Dear clients, friends and family:
Following is the 2018 fourth quarter performance for CMG’s Tactical Investment Strategies along with our thoughts on each strategy over the past quarter. Market index performance is presented at the bottom of the chart.
* Please note all strategy returns are reported net of a 2.25% management fee.
CMG Tactical Fixed Income Strategies
The CMG Tactical Fixed Income Strategy (“CMG FI”) returned -0.77% for the fourth quarter and finished the year -5.85%, net of fees. It was a difficult year for all asset classes, but fixed income in particular had a challenging year. Historically, when equity markets are volatile and declining in value, bonds play a risk diversifying role in a portfolio. 2018 was different and yet may be a sign of what to expect in the next couple of years. In the first quarter, bonds declined along with equities as the Fed was still very much in a tightening mood. During the fourth quarter, after October, it became clear that rates had reached an upper limit over the intermediate-term and when the equity market sell-off accelerated, several fixed income segments rallied and added meaningful portfolio diversification where they had not earlier in the year. All of the losses for the quarter occurred in October while the strategy held high yield bond and emerging market debt positions. Two weeks into the month, the strategy reallocated to cash and held a defensive position through month end. In November, CMG FI held an international bond position and the other half of the portfolio in cash. The strategy held international bonds through December and the balance of the portfolio was traded out of cash and into municipal bonds, which were also held for most of December. Both positions were amongst the top performing segments of the fixed income market.
The CMG Managed High Yield Bond Program (“CMG HY”) returned -1.39% for the fourth quarter and finished the year -2.67%, net of fees. CMG HY began the quarter fully invested but quickly moved to a defensive position in early October. The strategy remained in a defensive position for the entire quarter, avoiding a large draw down. The strategy moved back into high yields in early January. The year ended much as it had begun: high yields struggled to start the year and ended the year beaten down and negative on the year.
High yields had a particularly difficult fourth quarter, albeit not totally surprising given that the high yield spread versus Treasuries reached its lowest level in more than ten years. It was highly probable that once spreads reached such a tight level there would be a spring back to higher levels (and lower bond prices). Two factors added fuel to the fire: the equity market sell-off (high yield bonds behave like equities sometimes and bonds at other times) accelerated the losses in riskier positions and the flight to quality in government bonds. As a result high yield spreads jumped from 3.16% versus Treasuries in October to close to 5.5% by the end of December. Negative performance for the quarter moved the Bloomberg Barclays U.S. Corporate High Yield Index out of the black and into the red for the year.
The outlook for high yields in 2019 is brighter assuming a couple of macro events play out. First, the Fed has signaled that it is close to normal policy and that it will slow down the pace of tightening in 2019, thereby easing pressure on rates. If the Fed maintains this position and/or moves to a more accommodative position, high yields should have a modest tailwind. Additionally, the sell-off in the fourth quarter brought valuations back to moderate levels after prices reached an extreme in October, making high yields more attractive to investors.
CMG Tactical Equity Strategies
The CMG Opportunistic All Asset Strategy (“CMG Opportunistic”), returned -2.44% for the fourth quarter and finished the year -4.72%, net of fees. The CMG Opportunistic All Asset Variable Annuity Strategy returned -0.86% for the fourth quarter and finished the year -5.67%, net of fees.
CMG Opportunistic significantly outperformed its peer group and benchmark on a relative basis during the quarter as the portfolio was conservatively positioned before the market sell-off. The strategy managed risk exposure well this past year and although our positioning has been defensive for a large portion of the year (after the first quarter sell-off) costing us some upside, we are pleased that the strategy weathered the downside and preserved capital. As we discussed last quarter, our view was that market conditions were signaling an event, and although our model was early in reducing risk exposure, we were rewarded for our patience by avoiding most of the drawdown in a historically bad fourth quarter.
The strategy began the quarter in a defensive position with only three positions on: Indian equities and two lower beta equity positions in utilities and pharmaceuticals. The sell-off in October turned our relative strength indicators negative on equities and by the end of the month the portfolio held only short-term fixed income positions – ultrashort duration bonds. Markets stabilized in November and as equity market rebounded, our models added risk, investing approximately 20% of the portfolio in consumer staples and Latin America. It was a short reprieve before the selling resumed in December driving equity indices into correction mode and wiping out gains for the entire year. CMG Opportunistic quickly rotated out of Latin America and consumer staples into utilities and several bond positions. Unlike the start of the year when equities and bonds declined at the same time, fixed income positions rallied as investors sought safe havens. In addition to holding the majority of the portfolio in short duration bond ETFs, the portfolio also held exposure to municipal bonds and long duration bonds, two of the best performing segments of the fixed income markets in December.
