 left off, with a continued rally in global equity markets. However, there were enough signs that financial market participants started to factor in many political, fiscal and economic obstacles facing the new Trump administration’s highly anticipated fiscal agenda. Investors tempered their post-election risk-on posture by moving back into bonds, with long-term mutual fund and ETFs in the fixed income space seeing inflows of more than $100 billion in the first quarter, versus total outflows of almost $9 billion in November and December of 2016. At the same time, investors continued to pour money into equity funds, which saw $73 billion coming in over the first quarter of 2017 versus $45 billion over the last two months of 2016.

The S&P 500 index gained 6.07% in the first quarter even as the yield on ten-year U.S. treasury bonds fell by five basis points, ending the quarter at 2.45. The yield curve flattened thanks to the Federal Reserve raising the federal funds rate by twenty-five basis points at their March 17th meeting. Three-month U.S. treasury yields rose twenty-five basis points to 0.76, while three-year yields saw a three basis point rise, ending the quarter at 1.47.

That investors were growing skittish over the Trump administration’s agenda, especially their “America First” policy (as articulated by the President in his inauguration speech), was further highlighted in the fact that the U.S. dollar index pulled back by 1.8% in the first quarter, after climbing 4.5% between election-day and the end of 2016. The decline in the U.S. dollar buoyed foreign equity indices priced in USD terms, with the MSCI EAFE Index (net) and the MSCI Emerging Markets Index (net) gaining 7.25% and 11.45%, respectively.

The Spouting Rock/Convex Global Dynamic Risk Fund (Institutional and Advisor Classes) (CVXIX and CVXAX) both gained 3.25% in the first quarter of 2017, compared to a return of 0.19% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index. As of 03/31/17, the Spouting Rock Global Dynamic Risk Fund average annual returns since the fund’s inception on 11/24/14 are 2.46% for CVXIX and 2.25% for CVXAX, compared to 0.21% for its benchmark. The returns for the one-year period ending 03/31/17 are 8.07% for CVXIX and 8.01% for CVXAX, compared to 0.36% for its benchmark.

Solid economic growth despite obstacles facing Trump agenda

Expectations for the new administration were tempered in the first quarter thanks to their agenda running into significant political obstacles. The top legislative priority for the administration, and Congressional Republicans, as they started their tenure was comprehensive tax reform. For tax reform to pass through simple majorities in Congress, and without any support from Democrats in Congress, legislation must be revenue-neutral after the first ten years. In a bid to make this an easier task, Republicans decided to tackle health care reform first, which would include repealing all the taxes in the Affordable Care Act (ACA) and thereby lowering the revenue baseline against which tax legislation would be measured.

However, legislators found it difficult to negotiate around the contentious set of trade-offs that ACA repeal and replace would entail, and the whole effort sank in late March. This raised questions about the ability of Congressional leadership and the White House to shepherd their ambitious legislative agenda through Congress. The good news is that the Trump administration took over an economy that continues to chug along at a steady pace, and is likely to do so even in the absence of a major fiscal push.

The U.S. economy grew just under 2% in 2016, close to its average annual real GDP growth since 2010. The post-election surge in consumer and business confidence aside, the hard economic data from the first quarter points to an economy that continues to grow along this trend. The unemployment rate fell to 4.5% in March, while monthly job creation averaged 178,000 in the first quarter, only slightly below the average 187,000 seen in 2016. The strong growth in payrolls suggests that there may be more slack in the labor market than previously realized. This is also reflected in the fact that wage growth, while strong, is still not climbing rapidly. Wages grew at an annual rate of 2.7% in March, slightly lower than the 2.9% rate in December 2016.

Personal consumption continues to drive the U.S. economy even though growth in personal spending fell to an annual rate of 2.6% in February, compared to 3.2% in December. Auto sales have clearly slowed from their record pace of growth in late 2016 but retail sales and food services (ex autos) jumped, growing close to 6% year over year in January and February. Interestingly, retail sales are growing despite a record number of store closings in the first quarter and retailers shedding 60,000 jobs in February and March. A lot of retail spending is clearly moving online. Home prices continue to grow at a steady rate between 5-6% annually, even as new home sales jumped in February to its highest level since July 2016 (though sales are still below their pre-financial crisis level).

