Equity markets continued their low volatility surge in the fourth quarter (Q4), with the S&P 500 posting a 6.6% return across the quarter and ending 2017 with a 21.8% annual gain. A lot of attention during the quarter was focused on whether or not Congress would be able to write and pass tax legislation before the end of the year. After much scrambling, both the House and Senate pulled off a massive effort at restructuring the US tax code, and eventually got it to President Trump’s desk before the end of the year.
Strong equity markets were not unique to the US thanks to a cyclical upswing in economies across the world, particularly in developed markets. The MSCI EAFE Index (net) rose 4.2% in Q4, and ended the year with a 25.0% gain. Emerging markets lapped everyone else, with the MSCI EM Index (net) rising 7.4% in Q4 and 37.3% over the entire year. The Technology sector was chiefly responsible for powering equity market gains across the world, as global growth lit up all the green signals for investors to take risk-on positions. The MSCI ACWI Index (net) gained 5.7% in Q4 and 24.0% across 2017.
One big puzzle in Q4 was the continued flattening of the yield curve, despite above-trend growth in the US. US ten-year treasury yields rose 7 basis points (bps) in Q4, from 2.33 to 2.40 – which is lower than where it began the year (at 2.45). At the same time the spread between yields on ten-year and two-year treasury bonds fell from 86 bps at the beginning of Q4 to 51 bps at its end. Overall, the spread compressed by 74 bps in 2017. Rates at the short-end of the curve were boosted by the Federal Reserve staying on their tightening path, which included the year’s third rate hike at their December meeting. So the real question was why yields on the long-end of the curve seemingly refused to budge.
The Bloomberg Barclays US Aggregate Bond Index gained 0.4% in Q4, and rose 3.5% overall in 2017. The Bloomberg Barclays Global Aggregate Index outperformed thanks to a lower US dollar, gaining 1.1% in Q4 and 7.4% across the entire year.
The Spouting Rock/Convex Global Dynamic Risk Fund (Institutional and Advisor classes) (CVXIX and CVXAX) gained 3.69% and 3.58%, respectively, in the fourth quarter, compared to a return of 0.28% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index. The returns for the one-year period ending 12/31/2017 are 13.29% for CVXIX and 12.97% for CVXAX, compared to 0.86% for its benchmark. As of 12/31/2017, the average annual returns since the fund’s inception on 11/24/2014 were 4.95% for CVXIX and 4.69% for CVXAX, compared to 0.40% for its benchmark.
A Christmas bonus for the United States
Republicans in Washington D.C. finally passed the number one item on their wish list – tax reform, or rather tax cuts – in December. The primary component of the package, scheduled to take effect in 2018, is a substantial reduction in the corporate tax rate from 35% to 21%. The idea is to make US companies more competitive on the global stage. While tax cuts will certainly raise the amount of cash on corporate books, it remains to be seen whether businesses will use excess cash to boost spending over and above current trend – or if the result will be increased M&A activity, buybacks, dividends and/or debt repayment. Consumers are slated to get a break on their taxes too, though these are not as significant as those on the corporate side, and they are scheduled to expire within ten years.
Even as tax legislation was making its way through the halls of Congress, and uncertainty over its passage ebbed and flowed, the US economy picked up a bit of steam over the last three months of the year. This is perhaps most exemplified by an unemployment rate that hit 4.1 percent in December, the lowest rate since 2000. Job growth recovered in the fourth quarter, averaging 203,000 per month, after hurricane-affected growth of only 128,000 in the third quarter. The only puzzle is that wage growth has refused to accelerate, with average hourly earnings growing only 2.5 percent year-on-year in December, versus 2.8 percent in September.