After a difficult quarter and the worst December on record since 1931 (yes, since the Great Depression), we are pleased with the performance of the strategy under such difficult conditions. Our value proposition is not to capture all of the upside and then some – it has always been and will continue to be risk managed returns. While strategies like ours are not always in vogue, especially when markets set new highs, we believe strongly that risk managed strategies have an important role to play in a portfolio. Most investors, whether they be professional or individual, need to manage risk while staying invested. For most investors, a long-term investment horizon means that asset allocation decisions are slow moving and they (or their financial advisor) have to make difficult decisions about increasing or reducing risk, often under strenuous emotional conditions. It’s easy to say “stay the course” or the “economy is fine – buy the dip” before or after the crisis. But when you are in the heat of it, or “in the arena” as Teddy Roosevelt once said, it is hard to keep your cool, think logically and make the right decisions. It is for these reasons that we feel strongly that risk managed strategies play an essential role as portfolio diversifiers; reducing risk through tactical, unemotional asset allocation decisions to preserve capital and patiently wait for better opportunities. This mindset has been the essence of our investment philosophy since we opened in 1992 and it has helped us successfully navigate difficult markets, from the Dot.com bubble to the Global financial crisis. The strategy weathered a storm in the fourth quarter and as we can see the end of the line for the current record long economic expansion, we anticipate more storms (market declines, recession, and volatility) ahead.
The strategy held the following allocations (individual portfolio allocations may vary) to equities, fixed income, commodities and cash/cash equivalents at the end of October, November and December:
The CMG Tactical Equity Strategy (“CMG TE”) returned -0.39% for the fourth quarter and finished the year -0.95%, net of fees. CMG TE spent the quarter in a defensive cash position as equity markets, particularly international markets, were crushed. It is not an overstatement to say that international markets experienced a crash during the fourth quarter. International developed markets were down over 10% for the quarter while emerging markets declined between 8% and 10%. However, the blended returns of indices mask just how bad certain country specific returns were during the quarter. There were some emerging countries and regions that you would expect to be down: China (-10 to 20% depending on the type of exposure: tech oriented holdings fared worse) and Mexico (-19%). However, it was the decline in developed regions that were particularly stunning. Highly developed countries that are typically safe havens, like Norway (-20%), Germany (-15%), Switzerland (-10%) and Japan (-14%) declined more than Chile (-8%), Peru (-3%) and South Africa (-3%). Some countries were already so beaten down on the year that they were actually positive for the quarter: Turkey (+3% but down over 40% on the year), Indonesia (+8% but down -10% on the year) and the Philippines (+5% but down -17% on the year). It was a memorable quarter to say the least and it may have signaled a bottom for international markets, particularly emerging markets. After a strong year for the dollar, a pause by the Fed and lower growth after the fading of the tax cut stimulus, the conditions now seem set for international equities to outperform domestic equities. Against this backdrop we are pleased with the performance of the strategy on a relative basis. While we would always like to generate positive returns, we have a bias towards managing risk and protecting against large drawdowns rather than attempting to “catch a falling knife” by participating in short-term trades in oversold areas like Turkey or Brazil. It appears we have seen a bottoming for some regions and we are optimistic that more trading opportunities will emerge this year. Once a positive trend emerges over the intermediate term, our relative strength model and the strategy will be more likely to re-enter positions in the portfolio.
The CMG Beta Rotation Strategy (“Beta Rotation”) returned -2.41% for the fourth quarter and finished the year -0.88%, net of fees. Beta Rotation began the quarter in a risk on position, invested in equities, but quickly moved to a defensive position in utilities in early October. Utilities significantly outperformed broader equities and helped the strategy mitigate a large drawdown during the month. The strategy remained invested in utilities in November, generating strong returns and again outpacing the broader equity market. Beta Rotation was again well positioned as the market sell-off resumed in December. Utilities are highly sensitive to interest rates and during risk-off environments they are typically seen as a safer equity holding than most other sectors or industry groups. In December, the sector benefited from a lower beta (sensitivity to the market) and a bond market rally. The strategy was positive for most of the month and heading for a strong quarter when two trading days where utility stocks were down, -3% and -4% respectively, derailed an otherwise strong month. Beta Rotation recovered some of those losses in the last couple weeks of the year and subsequently switched to a risk on position in equities. The strategy has been well positioned to capture upside in the market rally that started 2019.