The surge in the survey-based ISM manufacturing PMI index post-election (hitting 57.2 in March) finally began to be reflected in the hard data, with year-over-year change in the industrial production index climbing into positive territory for the first time since March 2015. On another positive note, business spending is also growing, with new orders for nondefense capital goods rising at an annual rate of 2.9% in February. However, it remains to be seen if this will continue into the second quarter, or if the pickup in growth is only due to base effects.

Headline inflation, as measured by the personal consumption expenditure (PCE) price index, climbed to 2.1% in February on the back of rebounding energy prices. Yet, core PCE still refuses to budge above 1.8%, as has been the case since October 2012. Despite core inflation continuing to remain below the Federal Reserve’s target, the committee was optimistic enough about economic growth to raise rates by twenty-five basis points at their March meeting. At the same time, they continue to maintain a more dovish posture, with most members forecasting a total of three rate hikes in 2017.

Crucially, the minutes from the meeting showed that officials also discussed unwinding the Federal Reserve’s (Fed) $4.5 trillion balance sheet, composed primarily of Treasurys and mortgage-backed securities it purchased as part of its quantitative easing programs. The Fed can allow the bonds to simply mature, without reinvesting the proceeds, or sell them on the open market prior to maturity. It appears that they prefer the former approach since the latter can result in higher rates as they sell-off their bond portfolio. The open question is at what point the Fed will start to taper their reinvestments and whether they will treat this as part of tightening policy, pausing interest rate hikes.

Convex’s proprietary leading economic index (CPLEI) risk rating for the U.S. rose from Hold-Buy at the end of December to Buy in the first quarter. Domestic equity allocation was maintained between 56% and 60% of the portfolio throughout the quarter. The allocation was not increased beyond this range, despite the strong risk rating, due to dampening of expectations as the new administration’s fiscal agenda faced obstacles. The portfolio’s exposure to domestic equities contributed 3.03 percentage points to the fund’s first quarter return.

Global economy sees recovery in spots

Cyclical recoveries appear to have taken hold in parts of Europe, especially Northern European countries like Germany, Netherlands, and Sweden. Germany’s manufacturing PMI climbed to 58.3 in March, which is the highest reading in almost six years. As for the Netherlands, new orders grew by the largest amount since December 2013, even as industrial production rose 2.9% year-over-year in March, higher than the average 0.6% between 2001 and 2017. Europe’s unemployment rate also continues to tick lower, coming in at 9.5% in February, compared to 10.2% a year ago and currently at its lowest level since May 2009. Further south, Spain is also making steady progress. The country has seen its unemployment rate drop by more than 2.5 percentage points over the past year, falling to 18.0% in February.

Consumer prices have also been surging in Europe on the back of rebounding energy prices, with headline Eurozone inflation hitting 2% year-over-year in February, before easing to 1.5% in March. Yet, core inflation has remained low, falling from 0.9% in February to 0.7% in March. The European Central Bank (ECB) left policy rates unchanged at their March meeting while reaffirming their quantitative easing program, at least through the end of this year. With Europe’s economy seeing some momentum, ECB President Mario Draghi indicated that the ECB is unlikely to take any further action to support the economy. On the other hand, they would probably need to see sustained inflation close to their 2% target before considering any policy tightening.

As we wrote at the beginning of the year, political uncertainty looms as a dark cloud over Europe, with populist, anti-EU parties looking to make gains in 2017 elections. However, elections held in March in the Netherlands saw the Dutch Prime Minister holding off his far-right rival, whose performance was worse than expected. The next big election to watch is the April 23rd Presidential election in France, followed by German elections are in September. At the time of this writing, the right-wing populist (and anti-EU) Marine Le Pen seems likely to make the run-off vote in May. While she is expected to lose the run-off election, there is still considerable uncertainty as to the result and suffice to say, the entire EU project could be upended in a hurry if she pulls off an upset.