Consumer spending also ticked up during the fourth quarter, with retail sales (excluding autos) rising 6.3 percent year-on-year in December, the fastest pace since February 2012. However, light vehicle sales edged lower after a temporary hurricane related surge in September – vehicle sales were down 1.5 percent compared to December 2016. A big positive was the surge in activity within the housing sector. New home sales spiked in November to the highest level since July 2007 and up 26.6 percent from a year ago. Home prices also accelerated, with the Case-Shiller 20-City Composite Home Price Index rising 6.4 percent in October and breaking out of the sub-6 percent range we have seen since 2014.
In addition to a strong consumer sector, business spending picked up rapidly in the fourth quarter, rising at a pace of almost 10 percent in October (year-on-year) before dropping slightly to 8 percent in November – which is the fastest pace since April 2012. Economic activity in the manufacturing sector continues to pick up, with the ISM manufacturing PMI index at 59.7 in December and one of the highest in the World.
All of this has given the Federal Reserve enough justification to remain firmly committed to their projected policy path. They raised rates for the third time in 2017 at their December meeting amid confidence that the labor market was tight and belief that inflation is just around the corner. Inflation did pick up slightly in Q4, with core personal consumption expenditures price index rising 1.5% in November, up from a low of 1.3% in August.
Convex’s proprietary risk rating for the US reflected the economy’s renewed strength, rising from Hold at the beginning of the fourth quarter to Hold-Buy in November and Buy in December. Consequently, US equity allocation was increased from 46% at the beginning of October to 60% by December. The allocation to US equities contributed a positive 306 basis points to the fund’s fourth quarter return of 3.69%.
Global economic upswing
Economic momentum was not isolated to the US, as the fourth quarter saw a simultaneous upswing across the developed world. Eurozone manufacturing PMI was 60.6 in December, which is close to the highest reading ever. PMI levels ended 2017 at or close to record levels in Germany, Netherlands, Austria and Ireland, while France was at a 17-year high. Industrial production in the Euro area rose 3.2 percent year-on-year in November, only slightly behind the 3.9 percent pace for October. Optimism continues to surge in Europe, both amongst businesses and consumers – December saw business confidence is at its highest reading since 1985 while consumer confidence is at its highest level since 2001.
Europe’s labor market is also improving quite rapidly, with the unemployment rate falling to 8.7 percent in November, the lowest rate since January 2009. Note that high levels of unemployment still plague a number of countries, most notably Spain, and unemployment remains well above pre-crisis levels across a large part of the continent. As a result, there has been no pressure on wage growth and inflation only moved further away from the European Central Bank’s (ECB) target rate in the fourth quarter. Yet the ECB does appear to be confident that economic recovery has taken hold. At their October meeting they unveiled plans to begin tapering their quantitative easing program starting January 2018, and perhaps end it by September.
Convex’s proprietary risk rating for Europe was maintained at Hold in the fourth quarter. Other than Germany, which was rated Hold-Buy, most of the other countries in Europe were rated Hold throughout the quarter. The exceptions were the United Kingdom – rated Caution as they continue to grapple with the ramifications of Brexit – and Italy, Ireland and Denmark, all of which were also rated Caution-Hold. Allocation to developed Europe averaged almost 10% in the fourth quarter and contributed 3 basis points to the fund’s fourth quarter return of 3.29%.
Japan is in the midst of an economic summer and is now on track to see eight straight quarters of expansion as of the fourth quarter of 2017. Manufacturing PMI for December rose to 54, reflecting the strongest growth for the sector since February 2014. Economic momentum is clearly riding high on the back of business spending and exports (which climbed 16.2 percent year-on-year in November). The economy received an added boost, vis a vis Abenomics, when Prime Minister Shinzo Abe secured a strong mandate in the October elections. The Japanese Central Bank also looks set to keep monetary policy on the easy side for the immediate future. The risk rating for Japan stood at Hold throughout the fourth quarter. The portfolio averaged a steady 6% allocation to the Japanese equities across the quarter, which contributed 50 basis points of gain to the fund return.
