Equity markets continued to grind higher over the summer, with the S&P 500 notching a quarterly return of 4.5% and posting eleven straight months of gain. The index has gained 14.2% through the first three quarters and is at record high levels. Even an escalation of the situation in the Korean peninsula caused the briefest volatility spike. Volatility, as measured by the VIX index, rose from below 10 to close above 16 on August 10th, as markets responded to President Trump’s warnings against North Korean aggression. However, the index plunged back below the 10 handle in September, falling to its lowest close since December 1993.
Equity markets outside the U.S. also saw significant momentum, reflecting a solid and stable global economy. The MSCI EAFE Index (net) gained 5.4% over the third quarter (Q3), powering the index to a year-to-date gain of 20.0%. The MSCI Emerging Markets Index (net) rose 7.9% in Q3 and is up 27.8% year-to-date, keeping it on track for its best year since 2009.
Fixed income gained over the first two months of the quarter as falling inflation numbers raised doubts as to whether the Federal Reserve would raise rates for a third time before the end of the year. However, they reiterated their commitment of raising rates at their September meeting, sending yields higher. U.S. ten-year yields ended the quarter at 2.33, just 2 basis points higher than where it started Q3. Unlike the previous quarter, we did not see significant yield curve flattening either. The spread between yields on ten-year and two-year U.S. treasury bonds fell 7 basis points to 0.86, while the spread between ten-year and three-month yields was more or less flat at 1.27.
The Bloomberg Barclays U.S. Aggregate Bond Index gained 0.8% in Q3 and is up 2.6% over the first three quarters of the year. The Bloomberg Barclays Global Aggregate Bond Index outperformed, rising 1.76% in Q3 and up 6.3% year-to-date as of September 30th.
The U.S. dollar index continued to fall thanks to growth picking up around the world. The trade weighted dollar index (against major currencies) fell 2.7% during the quarter, and is now down 8.0% year-to-date through Q3.
The Spouting Rock/Convex Global Dynamic Risk Fund Institutional (CVXIX) gained 3.07% in Q3, with a year-to-date gain of 9.26%, The Advisor class (CVXAX) gained 2.88% in Q3 and 9.07% year-to-date. This compares to a Q3 return of 0.26% and year-to-date return of 0.57% for its primary benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index.
As of September 30th, the average annual return since the fund’s inception, on November 24th 2014, are 4.07% for CVXIX and 3.83% for CVXAX, compared to 0.33% for its benchmark. Returns for the one-year period ending September 30th are 10.50% for CVXIX and 10.34% for CVXAX, compared to 0.66% for its primary benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index.
U.S. economic momentum slows
Economic momentum in the U.S. is clearly slowing as the post-financial crisis expansion continues to age. Monthly payrolls grew at an average rate of only 91,000 in the third quarter, with September registering the first monthly job loss (-33,000) in seven years – though this was most likely related to losses due to hurricanes in Texas and Florida. The pace of job growth over the first nine months of the year is at its lowest level since 2011, even as the unemployment rate fell to a 16-year low of 4.2% by the end of Q3. At the same time, the percentage of people who went from not being in the labor force to being employed surged in September, to its highest level in more than 25 years. This suggests that there may be more people out of work, but excluded from the labor force, than the official unemployment rate indicates.
Personal consumption, the backbone of the U.S. economy, remains stable. Auto sales initially plunged in 2017 (albeit from record levels last year) but September saw sales rebound to the highest rate since July 2005, thanks to cars being replaced after hurricane damage in the South. Consumer confidence remains high, with retail sales excluding the auto sector growing at a steady annual pace. New home sales were 17% higher in August compared to the same month last year, even as home prices rise between 5% and 6% annually.
Business spending also continues to grow, boosting manufacturing. Manufacturing has made a strong comeback in 2017, with ISM PMI posting a new six-year high of 60.8 in September. The energy sector is also recovering as oil prices stabilize around $50 a barrel.
A fiscal package from Washington to boost the economy above its post-Financial crisis trend remains elusive. Health care reform appears dead for now, but the Trump administration and Congress have released outlines of a tax reform package that they expect to pass before the end of 2017. As hard as health care was, tax reform could create winners and losers across the economy. So it remains to be seen whether this will actually happen.
