Thursday, September 29, 2016

Research Director’s Monthly Commentary, September 2016


Q4 Investment Strategy Meeting Summary

We held our Q4 investment strategy meeting on September 28, 2016. With respect to macro fundamentals, we do not see much change from last quarter’s meeting. We view the U.S. economy  currently mired in a “2% world”, meaning 2% GDP growth and 2% inflation. The U.S. economy is actually growing less than 2% so far this year, but we expect some acceleration in second half GDP growth. There are signs that U.S. inflation may be accelerating somewhat as a result of moderate upward pressure on wage growth; however, at this point, we continue to expect overall inflation to remain moderate. In terms of the global outlook, it appears that China’s economy has stabilized as a result of government measures to prop up growth; however, the estimated long-term growth rate for China’s economy is coming down. While the stabilization in China’s economy is positive for global growth, the slower expected growth in China could act as an additional factor keeping global growth relatively subdued.

We continue to view Federal Reserve policy as accommodative to the financial markets. It is clear from last week’s FOMC meeting that the Fed continues a relatively light hand with respect to interest rates. While we expect a fed funds rate hike in December, the latest FOMC meeting shows that the Fed has backed off its expected number of rate increases for 2017 and 2018 with the majority of FOMC now expecting only two rate hikes in each year, down from the previous four in each year. This is significant and indicates the Fed expects to remain gradualistic in its approach to monetary policy. The implication of this for the financial markets is positive, particularly for equities. This plus an improving outlook for corporate profit growth are reasons why we remain constructive towards stocks.

We made several tactical changes to your portfolios following the meeting. We increased exposure to equities slightly. Within the mature (large cap) equity area, we added a position in the biotechnology industry (IBB) as we believe health care remains an attractive secular growth story and biotech in particular appears undervalued. Within developing equity, we added a position in small cap value stocks (VBR), which we believe offer attractive value. We also continue to maintain a position in the homebuilding industry (ITB) which we view as one of the strongest sectors of the U.S. economy. Within the international sector, we added a small position in the emerging markets area (VWO) as we believe that sector will benefit from stabilization of the Chinese economy. Within natural resources, we added a position in energy (XLE) as we believe the outlook for oil prices should improve and valuation remains relatively attractive. Our overall exposure to fixed income remained unchanged. While we reduced exposure to long bonds, we increased exposure to short maturity bonds and increased portfolio yield through the addition of a shorter-term high yield bond ETF (SHYG).

In our objective to manage risk in your portfolios, we set a “trigger” at our meeting that would  cause us to reduce market exposure under certain conditions. The reason for this is our concern over the potential for increased market volatility around the upcoming presidential election. Historically, the presidential election can be a time of heightened stock market volatility and we believe it could be somewhat more acute this time. Our trigger is based on a combination of two factors: the combination of 1) a closing price on the VIX (forward implied CBOE volatility index) exceeding 20.0; and 2) a closing price on the S&P500 below 2000. We believe this combination would signal to us that market volatility may be increasing at a pace faster than we feel comfortable with and which would justify some action to reduce exposure.

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