Managing Through Uncertainty
The end of June marks the midway point of the year, and so far, it’s been quite a ride. Both the Canadian and U.S. markets logged modest returns, well off their respective lows of the year, but none the less underwhelming.
Markets never move in a straight line, and the path to these modest returns (0.40% for the TSX and 1.67% for the S&P 500) has been bumpy to say the least. The challenge for discretionary Portfolio Managers to this point in the year has been interpreting and managing the headline risks to protect investor assets, while capitalizing on the upswings.
Labour market numbers both in Canada and South of the border offered encouraging signs that economic growth should be sustainable, this, along with U.S. tax reforms should provide a tailwind, however geo-political friction and the ongoing trade “tantrum” continue to foster uncertainty.
The true impact from the most recent tariffs levied (and the new ones proposed) won’t manifest until the next round of corporate earnings in the third quarter. However, so far, the markets are moving higher with the anticipation of solid earnings and a resolution to global trade disputes.
As our CIO Richard Croft suggests, the trick is to manage through the uncertainty to benefit from a positive end game.
TCG 531 Equity Growth Fund
The Equity Growth fund suffered a small loss in the month of June losing 0.34% while its benchmark, the TSX Total Return Index, was positive 1.69% led by strong returns in the Energy and Industrials sectors.
Lead manager Alex Brandolini comments that the Equity Pool was having a great 2nd quarter up until the end of June where concerns around trade wars shifted market sentiment causing the Equity Pool to register flat performance over the past three months.
Despite this most recent drag, the fund remains up 4.19% compared to the TSX TR at 1.95%.
Mr. Brandolini sites 4 key factors influencing fund performance:
- Trade wars
- Amazon effect
- Flattening yield curve
- Momentum interruption
Short term market events created a perfect storm within the fund since fears of a trade war hit two of the overweight sectors – Technology and Industrials.
The Amazon Effect
The Amazon effect hit one of the equity funds Health Care stocks as the online market place acquired an online pharmacy and investors expressed concerns around profit margins.
A Flattening Yield Curve
Bank stocks were also hit by a flattening yield curve as banks borrowing short term and lending long stand to face margin compression if this trend continues.
By the end of the quarter, Momentum and Growth stocks acted as a drag on market performance while Value and Dividend stocks performed well as investors moved towards quality as trade tensions escalated. Notable actions taken in the Equity Growth Fund included put writing on Momentum stocks to take advantage of higher implied volatility.
In addition, with an increased expectation for volatility, some cash that had been sitting on the sidelines was deployed into lower beta stocks. Stocks with a lower beta are less corelated with the broader markets and tend to maintain some stability during market declines.
We also took the opportunity to add to current Technology holdings on the most recent market pullback. Out-of-the-money covered call writes on some of these names were also implemented. This option strategy increases the yield on the position while maintaining the opportunity for significant upside in some of the top performing tech companies.
TCG 534 Income Fund
Our Income fund finished the month of June up 1.07% compared to the Real-World Index Income benchmark at 0.96%. Year to date the fund sits positive at 2.61% compared to it’s benchmark at 1.04%
In line with our expectations for a U.S. dollar pull back, lead manager Mark McAdam reduced the U.S. Dollar position and looked towards the options market to maintain exposure to U.S. equities while mitigating some of the currency risk.
As with the Equity Growth Fund, our Income Fund continues to benefit from market hypersensitivity and the volatility that comes with it.
Mr. McAdam has set aside approximately 8% of the funds cash for deployment during the upcoming earnings season. We will be patiently waiting to buy solid companies that experience a sell off due to a market overreaction to short term challenges, citing Oracle and Alibaba Group as examples. The stock will be purchased with a covered call strategy overlay to benefit from the depressed share price and expensive option market.
Mark also notes that our TLT strategy continues to generate a good return with modest risk. This strategy involves a combination of put writing and covered call writing around the iShares 20+ Year Treasury Bond ETF (TLT). Option strike prices and expiration dates are selected based on our expectation on how U.S. Interest rate decisions will impact the bond market.
TCG 539 Option Writing Fund
Our Option Writing Fund is designed to drive cash flow using income generating option strategies regardless of market direction.
The fund finished June positive with a 0.54% gain, lagging the Montreal Exchange Covered Call Writers index which finished the month with a positive 1.77%. Year to date the Option Writing Fund and its benchmark are neck and neck coming in at 1.63% and 1.62% respectively.
Lead manager Richard Croft highlights that during the first quarter of 2018 we moved away from selling short term options with an average term to expiry of 21 days – to selling longer term options with an average expiration term of 55 days, to take advantage of higher volatility. While this created a bit of a drag on performance in the first quarter, the strategy is paying off as the share class has rallied 4.34% through the second quarter of 2018.
Mr. Croft adds that the pool continues to follow a dual style mandate with about 50% of the portfolio holding Value stocks and another 45% falling into the Momentum camp. Most of the momentum plays are with the FAANG stocks (i.e. Facebook, Apple, Amazon, Netflix and Google) which have rallied sharply despite trade frictions.
We continue to maintain this strategy although we have lightened our exposure to longer term options as volatility contracts. Currently our average term to expiry is 41 days. We suspect this expiry spectrum will continue to contract unless volatility spikes because of a surprise in second quarter earnings or on the trade front.
Current Outlook and Expectations
Given the short-term nature of recent news headlines and the fact that they came in quick and in a consecutive order, our long-term outlook has not changed as we believe the headwinds to the market will be resolved.
Our focus remains on:
- Trump’s objectives
- Analyst expectations on Technology
- Industrial sector oversold
- Fed overtightening being unlikely
While Trump’s tactics appear concerning to the markets, it is useful to evaluate what he wants. We don’t think he’s interested in the tariff revenue because it is immaterial to running the U.S. economy. Rather, we think Trump is seeking to end intellectual property rights violations taking place in China and he wants less barriers to entry into Chinese markets for foreign investment. It is conceivable that he’s using trade as a bargaining tactic. U.S. ambassadors have already come out and said they could abandon tariffs with European partners in exchange for trade concessions. It is not much of a leap to think Trump is giving China the same message.
Trade policy concerns are also not enough to overcome improving analyst optimism toward Q2 earnings results.
Expectations for S&P 500 EPS and sales in the quarter have risen 0.6% and 0.9%, respectively since the end of March. Q2 EPS results are expected to rise 22% from a year earlier. Technology stocks are expected to post a 25% year over year performance.
Technical indicators suggest the Industrials sector is overdue for a bounce as earnings season approaches. It is the S&P 500’s worst performer since trade concerns broke out. This sector is now testing support at its early-May low. The 14-day Relative Strength Index (RSI) also indicates Industrials are more oversold than at any point since the sector’s February low.
With respect to the Momentum trade, growth dynamics haven’t reverted, and the underlying market and economic fundamentals support the idea that this has been a Momentum interruption rather than a material shift.
Fed Overtightening Unlikely
While the Fed (Federal Open Market Committee) has a mandate to control inflation, it is unlikely short-term interest rate will be increased at a rate that will derail growth.
Considering this, we expect that the markets will remain sensitive to the headlines and that market volatility is here to stay for now.
Our outlook remains positive and we will continue to take advantage the volatility by taking positions in companies we want to own on pull backs and capitalizing on increased option premiums resulting from the market uncertainty
As always, we will continue evaluate and adjust as market conditions change.