At the same time, the Federal Reserve has clearly derived enough confidence from recent economic numbers to stick to their plan of raising rates three times this year, with the third hike coming in December. This is despite inflation falling further away from their target – core personal consumption expenditures fell below 1.30% in August, its lowest level since October 2015. Instead, the impetus to continue raising rates comes from the fact that unemployment has fallen to 4.2%.
Convex’s proprietary leading economic index (CPLEI) risk rating for the U.S. fell from Hold-Buy at the beginning of Q3 to Hold in August and September, as economic data, especially on the consumption side of the economy, softened slightly. Domestic equity exposure was subsequently reduced from 44% at the beginning of the quarter to 35% by the end of August. The allocation to U.S. equities contributed 148 basis points to the fund’s second quarter return of 3.07%.
Optimism abounds in Europe
Business and consumer confidence continue to rise in the Euro region as the recovery strengthens. Demand has clearly picked up across the Euro-area and globally, boosting exports from some of the Northern European countries that rely on manufacturing. Manufacturing PMIs in Germany (60.6), Netherlands (60), Sweden (63.7) all hit new highs in September.
Even France, which has lagged some of its European neighbors this cycle, saw its PMI surge to a six and half year high of 56.1, driven by rising domestic and foreign demand. Potential labor market reforms by the new Macron government gives cause for further optimism.
Spain also saw its PMI rebounding to 54.3 in September from a 12-month low of 52.4 in August. Consumer confidence also hit an all-time high in Spain in August, though retail sales appear to have lost some of its second quarter momentum. However, the Catalonia independence movement does raise uncertainty for Spain since it is a significant threat to the country’s legal order. Secessionists have openly defied the authority of Spanish courts, police and the government in Madrid. It remains to be seen as to how Madrid will deal with its biggest constitutional crisis since democracy was established in the 1970s. Prime Minister Rajoy could crack down hard on the separatists, or hold back while economic and political pressure prompts them to back down. It seems highly unlikely that Madrid will compromise and give the Catalans increased autonomy similar to the Basque region (including control of tax collection), let alone outright independence.
Meanwhile, the European Central Bank (ECB) looks set to end crisis-era stimulus measures amid strengthening economic growth and a potential shortage of eligible bonds for its quantitative easing (QE) program. At their September meeting, ECB President Mario Draghi said the bank would spend most of its October meeting discussing how to end its €60 billion a month bond-buying program. Yet he repeatedly stressed that the bank will hold interest rates at their low level well past the horizon of QE, in a bid to temper some of the euro currency’s recent surge. The euro has surged more than 5.5% since Draghi’s speech in Sintra, Portugal on June 27th, when he first hinted that the ECB might be ready to taper. The common currency has gained 10.4% against the dollar over the first nine months of the year and its rise prompted the central bank to cut its inflation projections for 2018 and 2019, even as they raised growth forecasts for these years.
The United Kingdom remains shrouded by the enormous uncertainty of how Brexit will proceed. Prime Minister May recently requested a two-year transition deal to ease Britain’s exit from the European Union and provide businesses some clarity as to what the trade relationship will look like after March 2019 (when Brexit becomes final). May also wants talks on a future trade relationship to proceed concurrently with divorce terms. However, the EU plans to reject this request since there has not been sufficient progress on the terms of the divorce itself, i.e. the size of the Britian’s financial obligations to the EU, as well as on issues such as the rights of EU citizens residing in the UK and status of the Irish border post-Brexit. While British leaders appear confident that a deal can be struck, EU member countries like Germany are telling their firms to brace for a very hard Brexit or face heavy losses.
The CPLEI risk rating for European developed markets held at Hold-Buy in Q3, on the back of solid macro-economic numbers in Germany, Netherlands, Spain and Sweden. Ratings for the United Kingdom and Italy remained at Caution-Hold. Allocation to developed Europe was raised from 12% at the end of Q2 to 17% by the end of August, and contributed 82 basis points to the fund’s third quarter return of 3.07%.
Over on the other side of the world, Japan has seen business confidence rise to its highest level since the third quarter of 2007 on the back of rising trade momentum – exports surged more than 18% year-over-year in August (the biggest gain in almost four years) while imports climbed more than 15%. The country looks well on track to record a seventh straight quarter of growth in Q3, which would make this the longest expansion since 2006. The CPLEI risk rating for Japan held at Hold-Buy throughout Q3. The portfolio averaged a 6% allocation to Japan across the quarter, which contributed 24 basis points to the fund’s third quarter return.