The fund portfolio held an average 2% allocation to an Emerging Market basket in November and December, which added 7 basis points to the fourth quarter return. The risk rating for the region rose to Hold, on the back of a higher rating for China (which rose from Caution-Hold to Hold). Despite relatively strong data coming out of China, the fund still took a cautious posture due to concerns over rising debt levels and financial stability. Export oriented countries vital to the global supply chain, like South Korea and Taiwan, also saw their risk ratings at Hold thanks to rising global demand. Brazil saw its risk rating rise to the same level after posting encouraging manufacturing and sentiment data in October and November, even as inflationary pressures eased. India remained at Caution-Hold as the country saw falling credit growth and implementation issues around a new goods and sales tax.
The overall risk rating for the World rose from Hold at the beginning of the quarter to Hold-Buy in November, thanks to renewed economic momentum in the US. Fixed income allocation averaged a steady 20% of the portfolio across the quarter, with exposure split almost equally between quality (predominantly on the corporate side) and high-yield bonds. The allocation contributed 2 basis points to the fund’s fourth quarter return. The portfolio’s allocation to cash was reduced from 12% at the beginning of the fourth quarter to 3% in December, as the fund increased exposure to equities.
With the Federal Reserve committed to rate hikes and a new tax bill that significantly restructures the US tax code, especially on the corporate side, there certainly is a lot going on in the US. At the same time, as we mentioned above, the global economy is seeing a simultaneous upswing. While we shy away from making forecasts and predictions, we are closely watching and seeking answers to several questions as 2018 gets underway.
1. Will businesses spend more in 2018, on the back of tax reform?
This is the big question. Tax cuts will certainly raise the amount of cash on corporate books but it remains to be seen how much will be spent on capital investments. Prior evidence and statements from CEOs suggest that a large part of may be used toward buybacks and higher dividends. Also, provisions governing international taxation are significant, with potentially huge implications. So the full impact of the tax bill may not be known in the short term.
2. Will wage growth and inflation pick up in 2018?
The lack of wage growth and the backsliding of inflation in 2017 was a puzzle, despite a seemingly tight labor market. Federal Reserve officials maintained that the lack of inflationary pressure was a result of transitory factors, like falling cellphone plan prices. However, our research indicates that the slowdown was broader. The question is whether this is likely to change, especially in the face of disinflationary effects like demographics and online retailing.
3. How many times will the Federal Reserve raise rates in 2018?
The Federal Reserve stayed true to their forecast of three rate hikes in 2017. They forecast three more rate hikes in 2018, based on their baseline assumption of approximately 2.5 percent GDP growth. What will be interesting is if GDP growth actually edges closer to the 3 percent mark in 2018. This would in all likelihood drop the unemployment rate further below the committee’s forecast of 3.9 percent for 2018. One can easily envision a scenario in which members start to worry about an overheating economy, especially if inflation also picks up (their forecast for 2018 is 1.9 percent), and perhaps include a fourth hike to slow things down.
4. Will the yield curve invert by the end of 2018?
Of course, as the Federal Reserve looks set to tighten monetary policy and raise short-term rates, the question is whether the yield curve will invert by the end of 2018. Essentially, the question boils down to whether we will see yields along the long end of the curve move up in tandem with short-term rates. Despite forecasts of rising long-term rates since 2013, yields have consistently fallen over each of the past four years. Our own work has shown that external demand, especially from Europe – which faces negative yields and a shortage of safe assets – exerts downward pressure on yields. If the Federal Reserve rate hike path is steeper than the ECB or BoJ, the yield differential will only increase, putting further downward pressure on yields.
5. What will be the US approach to NAFTA and trade with China?
US officials laid down a tough line during recent NAFTA renegotiations, rolling out a controversial set of proposals that shocked Canada and Mexico, not to mention Congress and the business and agricultural community. The Trump administration also initiated investigations into Chinese trade practices, especially around intellectual property. In the event that the trade representative recommends tariffs, or even blocks China’s access to certain US markets, one could expect a swift retaliation from the Chinese. The probability of NAFTA falling apart and/or a trade war with China may be low but it is not insignificant. The consequences, especially unintended ones, for the global economy if countries revert to a protectionist stance in response to the US could be severe.
