2018 Q2 Quarterly Report

Economic Commentary

Unemployment has continued to decline during the 2nd Quarter (Q2) of 2018 to levels not seen since the beginning of this millennium. With the benefits of hindsight, we know how and why the music stopped on the Dot-com boom, a year after the lowest levels of unemployment since the late 1960’s. Currently, at 3.8%, we are again knocking on the door of the lower-bound limit while pondering its contribution to effects of tight labor market conditions. We can examine other economic factors for clues on how much longer the good times can last.

Civilian Unemployment Rate

Data from Federal Reserve Bank of St. Louis. Chart created by Hanlon Research.

Perhaps, the most important factor to monitor with an economy operating near full employment is the impact on prices, or inflation. If current GDP growth outpaces the amount of long-run potential GDP for an economy, a positive output gap emerges, meaning that the economy may be overheating, or on an unsustainable path. Rising wages leads to rising costs for businesses and eventually they must price their goods and services at higher prices for customers. 1st quarter (Q1) concerns for a spike in inflation have receded as expectations have moderated, leveling off near the Federal Reserve’s (Fed, FOMC) annualized target of 2%. This is important because if the Fed decides that the economy is overheating, they will raise interest rates more quickly than previously stated, which may inadvertently cause a recession.

Potentially exacerbating this effect are the consequences from the escalation of the trade war. Tariffs threaten to derail global growth and cause prices on imports of consumer products and input raw materials to rise substantially, with reciprocation hurting American export businesses. The uncertainty alone surrounding the fluidity of tit-for-tat exchanges of levies is enough to stymie growth as businesses are unable to properly plan in the short-to-intermediate term. The consequences of this are starting to show up in consumer confidence and business sentiment surveys. US markets have been resilient as the US is seen as having the upper hand in negotiations, but there is the risk that market participants are wrong in discounting ongoing effects from this trade war by assuming that the Trump Administration is simply posturing politically prior to this year’s mid-term elections.

Lastly, a major factor affecting global growth is that the US dollar has strengthened significantly in Q2, and has undermined Emerging Market (EM) stability, especially those primarily funded in US dollars. At first, it was due to US interest rates rising precipitously, making it more expensive to borrow in dollars. As the trade war has become more of a reality, EMs have been hit again while the Chinese yuan has devalued. Going forward this devaluation is likely to become a major issue during the trade war. Other EM countries have seen collateral damage, or have been impacted by country specific problems such as low liquidity or recent higher oil prices.

Market Commentary

US equities indices spent most of the Spring season fighting for direction, though mostly holding above technical support of 200-day moving-averages thanks to solid Q1 earnings, rising dividends, and promised share buybacks. “Goldilocks” economic data outweighed geopolitical concerns, while helping to clear up uncertainty surrounding future central bank policy. However, only the technology heavy Nasdaq Composite Index achieved new highs during Q2, before again pulling back on trade war headlines. The trade war has particularly hit hard the Dow Jones Industrial Average of multi-national corporations that are more exposed to import and export prices. Conversely, small-cap equities relatively outperformed thanks to being more domestically focused.

So-called FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks have continued their momentum, helping the Nasdaq outperform with strong quarterly results and future growth prospects. Investors have shrugged off privacy concerns involving users’ data, while Apple and Amazon have quelled concerns surrounding innovation and profitability with exponential growth of sales of subscription services like Apple Music and Amazon’s Web Services.

Last quarter’s laggard, the Energy sector, rallied despite the strengthening dollar thanks to a confluence of global factors affecting oil prices. An agreement between OPEC countries and non-OPEC Russia to reduce oil production output effectively put a floor on prices that benefited American producers and mid-stream or logistical companies. When news that OPEC was going to lift production cuts at their meeting in June to offset production loss resulting from the economic crisis in Venezuela, and from the US sanctions on Iran, oil prices took a hit, but rebounded after the actual meeting took place and production limits were raised by less than the predicted amounts.

Index Return - Year to Date

Data from Bloomberg. Chart created by Hanlon Research.