Growth in emerging economies remains muted. India is struggling to deal with the implementation of a new goods and services tax (GST) introduced in July, as well as fallout from the government’s demonetization policy last fall. China continues to meet GDP expectations, although much of the growth is fueled by significant government infrastructure spending and property investment. Tighter monetary policy and stringent capital regulation saw overall debt-to-GDP fall from 269 percent at the end of Q1 to 268 percent at the end of Q2. This is obviously small but is meaningful since it is the first decline in six years. It is an open question whether this is merely a blip or the beginning of a downward trend.
Convex continued to rate China, and most other emerging countries in Asia and Latin America, as Caution-Hold across Q3, due to less than stellar growth and macro risks. The Federal Reserve remains committed to raising interest rates and this would typically be accompanied by a rise in the dollar, making it harder for companies in this region to service their dollar-denominated debt (which is significant). However, we have seen the opposite this year, giving these countries respite from a stronger dollar – though this may prove to be temporary. They also face risks related to potential tariffs the Trump administration may impose on goods imported into the United States, in a bid to boost domestic manufacturing and the export sector.
The fund held opportunistic positions in selective emerging markets in Q3, including Taiwan (rated Hold), India (Hold) and South Korea (Hold-Buy). Total allocation to these countries was reduced from 4% in June to just above 2% in August, and eventually to zero by the end of the quarter as the ratings fell to Caution-Hold. Allocation to emerging markets contributed 21 basis points to the fund’s third quarter return.
The overall risk rating for the World fell from Hold-Buy at the beginning of the quarter to Hold in September, mostly due to slower economic momentum in the U.S. Fixed income allocation was reduced from about 29% at the beginning of Q3 to almost 20% by its end. The portfolio’s allocation to intermediate- and long-term quality bonds was reduced in September due to rising interest rates along the long end of the yield curve.
As always, we shy away from making forecasts and predictions. However, there are five questions we are asking as the fourth quarter gets underway.
1. Will tax reform, or tax cuts, get done before the end of the year?
The failure to pass health care reform has put pressure on the Trump administration and Congressional Republicans to make progress on tax reform, giving them at least one large legislative victory this year. The administration recently released a broad outline of what they would like to see in a tax bill, but Congress is yet to begin converting this into actual legislative text. As we discussed in our piece on tax reform, they will have to navigate a complex set of trade-offs as the bill gets written, let alone passed. Republicans would like to incentivize business by slashing the corporate tax rate from 35% to 20%, while also delivering tax cuts to individuals. Both of these objectives will have to be squared with several members’ desire to not raise the federal deficit and debt. However, base broadening measures like eliminating several business deductions and provisions on the individual side, like deductions for state and local taxes, are already facing intense opposition. This reduces the likelihood that tax reform will actually happen this year, if at all. At best, Congress is likely to pass a politically palatable package of temporary deficit-raising tax cuts.
2. How will trade partners retaliate against new tariffs imposed by the administration?
Tariffs imposed by the Trump administration – such as the recent 220% tariff on Canada’s Bombardier jets that were ordered by Delta airlines – is likely to raise tensions with trade partners and uncertainty. The Commerce department is also looking into imposing steel tariffs based on national security grounds, which would be the most significant act of protectionism for the U.S. steel industry in 15 years. In an ironic twist, steel imports have spiked as domestic consumers look to front-run higher tariffs and higher prices.
The administration has also put forward a set of controversial proposals ahead of the fourth round of NAFTA re-negotiations. These include higher domestic content for autos, restricted access for Canada and Mexico to the U.S. government procurement market, changing the dispute settlement mechanism (companies use this to take legal action against foreign governments that undermine their investments) and auto-termination of the agreement after five years unless all three countries renew the pact (a sunset clause) – all of which are opposed by Congress as well as the business and agricultural community. There is a serious chance of negotiations breaking down since Canada and Mexico have also opposed these provisions.