The end of the first quarter also saw Britain’s Prime Minister, Theresa May, officially triggering Article 50 of the EU Treaty and starting the two-year countdown to EU exit. This promises to be a period of considerable uncertainty and tumult since it appears that the two parties, Britain and the EU, have different views on how the process should move forward. Britain would like a trade deal that gives it access to the EU single market negotiated in tandem with the formal divorce process. However, EU authorities are clear on the fact that Britain must formally leave the union before any trade negotiations can even begin. There is also the issue of funding commitments owed by Britain to the EU, which is going to be politically hard for the British government to reconcile with.

Over on the other side of the world, the Japanese economy appears to be waking up after a long slumber, with exports climbing 11.3% year-over-year in February thanks to rising global demand. The positive sentiment reflected in strong PMI numbers since October of last year has carried over into the hard data, with industrial production expanding at a robust 4.8% year-over-year rate in February. Just as encouraging is the fact that core inflation also moved into positive territory, coming in at 0.2% year-over-year in February, after averaging close to -0.3% in 2016. At the same time, the Japanese central bank seems to be in no hurry to lift its foot of the monetary easing pedal, reaffirming their commitment to get inflation up to their 2% target, and taking as many measures as necessary to achieve this. They continue to maintain short-term rates at -0.1% and are focused on their goal of guiding the 10-year government bond yield towards zero through aggressive asset purchases.

The CPLEI risk rating for Germany and Netherlands rose to Hold-Buy during the first quarter, while the risk rating for Spain and Sweden held steady at Hold. The overall regional rating remained at Hold thanks to Caution-Hold ratings for France, Switzerland, United Kingdom and Ireland. The portfolio did not have any exposure to the region due to uncertainty over elections.

Japan saw its rating rise to Hold-Buy in the first quarter, from Caution-Hold in December. The portfolio averaged a 5.5% allocation to Japan across the quarter, supported by a positive risk rating and continued easing policies by its central bank. Overall international equity exposure averaged about 8% of the portfolio in the first quarter, and contributed 0.11 percentage points to the fund’s quarterly return (with Japanese exposure contributing 0.06 percentage points of this).

The portfolio did not allocate to emerging markets during the first quarter, as this region was rated as Caution-Hold, including Caution-Hold ratings for China, South Korea, Hong Kong, Singapore and South American countries like Brazil and Chile.

The overall risk rating for the world rose from Hold in December to Hold-Buy in the first quarter, mostly on the back of positive US economic news. The portfolio averaged a 17% allocation to fixed income and 14% allocation to cash during the quarter, with the former contributing 0.07 percentage points to the overall quarter return. Fixed income allocation, which averaged 9% in January, was increased to more than 25% in February as the yield curve flattened amid a dampening of expectations for fiscal policy. Yet, most of the allocation was concentrated in corporate bonds (19% allocation split between high yield and quality) thanks to a strong Buy risk rating for the U.S. The portfolio had no allocation to short-term instruments due to expectations of the Federal Reserve raising interest rates at their March meeting.

Looking Forward

The biggest question on investors’ minds as the year began was how the new Trump administration would get out of the gate as they looked to implement their ambitious fiscal agenda. However, that entire agenda now appears to be stuck in the Congressional grinder, and so the question remains open.

As always, we shy away from making forecasts and predictions. However, there are five questions we are asking as the second quarter gets underway.

1. Tax reform or tax cuts?

The Trump administration’s top priorities of healthcare reform and a comprehensive tax overhaul have run into the realities of politics on Capitol Hill. Given that Congress was unable to even set a vote on health care reform, it is unclear whether a more ambitious legislative project like comprehensive tax reform will happen.

Current blueprints indicate that tax reform would have an enormous impact on every single aspect of the largest economy in the world, and certain provisions like the border adjustment tax would even impact global trade. Legislators can probably reach consensus in areas that involve cutting taxes, whether individual or corporate. However, the real test is whether Congress can reach an agreement on offsetting revenue, so that the legislation is revenue-neutral and does not explode the deficit. This is enormously challenging even under the best of circumstances. There is always some constituency or group that is lined up against proposed tax increases or spending cuts. In the case of tax reform, the lobbying effort will be immense, with powerful groups lined up for and against every single provision (like the border adjustment tax, which retailers are against).