The CMG Tactical Rotation Strategy (“Tactical Rotation”) returned -10.74% for the fourth quarter and finished the year -8.06%, net of fees. Tactical Rotation began the quarter positioned 50% to domestic equities (SPY) and 50% to international equities (EFA). October was a testing month for all of the asset classes the strategy chooses from: the best performer, bonds, still declined almost a percent and was the worst asset class during the previous quarter. After a difficult month that accounted for the majority of the quarterly performance decline, the strategy reallocated 100% to cash for the month of November. After a quiet November, equity markets continued their decline in December. Tactical Rotation held a 50% position in REITs (VNQ) and held 50% in cash. Unfortunately, after a strong November, REITs declined along with equities in December adding to the strategy’s drawdown for the quarter. For January, the strategy is allocated 50% to bonds (BND) and 50% to cash.
The Scotia Partners Dynamic Momentum Program (“Scotia Dynamic”) returned -5.85% for the fourth quarter and finished the year -17.27%, net of fees. Scotia Dynamic held large cash positions and outperformed equity markets in the fourth quarter. It was a difficult year for the strategy as hard sell-offs in the first and fourth quarter accounted for the majority of the strategy’s decline during the year. At the end of the year, we made the decision to remove the strategy from the platform. For investors seeking long equity exposure we recommend taking a look at our Beta Rotation strategy which seeks to capture market upside with less volatility historically than Scotia Dynamic.
Market Commentary and Outlook
What an end to the year. After reaching all-time highs during the year, it was remarkable to witness the fear and panicked selling that characterized the fourth quarter for global equity markets. More than one market veteran had flashbacks of the financial crisis or the crash of ‘87. The quarter was in many ways like a hurricane: coming ashore in October, the calm eye of the storm in November and then a resumption of the destructive onslaught in December. When the clouds passed, the decline in December ended up being the second worst on record. The worst: 1931 during the Great Depression and what was a decidedly different economic environment. Furthermore, there were few places to hide during the quarter with the exception of cash. It was the first time since 1972 that all major asset classes had returns below zero and not one returned more than 5%. The best performing assets for the entire year were cash or cash like proxies that benefited from a surge in short-term interest rates on the back of tighter monetary policy. These are not the normal characteristics of a strong economy or a bull market.
The decline at the end of 2018 has a silver lining for 2019: markets look a lot cheaper on a valuation basis then they did 3 months ago, thereby making forward looking returns slightly more attractive (assuming earnings growth remains on path). Add in the fact that pessimism had reached extreme levels in recent months there is opportunity for upside in 2019. The bad news is that there remain risks that are not easily quantified or managed, namely of the political variety. After much criticism, the Fed has finally signaled that it is willing to slow down its pace of tightening. Chairman Powell may also well have been looking to deflect some of the political pressure coming from the White House. If so, it may prove to be a shrewd move as the focus will now turn to the administration’s trade negotiations with China as the primary market driver over the next quarter in the absence of activity from the Fed. If the administration fumbles, it will be much harder to push the blame back to the Fed. Rate hike prospects have declined with the median expectation of FOMC members falling from three to two for this year while investors, via futures markets, are signaling none at all.
Despite strong economic growth in the past year, there remains an anxiety about this market that is keeping equity markets from moving higher. That the source of those concerns is political and difficult to quantify continues to unnerve global markets. It feels like markets could move to new highs or fall to multi-year lows depending on which way things break on a few issues we highlight below. The risk of recession has risen in the EU and China and the U.S. is at risk of a slowdown as well. The uncertainty of these outcomes has increased volatility as investors have less clarity about the direction of markets. Below we break down some of key events that will impact markets in 2019.
The Art of Not Wanting a Deal
After a year of sabre rattling and tit for tat tariffs, the U.S. and China are sitting down to negotiate a trade deal. The stakes are high and the expectations, or more appropriately the hopes of investors for a positive 2019, are even higher. The outcome of these negotiations more than any other event this year may determine whether the global economy expands or declines, potentially into a recession. The success of the negotiations will be determined by the most mercurial politician of recent times. Recent signs from the administration that it is considering removing some tariffs to hasten a trade deal are encouraging. Additionally, Trump is besieged by negative news on all sides and a deal with China would allow him to positively affect the news cycle. The real question is will he take a deal? Aside from immigration, trade and China are the other big issues that Trump cares about. Both issues are the core of his message to a base that has narrowed after losses during the midterm elections. Will that core group of supporters remain energized in the absence of these fights? There is no doubt that a trade deal would be a positive for markets irrespective of the substance of the deal. In fact, the renegotiation of NAFTA yielded little of substance other than a more complicated acronym but markets saw it as an obstacle removed and hence a bullish sign. The ultimate outcome of the negotiations with China may end up looking similar. That’s not necessarily a bad thing.