US interest rates, represented by the US 10-Year Treasury Note, are up modestly from the end of Q1, near 2.85%. Mid-May highs over 3.1% were short-lived, as yields dipped back below 2.8% prior to the beginning of June. The yield spread for high-yield bonds over treasury securities has narrowed to 3.7% from around 3.75% ending Q1, indicating that investors are content requiring marginally less yield from riskier high-yield investments.

Hanlon Tactical Portfolio Commentary

The equity portion of our Hanlon Tactical Models entered the 2nd quarter fully invested, as the S&P 500 held technical support levels during bouts of 1st quarter volatility. During the 2nd quarter, our technical research led to our cutting exposures to the Consumer Staple and Industrial sectors, due to their relative weakness. However, we re-established our position in Industrials prior to the end of the quarter, while remaining fully invested in Financial, Healthcare, Material, Technology, Utility, Real Estate, Consumer Discretionary, and Energy sectors.

For the fixed income portion of our Hanlon Tactical Models, we began the quarter with a higher cash position attributed to our reduced exposure to the high-yield corporate bond segment. Our allocation to local currency Emerging Market bonds was removed prior to the segment’s precipitous fall, in mid-April, to make way for Municipal bonds, which have performed well YTD. Cash was reduced during the period, in lieu of attractive yielding opportunities in the Real Estate and Energy MLP space, that together with Municipal bonds, Convertible bonds, and Senior Bank Loans, are currently assisting in diversifying our Tactical Managed Income Model from a typically more focused high-yield corporate bond exposure.

Hanlon All-Weather Portfolio Commentary

This quarter’s performance for the holdings of Hanlon All-Weather models can be characterized by a reversal of the Q1’s lagging domestic and leading international investments. US dollar strength and trade war escalation disproportionately affected international markets and particularly Emerging Markets. The Hanlon All-Weather US equity holding, the iShares Core S&P Total US Stock Market ETF (ticker: ITOT), which was helped by the relative performance of small and mid-cap equities, returned 3.84% during the second quarter. International equities were negative for the period, seeing a reversal where Q1’s leading equity segment, Emerging Markets, became Q2’s worst performer, down 9.34%. The iShares International Treasury Bond ETF (ticker: IGOV), which was top performer of all Hanlon All-Weather holdings in Q1, was this period’s fixed income laggard. The SPDR Bloomberg Barclays TIPS ETF, whose principal is adjusted for inflation, outperformed the other bond holdings, gaining .8% in Q2.

The tactical equity portion of the Hanlon All-Weather models contributed positively to the quarterly return, with the large-cap equity portion up 2.11%. The tactical fixed income portion was relatively flat, down .03%.

The Alternative investment components were 2nd quarter standouts, with the commodity portion represented by the FlexShares Morningstar Global Upstream Natural Resources ETF (ticker: GUNR) gaining 4.87%. Real Estate Investment Trusts (REITs) and energy both bounced back with an excellent Q2, as the SPDR Dow Jones REIT ETF (ticker: RWR) and the JPMorgan Alerian MLP ETN (ticker: AMJ) returned 10.09% and 12.88%, respectively. The quarter-on-quarter reversals truly demonstrate the benefits of a well-diversified portfolio provided by the Hanlon All-Weather models.

Hanlon Strategic Models and Closing Remarks

It is our pleasure to introduce the all-new Hanlon Strategic Models. They deliver a low-cost strategic solution for buy-and-hold investors not seeking active downside protection from tactical investment approaches. Each Strategic model is tailored for specific individual risk tolerances, and optimized for efficiency and diversification. Please contact your advisor for more information.

As always, we will do what’s in the best interest of our clients consistent with our principals of Passion, Integrity, Vision, and Care. We will continue to monitor for opportunities, look-ahead for market dangers and make corresponding defensive moves in our Tactical allocations to seek downside protection and upside participation. For investors seeking a complete portfolio asset allocation solution, our All-Weather or Strategic models are the answer. We sincerely thank you for the opportunity to be of service.

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