The difficulty of passing a comprehensive tax reform package may lead Congress to pass a simple tax cut package instead. However, this is likely to be a temporary tax cut that will sunset after ten years, since legislative rules prevent legislation from increasing the deficit outside of a ten-year window (like the Bush tax cuts in 2001). So, the impact of such a tax cut is likely to be a lot more muted, and temporary.

2. Will the U.S. government shutdown at the end of April?

Again, this is a question related to Washington D.C. politics. Funding for the U.S. government is set to run out on April 28th. At the time of this writing, Congressional leaders are working on a bipartisan deal that will renew funding for another six months. However, the Trump administration is seeking to insert funding for the border wall project, which would lead to Democrats in Congress withdrawing support. By itself, a government shutdown would not have a significant impact on the economy, especially if it gets resolved quickly and Congress eventually passes a short-term fix (which is usually the case). However, it would not bode well for the legislative pipeline, which includes raising the debt ceiling in the third quarter, if they find it difficult to pass even a short-term funding bill.

3. Will Euro area cyclical recovery continue?

As we wrote earlier, inflation has picked up across Europe in the first quarter, even as several countries in the region see declining unemployment and higher manufacturing output. The question is whether this will continue into the second quarter and the rest of the year, and how much of this apparent resurgence is due to base effects i.e. poor numbers a year ago.

A related question is whether continuing economic upswing in Europe will give the ECB an excuse to start tightening monetary policy, or rather, pull back some of its quantitative easing measures. There is already a lot of pressure from the German contingent to begin this process.

4. What will be the outcome of the French Presidential election?

Latest polling indicates that the far-right, anti-EU candidate, Marine Le Pen, is poised to finish first in the April 23rd French election, which will send her into the run-off election (on May 7th) against the second-place finisher. Emmanuel Macron, a former investment banker from the progressive party, “En Marche!” (and the only candidate who is EU/globalization friendly), is the favorite to head into the run-off against Le Pen, and subsequently favored to win the run-off election to become France’s next President.

However, as we saw with Brexit and the U.S. Presidential election, there is ample reason to be wary of polls and so we are cautious about the outcome. At the same time, the most likely scenario is that neither of the two candidates favored to get to the run-off, Le Pen or Macron, will have parliamentary majorities with which to enact their agendas. So a Le Pen victory would not immediately mean a French exit from the EU, but it will certainly put a huge dampener on the European Union project since an EU exit is her long-term objective (along with a return to the franc). Uncertainty will rise as the range of outcomes widen, and could potentially have significant geopolitical impact as France looks inward and begins to pull back from its European and global commitments.

5. Will the yield curve continue to flatten even as the Federal Reserve raises rates?

Markets are pricing in more than 50% probability for the Federal Reserve to raise rates by another twenty-five basis points at their June meeting. At the same time, if long-term yields continue to fall, as they did in the first quarter, we could see the yield curve continuing to flatten. During the first quarter, ten-year inflation expectations as measured by the breakeven inflation rate – the difference between nominal yields and real yields (based on treasury inflation protected securities) – remained steady close to the 2.0% rate. Instead, long-term yields fell thanks to a fall in the term premium, which is back into negative territory after rising above zero during the immediate post-election period. We will be closely monitoring whether this risk-off sentiment continues into the second quarter.

The Convex proprietary risk rating for the world stands at Hold-Buy as we move into the second quarter. We continue to monitor economic prospects of thirty different countries across five regions of the globe. We also remain vigilant about potential risks arising from known-unknown risks, continuously seeking answers to the questions we asked above.



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As of 03/31/17, the Spouting Rock/Convex Global Dynamic Risk Fund average annual returns since the fund’s inception on 11/24/14 are 2.46% for CVXIX and 2.25% for CVXAX, compared to 0.21% for its benchmark. The returns for the one-year period ending 03/31/17 are 8.07% for CVXIX and 8.01% for CVXAX, compared to 0.33% for its benchmark. 

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