BREXIT
The Economist has it right on the cover of its recent edition: the mother of all messes. The start of 2019 has not been kind to Prime Minister Theresa May. After surviving a no-confidence vote from her own party last year, May had her Brexit deal rejected. The scale of the loss was staggering: 432 votes to 202 with her own party members voting against the proposal by three to one. It is the largest defeat for a ruling party on record, a long record at that. Subsequently, May barely survived a full parliamentary no confidence vote (325 to 306) in her government and narrowly avoided a snap election. In a twist of fate, the same members of her party who voted against her Brexit deal helped keep her in power. You can’t make this stuff up. May has spent the last two years negotiating with the EU and the current deal is the best that can be made of trying to, as Boris Johnson put it, “have your cake and eat it too”. There is now not enough time to negotiate a new deal and two things are likely to happen: Britain will ask for an extension to avoid leaving with no deal at the end of March and the calls for a second referendum will grow louder. It is the right thing to do as Brits are extremely divided on Brexit and have been misled on the cost of leaving. Only a second referendum where the specifics of a Brexit deal are presented to voters will move this forward. Will May still be in power to oversee such a referendum? To say her leadership has been uninspiring is an understatement but is there really anyone who wants to take on this impossible task?
Dollar Down
Last year was a good year for the dollar, but after rising 7% against a basket of currencies, it might have peaked. Strong economic growth and rising interest rates drove the dollar higher over the past several years. Both factors are likely to have a neutral or negative impact on the dollar’s value this year. As mentioned earlier, the Fed has indicated that it is close to its interest rate targets and has signaled more dovish overtones since the hike in December. Other developed economies, namely Europe and Japan, are well behind the U.S. with respect to tightening monetary policy. The reason has been lackluster growth compared to the U.S. A resolution to the trade war between the U.S. and China could be the spark for growth in Asia and other emerging markets. The EU and Japan benefit more than the U.S. from emerging market demand. Stronger growth would push interest rates up (or remove accommodative policy) and give a lift to the Euro and the Yen. Clarity on Brexit may well lift the pound off its lows as well. Of course, a deal with China could fall apart, economic growth stumbles and the dollar remains elevated and overvalued in the short- to intermediate-term (although the Yen and Swiss Franc would likely benefit more during a flight to safety). Finally, another trend is reducing demand for the dollar (albeit on a relatively small scale right now) and bears watching: divesting from the dollar in foreign reserve holdings. In response to sanctions, Russia sold $101 billion worth of dollar holdings, moving into the euro, yen and yuan. Russia’s yuan holdings, at about ten times the average for global central banks, is a clear outlier. I have discussed for several quarters the slow moving impact of America First policies. This is one of them. An acceleration of these types of shifts is another side effect if the negotiations with China do not bear fruit.
Business Confidence and Consumer Sentiment
After giving Trump the benefit of the doubt during his first year in office, consumers, investors and business leaders are now showing reduced confidence. Sentiment indicators remained high in 2017 on the heels of several bullish signs from the new administration: less regulation and a corporate tax cut helped push markets to new highs. However, in 2018 these positive factors were negated by fears of rising interest rates and trade wars. Sentiment readings are reflecting anxiety about these changes as evidenced by the most recent consumer sentiment reading which declined to the lowest level since Trump was elected. The magnitude of the decline was a surprise relative to estimates and reflects concerns about the volatile fourth quarter for stocks, the ongoing trade war and the government shutdown. The next several readings of the index will be critical in assessing whether this negativity is temporary or the sign of something more substantial. Sentiment amongst global business executives, in contrast to consumers, has been negative for most of the past year. McKinsey’s December survey of global executives resulted in the least-positive views on the economy in over a year. Fewer executives expect economic conditions and growth rates to improve over the next 6 months, a dramatic reversal from the start of 2018. Emerging economy respondents in particular have become more apprehensive: in developed Asia for example, half of respondents now say economic conditions have worsened. Three months earlier only 27% felt that way. The most cited threats to growth persisted all year: most respondents see changes to trade policies (53%) and geopolitical instability (46%) as the biggest threats. A resolution to the trade war with China would help raise spirits amongst both consumer and business leaders. A failure to secure a deal or draw a truce will entrench negative sentiment further and increase the probability of a recession.
Kindest regards,
PJ Grzywacz
President
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