6. Will the global economy continue to steam ahead?
As we wrote above, the global economy, especially in developed countries, has been on a remarkable upswing over the past year. This has come on the back of rising exports and business spending, which should only continue if the global economy continues its recent trend, resulting in a positive feedback cycle. Emerging market economies have also seen a boost amid rising demand in the developed world and inflation has also been under control – commodity prices have been less volatile, remaining in a favorable trend for both importers and exporters. Credit growth has been strong in Asia, especially in China and South-East Asian countries like Philippines and Vietnam. A potential headwind could arise if inflation picks up faster than expected in developed markets, without a proportionate rise in demand. This would force their central banks to tighten policy at a quicker pace and force EM policymakers to do the same even if it may not be ideal.
7. Will European and Japanese Central Banks start to pull back ultra-easy monetary policy?
With Europe and Japan seeing robust economic growth for the first time in years, the question arises as to whether their respective central banks should continue highly accommodative monetary policy, and whether they can wind down stimulus measures in a stable manner. As the same time, inflation in both regions remains well below central bank targets. The ECB is tapering its bond purchases but it is unlikely that we will see them start to raise rates in 2018, especially if inflation remains on the lower side. While the BoJ also appears committed to keeping policy on the easy side, they recently announced that purchases of long-dated bonds would be trimmed. This immediately roiled fixed income and currency markets, indicating that markets are clearly sensitive to any sign of tapering.
8. Will the US dollar reverse its decline in 2018?
Typically you would expect the dollar to rise amid Federal Reserve tightening and tax reform. Exactly the opposite happened in 2017, with the trade-weighted US dollar index (against major currencies) falling 8.6% over the year. One positive side effect of a falling dollar was that net exports did not drag on US GDP growth in 2017 (first three quarters), in sharp contrast to the 2014-2016 period. The lower US dollar has also given EM a reprieve form tighter policy in the US. A lower dollar makes it cheaper to service dollar-denominated debt, which boosts purchasing power of foreign businesses, leading to ever more credit growth and higher real investment returns, especially in EM. In other words, the global economic upswing is feeding off dollar denominated credit, which in turn makes the dollar weakness self-sustaining. So the dollar could find itself under renewed pressure if the global economy continues to power ahead.
9. How will China manage its rebalancing and deleveraging process?
China posted higher reserves for the eleventh straight month in December 2017 thanks to strict capital controls. A weaker dollar has helped reduce pressure on the yuan and China’s economy has held up amid the global recovery, boosting exports. Yet the reality is that China has not quite begun to rebalance its economy, with growth still dependent on traditional industries. Also, while officials appear to have begun the process of deleveraging – putting curbs on financial institutions and the shadow banking sector – debt across Chinese firms continues to grow, with levels at the end of September growing at the fastest pace in four years. It remains to be seen whether authorities will extend the deleveraging process beyond financials, and if this can be done without posing a threat to the economy.
10. Tail-risk from North Korea?
A potential tail-risk is the possibility of war in the Korean peninsula. North Korea made significant advances to its missile and nuclear program in 2017, even as they face increasing pressure from the White House and the United Nations. Any hostilities between the US and North Korea faces enormous risk, including unimaginably large loss of life. South Korea is a vital player in global trade and military action in the peninsula will probably cause severe economic disruption across the globe.
The Convex proprietary risk rating for the world stands at Hold-Buy as we move into 2018. 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 3/31/2018, the average annual returns since the fund’s inception on 11/24/2014 were 3.78% for CVXIX and 3.51% for CVXAX, compared to 0.48% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury. The returns for the one-year period ending 3/31/2018 are 6.94% for CVXIX and 6.52% for CVXAX, compared to 1.11% for its benchmark.
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