At the beginning of the year, we wrote about an aging bull market that we thought could be ridden, but with the caveat that one wouldn’t want to take too much risk given the magnitude of the move, current valuation levels in the U.S., and an overall evidence profile that was clearly mixed with pockets of both strength and weakness. When weighing the evidence, our dashboards offered no reason to reach for additional risk this late in the cycle, but instead we tried to focus on some big picture themes that could help us find attractive opportunities to position for.
Q1 Thematic Playbook Worked Well
Early this year we developed a roadmap based off of our forecasts, and that served us well in the first quarter. The roadmap was largely based upon four broad investment themes which are outlined below. While not everything worked out according to plan, most of our themes worked fairly well in the first quarter.
Theme #1: Follow the Dollar
For a variety of reasons, we like the prospects for the U.S. dollar to continue to strengthen over a multi-year timeframe. The first quarter saw a continuation of the dollar rally, with the dollar index gaining approximately 9%. This benefitted several different portfolio positions, including direct dollar index holdings, underweights in commodity and commodity equity, and also currency-hedged international holdings. For the first quarter, this theme worked about as well as we could have hoped for.
Theme #2: Follow Central Banks
Another theme that worked to our advantage was following the liquidity trail by making sure that we had exposure to countries where central banks were expanding stimulus programs. This theme didn’t disappoint either, with positions in both Europe and Japan delivering very good quarters. Of course, given that central bank largesse was weighing on currency markets, there was a sizable difference in returns depending on whether our positions were owned in dollars or in local currency terms. In the first quarter, this difference was most pronounced in Europe. For example, the difference in performance between a Europe ETF that doesn’t hedge currency exposure (EZU) and one that does (DBEZ) was an impressive 12%. This was due to the value of the euro plummeting as the European Central Bank embarked on a new asset purchase program, while the U.S. Federal Reserve is drawing closer to an interest rate hike later this year.
Theme #3: Avoid Emerging Markets Value Traps
There are several areas – such as Emerging Markets, commodities, and energy-related stocks – that we believe represent longer-term “value traps.” In the first quarter we carried underweights in these areas, and our mindset has been to not get caught in the value hype, and generally look to sell the rips rather than buy the dips. This theme had mixed results during the quarter. Emerging markets were extremely volatile, but did benefit from China’s outperformance. Commodities and energy did lag during the quarter, but also started to show signs of life (interestingly enough, at the same time that Chinese stocks bottomed and took off).
Theme #4: Prepare for More Disinflation
The combination of slow global growth, a strong U.S. dollar, and lower commodity prices is likely to continue keeping inflationary pressures at bay. So despite current low interest rates, we believe that portfolios should be positioned with no less than neutral levels of rate sensitivity. We’ve favored a barbell approach with a mix of high quality Treasuries/municipals on one end, and higher yielding credit that should benefit from strong corporate balance sheets on the other. The theme worked well as the CPI in the U.S. dropped to 0% during the quarter, which kept yields low, while credit-sensitive fixed income bounced back after declining late last year.
Inflection Point Arriving?
All in all, it was a good first quarter. Unfortunately, however, we can’t simply bottle it and walk away. The world constantly adjusts, and we have to acknowledge those adjustments as they come. While things generally worked well to start the year, we appear to be nearing an important inflection point that may have implications for portfolio positioning as the second quarter gets underway.
What We Aren’t Wavering On
One theme we are not wavering on is to follow global central banks. The European Central Bank continues to show major commitment to reflating its economy by recently embarking on a large scale asset purchase program, while the Bank of Japan is also buying assets at a furious pace in attempt to end its drawn out battle with deflation. Our commitment to this theme is strong, and we will likely continue to build into it in coming quarters unless there are important facts that change.
Dollar & Oil: Is a Major Counter-Trend Movement Brewing?
One of the bigger questions we are wrestling with at the moment is whether or not the possibility of a material counter-trend movement within the dollar and commodity markets should influence current positioning. Make no mistake, our longer-term conviction consists of a strong dollar bias and also that the commodity super cycle has ended. That being said, in the shorter-term the dollar seems ripe for a pullback after a strong surge. This possibility has led us to consider various options for how to deal with what should ultimately prove to be a temporary pause in the dollar’s upward trajectory.
Crude oil, which is typically inversely correlated with the dollar, also encountered extreme volatility as it plunged 60% from its high last summer. Some believe that oil has found an intermediate-term bottom; if that’s the case, then there’s a significant chance that a reflective bounce could be commensurately material, with some technical targets as high as $70-$80 dollars per barrel. That would imply a considerable extension of its recent bounce, which is already up by 35% from its recent low. A surge of such magnitude would likely lift the entire commodity complex, and would leave ample room for commodities and energy-related stocks to bounce from here and relatively outperform over the next quarter or two, even within the context of a longer-term bear market.
Signal or Noise from China?
China’s domestic stock market has been soaring since the fourth quarter of last year, nearly doubling in that span. The move has been driven by a move last fall to open market access to a broader number of investors, as well as increasing actions on the part of China’s central banks to counter the ongoing economic slowdown. There continues to be an ongoing debate within the investment community regarding whether China will experience a “hard” or “soft” landing as they transform their economy away from the previous model of investment-led growth and towards more consumption. The jury is still out on that issue, but the latest move in the market may be a signal that better growth lies ahead. If China does reaccelerate, it would have important implications for the overall global growth outlook due to the size of its economy and trade ties to many other countries.
Disinflation or Inflation?
Another one of the themes reflected in portfolios is based on the view that the current disinflationary environment would continue to keep a lid on bond yields. This theme was partially predicated on a strong dollar helping to thwart the inflationary tendencies that would normally percolate by this stage of an economic expansion. It’s also based in part on weaker growth outside the U.S. contributing to an overall lack of demand in the global economy. Clearly if we get a short-term surge in commodities, it could temporarily derail the softening inflation picture.
The other component that could challenge a disinflationary view is the state of the global economy. The U.S. economy likely grew very little in the first quarter, with analyst GDP estimates ranging from 0% - 1.5% growth. We continue to think this was largely a replay of 2014 that was driven by weather and west coast port shutdowns, and are expecting a rebound in growth in coming quarters due to the lagging effects of low oil, low interest rates, and a solid job market providing a boost to the U.S. consumer.
But just as important as the U.S. growth backdrop, the currency weakness overseas has clearly redistributed growth abroad. Europe’s economy seems to be rebounding faster than anticipated, Japan is no longer in recession, and the wild card may lie in the emerging markets where data is still weak, but where central banks have just begun an interest rate easing cycle that may boost growth in those economies. We realize that the overcapacity that exists around the globe will not end overnight. But any sign of an upturn in inflation could ignite an overdue rise in bond yields.
What to Do?
The first quarter was favorable for Pinnacle portfolios as most of our investment themes worked. But now, markets seem to have arrived at a critical juncture where trends are likely due for a pause of unknown duration, leaving us to determine whether we may need to shift tactics or simply ride out potential countertrend moves. While the internal strategy discussions continue, the best we can offer at the moment is to stay tuned as we ponder whether it’s time for a few halftime adjustments.