3. Will inflation pick up in the fourth quarter?
The Fed has raised rates twice already this year and is expected to do so for the third time in December despite inflation going in the opposite direction from their target. Fed officials have attributed this to transitory factors such as cellular phone plan prices, which have fallen steeply due to increased competition. However, our own research indicates that the decline is more broad-based than just cheaper wireless service. The question is whether this falling inflation trend will reverse, and if not, whether that causes the Fed to pause, especially if job growth continues to slow. On a positive note, wage growth appeared to have turned a corner in Q3, with annual wage growth surging to a pace of 2.9% in September, up from a low 2.5% in June. Though it remains to be seen whether this is a temporary bump due to low-income workers, especially in the restaurant industry, not showing up for work amid hurricanes in the South.
4. Will the euro’s surge make Eurozone exports more expensive and crimp economic growth?
Rising global demand has boosted the European export sector, which in turn has bolstered Europe’s recovery. At the same time, as we wrote earlier, the euro has appreciated significantly this year, especially in Q3 amid wide anticipation that the ECB will unwind its stimulus program sooner rather later. The big near-term question is whether a strengthening euro will reduce demand for the regions exports, slamming the brakes on Europe’s recovery. While a good chunk of Europe’s exports are within the Eurozone, more than 50% flows to regions outside it. So far exports appear to be shrugging off a stronger euro – for example, German exports surged in August to the highest level in twelve months. It remains to be seen whether this will continue, and if not, whether the ECB will slow the pace of tapering.
5. Will the rhetorical back-and-forth between President Trump and North Korea subside, or erupt into something worse?
The tension between President Trump and the North Koreans has escalated over the past two months, with both sides calling for total destruction. The President has continued to threaten military action and leaned on China to implement a stricter sanctions regime on its neighbor even as North Korea frantically races to further develop its nuclear missile capability. While all-out war on the Korean peninsula appears to be highly unlikely, the heated back-and-forth and an apparent lack of even back-channel communication does raise a tail risk possibility of a miscalculation by either side.
The Convex proprietary risk rating for the world stands at Hold as we move into the fourth quarter. We continue to monitor economic prospects of thirty different countries across five regions of the globe and remain vigilant about potential risks.
Any statement regarding market events, future events or other similar statements constitute only subjective views, are based upon expectations or beliefs, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond Spouting Rock’s control. In light of these risks and uncertainties, there can be no assurance that these statements are now or will prove to be accurate or complete in any way. No representation is made that Spouting Rock’s investment processes, strategies or investment objectives will or are likely to be successful or achieved.
As of 9/30/2017, the Spouting Rock/Convex Global Dynamic Risk Fund average annual returns since the fund’s inception on 11/24/2014 are 4.07% for CVXIX and 3.83% for CVXAX, compared to 0.33% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury . The returns for the one-year period ending 9/30/2017 are 10.50% for CVXIX and 10.34% for CVXAX, compared to 0.66% for its benchmark.
The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Performance data current to the most recent month end can be obtained by calling Spouting Rock Fund Management at 610-788-2128.
The gross expense ratio is 8.87% for CVXIX and 9.27% for CVXAX. The net expense ratio for CVXIX is 1.60% and CVXAX is 2.00%.
The Fund’s adviser has contractually agreed to waive its management fee and/or reimburse expenses through January 31, 2018 so that total annual fund operating expenses (excluding portfolio transaction and other investment-related costs (including brokerage fees and commissions); taxes; borrowing costs (such as interest and dividend expenses on securities sold short); acquired fund fees and expenses; fees and expenses associated with investments in other collective investment vehicles or derivative instruments (including for example option and swap fees and expenses); any amounts payable pursuant to a distribution or service plan adopted in accordance with Rule 12b-1 under the Investment Company Act of 1940; any administrative and/or shareholder servicing fees payable pursuant to a plan adopted by the Board of Trustees; expenses incurred in connection with any merger or reorganization; extraordinary expenses (such as litigation expenses, indemnification of Trust officers and Trustees and contractual indemnification of Fund service providers); and other expenses that the Trustees agree have not been incurred in the ordinary course of the Fund’s business) do not exceed 1.35% of the Fund’s average daily net assets.
As of 09/30/2017, the Fund did not directly invest in shares of Delta Air Lines Inc or Bombardier Inc. The Fund portfolio held a 7.09% weight in the SPDR S&P 500 ETF and 4.83% weight in the Industrial Select Sector SPDR ETF, in which Delta Air Lines Inc shares had a weight of 0.16% and 1.48%, respectively. The Fund portfolio held a weight of 3.18% in the iShares MSCI Canada ETF, in which Bombardier Inc had a weight of 0.30%.
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