First Quarter 2017

The outlook for the economy and markets is opaque and best characterized as a tale of two viewpoints.  On the one hand, there has been a strong positive reaction to “soft” data.  Consumer and business sentiment and financial indicators, such as the stock market, are near record highs.  They portray optimistic expectations about the economy and fiscal policies.  In contrast, the “hard” data is forecasting a moderately growing economy, not dissimilar from recent past levels.  Clarity on whether the post-election surge in optimism will translate into stronger growth will unfold with time.  However, the dispersion between current expectations and ultimate reality, and optimism and uncertainty, imply that “status quo” for risk assets is not a high probability scenario.

A boost in economic momentum requires the implementation of meaningful pro-growth fiscal initiatives.  Since the election, risk markets have responded positively to President Trump’s agenda of strong fiscal stimulus, tax reform and deregulation.  As we move into the second quarter, policymaking reality will take center stage.  The recent healthcare bill’s failure highlights some of the headwinds for the administration’s agenda.  With the markets discounting successful implementation of these policies, it is possible that political gridlock will become a catalyst for fading the “risk on” trade.  As the wisdom of a substantial fiscal policy program gets debated during a period of low unemployment and late cycle conditions, concerns around unintended consequences will increase.  This creates an environment where a moderately defensive posture should eventually pay dividends.

The Fed increased the Fed Funds rate by 25 basis points in March, signaling a more aggressive tightening schedule in 2017.  Fed projections indicate three rate hikes in each of the next two years. The FOMC’s Summary of Economic Projections for GDP, unemployment and inflation reflect consistency with prior forecasts and less optimism than the market.  This moderate growth baseline of about 2% sets a low hurdle for the Fed to implement their tightening cycle.  As monetary policy is enacted over the next few years, the levers that they use are likely to expand.  Currently, the focus is on using Fed Funds rate hikes to tighten policy.  Late this year, the Fed is likely to focus on balance sheet strategies to reduce their MBS positions.  As the new administration fills vacant seats and selects new leadership for the Fed, the players and strategy may shift.

The rate environment is likely to reflect the results of the administration’s capabilities in executing their agenda. Pugh Capital anticipates a trading range for the 10-year Treasury yield between 2.00-2.60% during the second quarter.  Downside risks can arise from disappointment and delays in fiscal reform and realignment to a slower growth and lower inflation scenario.  The higher end of the range might be triggered by stronger growth, less foreign demand for bonds, and political success on the legislative front.  Given the uncertainties expected to play out during 2017, we plan to keep the portfolio’s duration in line with the Index.

We will look to modestly reduce portfolio exposure to the MBS sector, given our expectations that the Fed balance sheet positions will soon become more of a market focus and a negative technical for MBS.   The portfolio remains overweight in CMBS and ABS as these sectors offer high quality securities at reasonably attractive spreads.  Corporate sector fundamentals are showing modest improvement in a number of indicators, such as earnings, leverage and defaults.  Business optimism surrounding the possibility of regulatory reforms and tax cuts is running high. Credit spreads have tightened and valuations are discounting successful implementation of business friendly legislation.  While the portfolio remains overweight corporates, we are shifting to a modestly more defensive posture on credit as a result of rich valuations and some skepticism about the market’s optimistic outlook.

Disclosure – As of March 31, 2017. Source: Pugh Capital, Bloomberg, and Barclays Indices. This market outlook and succeeding slides contains Pugh Capital’s opinions based on the information available at the time of the analysis. Opinions are subject to change without notice. Investors should evaluate their own risk tolerance, time horizon and other restrictions for their investment decisions. Statements concerning financial market trends are based on information available and current market conditions which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and investors should evaluate their ability to invest for the long-term, especially during periods of volatility in the market. Please do not redistribute. Refer to Disclosures for forecast, outlook and other information.