Investors Hit The Risk-Off Button: February 2017 Market Commentary

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Includes: CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, LLSC, LLSP, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TALL, TNA, TQQQ, TWM, TWOK, TZA, UDOW, UDPIX, UPRO, URTY, USA, USSD, USWD, UWM, VFINX, VOO, VTWO, VV, ZLRG
by: Benjamin Lavine, CFA

Summary

The cyclical, reflationary ‘Trump’ trade was cruising along up until the latter part of February when investors bailed on the ‘Trump’ trade and turned sharply defensive.

Towards the end of the month, U.S. small caps and cyclicals such as energy turned south as investors shifted into safe-haven yield-sensitive assets such as utilities and REITs.

The fixed income market has become less sanguine on Trumpflation as the long-end continues to flatten.

If there were signs that cyclical reflation was about to flag, those signs are not showing up in the credit markets as credit spreads continue to narrow.

S&P consensus operation earnings are being ratcheted up with investors now expecting 22% growth in 2017. Year-over-year revenue growth has also turned positive.

Data Source: Bloomberg

Investors Hit the Risk-Off Button

What appeared to be investors taking a 'breather' on the cyclical, reflationary 'Trump' trade following January's reversal has now morphed into a risk-off posture. Much of the recent shift in risk postures is related to investors questioning the government's resolve to push through infrastructure spending and tax reform. Do investors now have buyer's remorse when it comes to expecting additional stimulus to extend the cycle? Or is this just a knee-jerk reaction to the latest machinations emanating out of D.C. overlooking the stronger underlying economic currents that are expected to produce 22% growth in S&P operating earnings for 2017.

Small caps had kept up with large caps through the first part of the month but then broke down towards the end of the month (Exhibit 1a). Interestingly, the shift to risk off did not negatively impact 'value' as much (Exhibit 1b), partly due to the continued strong performance of financials, perhaps over positive expectations for Dodd-Frank reform and rising net interest margins. Risk-off manifested itself in the form of high dividend/high quality stocks outperforming the rest of the market ( Exhibits 2 and 3).

Exhibit 1a and 1b: U.S. Small Caps Lag During Risk-Off but Value Holds Up

Exhibit 2: Growth and Defensive Sectors Led Cyclicals

Exhibit 3: High Dividend and High Quality Outperform Other Styles

The S&P 500 Low Volatility Index (SP5LVIT in Bloomberg) returned 4.5% versus 3.9% for the S&P as investors rediscovered their love for low volatility in the face of fiscal uncertainty. The sudden preference for low volatility has resulted in the index trading at a forward price/book multiple above its 2016 Brexit levels (Exhibit 4), suggesting that its run looks overextended in the near-term. However, we don't generally advocate factor-timing low volatility, particularly around valuation levels, but forward implied expected returns seem less appealing should cyclical reflation become in vogue again.

Exhibit 4 - Valuation of Low-Volatility Surpasses 2016 Brexit Levels

Source: Bloomberg

Fixed income credit markets brushed off 'risk-off' as credit spreads continue to narrow and are now within reach of the 2014 lows Exhibit 5). Despite the weakness in energy stocks, energy credit is now priced in line with the broader credit markets. Global supply/demand imbalances are narrowing but we are seeing a renewed pickup in North American production in response to higher oil prices (Exhibit 6).

Exhibit 5: No Risk Off Here - Credit Spreads Narrow

Exhibit 6: Energy Supply/Demand Imbalances Narrow Despite a Pickup in Production in Response to Higher Oil Prices

Large Fiscal Plans May Not Happen Until 2018

The markets seem to oscillate around the day-to-day Trump Administration statements concerning the outlook for infrastructure spending, tax reform, and healthcare reform. Yet, a bigger picture should encompass not only a short-term economic boost from fiscal initiatives but also the longer-term implications of how those initiatives would impact productivity. This Bloomberg Briefs article, " Trump Infrastructure Plan is Big, Bold (and Vague)," helps put the policy goals of infrastructure in proper perspective:

"The main priority is to boost the potential capacity for faster economic growth over the longer run. Eliminating transportation bottlenecks, expanding internet speed/capacity and taking measures to improve public health and education are just a few examples that can improve the overall efficiency of the economy, and thereby foster a rebound in productivity growth in the longer run."

Indeed, per the article , the broader point is to focus on the long-term productivity benefits infrastructure spending brings, and that we shouldn't be so short-sided as to focus only on what the near-term impact of (or lack of) infrastructure spending will have on the economy. The article posits that $1 trillion of proposed infrastructure spending only translates into 0.6% boost to GDP; however, given the decreasing influence debt expansion has on economic growth (see Stockpiling Income December 2016 Update), infrastructure spending would certainly have a meaningful impact from a New Normal perspective. Tax reform may not happen until 2018 as it appears to be contingent on whether Republicans choose to tackle the Affordability Care Act (ACA), yet, even without these fiscal initiatives, improving revenue growth should help boost earnings growth for this year, assuming margins can be maintained in the face of higher input costs (Exhibit 7).

Exhibit 7: Recovery in S&P Revenue Growth Should Translate into Higher Earnings

The U.S. economy is not necessarily dependent on all these grand fiscal measures as the cyclical reflationary forces that have been in place post-Brexit are giving rise to strong S&P earnings growth, narrow credit spreads, and higher inflation, even though long-dated Treasury yields have dropped in anticipation of a return to New Normal disinflation beyond the current credit cycle. The spread between short-term versus long-term Treasuries has narrowed and long-term inflation expectations have dipped below 2%, yet these levels are still above the pre-election levels (Exhibit 8).

Exhibit 8: Drop in U.S. Term Structure and Inflation Expectations - Coming Back to New Normal Reality?

Positioning for the Long-Term - The Futility in Trading Around Anticipated Events (or Statements that Speak to Those Events)

The market is a discounting mechanism, and the rapid reactions to every administrative or Fed statement seem to affirm the Efficient Market Hypothesis of how quickly information gets priced into the markets. This month saw the return to high dividend, high quality style of investing - a distinct shift away from pro-cyclical positioning that is supposed to benefit under this new administration. Next month may see the continuation of the defensive posture as Fed Funds futures now price in a high likelihood of three rate hikes, the first of which will happen in March. Regardless, long-term investors should focus on expected returns as priced into asset classes within the macro environment and decide whether they are being compensated for taking on those risks while remaining true to global diversification. At the margin, it would appear that more optimism is being priced into the credit markets while not enough optimism is being priced into cyclical equities, but the markets should sort themselves out as the macro environment unfolds itself under whatever fiscal policies get executed over the next year.

Disclosure:

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as March 1, 2017 and are subject to change as influencing factors change.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm's Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing sales@3dadvisor.com or visiting 3D's website at 3dadvisor.com.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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