Second Quarter 2018

MARKET OUTLOOK / STRATEGY

Second Quarter 2018

For many years the financial markets have returned strong performance regardless of the environment. Indeed, with a few exceptions, even bad news was treated as good news as the era of easy global monetary policy emboldened investors to take risks. We believe that era is over.

The economy is exhibiting late-cycle tendencies, including full employment, rising inflation, greater corporate leverage, and tightening monetary policy. For at least the balance of the year, we expect that the tailwinds provided by the robust jobs market and solid consumer spending will cause the economy to continue to post reasonable growth numbers. Although the tax cuts have pushed out the timeline for the next recession, the possibility of trade wars threatens to offset that advantage. The discord that was clearly evident at the June G-7 meeting only adds to our concerns about global trade.

Given the ongoing economic growth and with inflation near the Fed’s 2.0% target, we expect quarterly 25 basis point rate hikes to continue through year end, barring significant geopolitical upheaval. The European Central Bank appears ready to join the Fed in unwinding its quantitative easing program, perhaps by the end of this year. The downside to this policy change is that it will also allow greater global market volatility as the unprecedented world-wide accommodation is removed, especially with the rise in populist sentiments in Italy.

Determining if and when geopolitical events will undermine market sentiment is as difficult as predicting where long maturity interest rates are headed over the next few months. However, geopolitical risks are clearly elevated in our opinion. Therefore, an overriding investment theme is that current spreads are not yet attractive enough given those risks and our defensive outlook.

We are comfortable with a relatively neutral position in credit given the cross-currents. However, with technicals reflecting more challenging conditions, we are viewing credits through a defensive lens. As a result, our security screens, usedto add credit exposure, have higher hurdles. We are also reevaluating existing holdings through a more risk-averse lens. A key focus is on avoiding event prone credits that are likely to use significant leverage.

The portfolio remains overweight in both high quality CMBS and ABS as part of our defensive positioning. While we expect continued supply of agency MBS from the Fed’s balance sheet unwind, we believe that it has largely been discounted in the market. The sector does offer superior liquidity and credit quality, and we will look to increase the MBS allocation on technically driven widening. The portfolio is presently positioned with its duration slightly short of the Index, in expectation of modestly higher yields.

Disclosure – As of June 30, 2019. Source: Pugh Capital, Bloomberg, and Bloomberg Barclays Indices. This market outlook and succeeding pages 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 the Legal & Disclosures section for additional disclaimers, disclosures, forecast, outlook and other information.