Volatility is Back & It’s Not a Bad Thing

MarketsETF Trends

This article was originally published on ETFTrends.com.

Volatility is back and it’s not a bad thing. Three of the most universal human traits are herding instincts, risk aversion, and the need for conclusive narratives. All are rooted in 5,000 years of evolutionary development and they were on full display over the last week.

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After sitting out most of the 2009-2017 risk assets’ rally, retail investors piled into the markets over the last eight months. They bought exotic instruments like Bitcoin, leveraged indices and VIX products. Then when the financial media began touting “the end of the 36-year bond bull market & impending equity markets correction” on the back of a recent surge in interest rates, they all tried to run for the exits at the same time.

And now, everyone is looking for a narrative to explain the fastest fall from a record high in S&P history – 10% in only 9 days. Here’s a good one: nothing has changed in our fundamental credit macro outlook, and if anything, the rise in rates has finally caught up with the US Federal Reserve outlook—meaning it would take a huge uptick in inflation to drive higher rates from here. And here’s another one: the VIX products that vaporized investor money were worth less than $5 billion in aggregate so they weren’t about to bring the market into a systemic crisis.  Louis Gave’s question — “Why would regulators even allow things like 3x levered Brazil ETFs, or inverted VIX ETFs, which will inevitably go to zero in a time of market stress?” — is one that market professionals should be thinking about. Getting a taste of trouble and thus avoiding speculative traps last seen in 2008 is a good thing for markets.

We are positioned in our Global Tactical portfolios to potentially capture global opportunities and avoid “problem” regions and sectors. It is certainly possible that the US Federal Reserve has “overshot” in withdrawing liquidity and raising rates given the disinflationary environment we inhabit that impacts employment—robotics, advances in artificial intelligence, and giant corporations forming healthcare consortiums come to mind. Even so, it’s good to remember that financial conditions are very “loose” and interest rates are extremely low in almost every developed and important emerging market (EM) country.

  • We hold a small tactical cash position in our GTC and GTA portfolios. While we remain constructive on equities, a better entry point may present itself in the near future.
  • We are avoiding foreign currency fixed income to benefit from higher US dollar interest rates. We expect spreads between US dollar and foreign currency interest rates to narrow, and therefore will benefit by concentrating all of our fixed income exposure in US dollar denominated
  • We are avoiding long duration fixed income in our portfolios. Interest rates may continue to rise as economic growth remains strong, inflation reemerges, and global central banks step away from the “extraordinary measures” they employed during the financial crisis.
  • We have exposure to four US equity sectors: financials, technology, energy, and aerospace & defense. Financials benefit directly from a higher interest rate environment in the US, as well as a more favorable tax and regulatory environment. The pace of disruption of old industries by new products and processes has continued to accelerate, and technology gives us exposure to this process of creative destruction. Strong economic growth will support global energy markets, and inflation may reemerge in 2018, which will support the energy sector. Global military spending will increase in coming years, as US hegemony fades and a multi-polar world emerges—the aerospace and defense industry will be a beneficiary.
  • We have exposure to hedged-currency Eurozone equities. A German “grand coalition” government has been agreed to, which brings much needed stability to the region. We have hedged our exposure to the Euro in order to benefit from a stronger US dollar.
  • We have exposure to both large- and small-cap Japanese equities. They are supported by favorable valuations, accelerating economic and earnings growth, the Bank of Japan’s ongoing aggressive monetary easing, and global money managers’ underweight exposure. We have not hedged any of our Yen exposure.
  • We have significant exposure to emerging market equities, which benefit from positive capital inflows and represent attractive relative value. We expect global capital flows to remain supportive and emerging market equities to continue to “catch up” after years of underperformance. Asia, in particular, represents an excellent opportunity.
  • We hold a position in global agriculture equities. Increasing inflationary pressures and underweight investor positioning should support the industry in 2018.
  • We hold positions in broad commodities and gold. We expect inflation to rise in 2018, which will support commodity markets.

Past performance is no guarantee of future results. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. Returns can vary dramatically in separately managed accounts as such factors as point of entry, style range and varying execution costs at different broker/dealers can play a role. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts are inherently limited and should not be relied upon as an indicator of future results. There is no guarantee that these investment strategies will work under all market conditions, and each advisor should evaluate their ability to invest client funds for the long-term, especially during periods of downturn in the market. Some products/services may not be offered at certain broker/dealer firms.

The investment descriptions and other information contained in this Markets in Motion are based on data calculated by W.E. Donoghue & Co. LLC (W.E. Donoghue) and other sources including Morningstar Direct. This summary does not constitute an offer to sell or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities. This report should be read in conjunction with W.E. Donoghue’s Form ADV Part 2A and Client Service Agreement, all of which should be requested and carefully reviewed prior to investing.

The Global Tactical Allocation Composite (“Composite”) was created on 1/1/2004. The Global Tactical Conservative Composite (“Composite”) was created on 1/1/2004. The Global Tactical Income Composite (“Composite”) was created on 9/1/2012. The Global Tactical Growth Composite (“Composite”) was created on 2/1/2015. From 01/01/2004 to present, John Forlines III, Chief Investment Officer of W.E. Donoghue (the “CIO”), and Robert Shea, President of W.E. Donoghue (the “President”) were primarily responsible for the management of the representative JAForlines Global (JFG) composites while the CIO and President were principles at JAForlines LLC. W.E. Donoghue acquired 100% of the assets of JFG on December 29, 2017.

Composite returns are calculated gross of investment management fees, net of investment trading expenses and underlying fund costs but do not reflect the effect of income taxes on the investment returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. Performance reflects the reinvestment of dividends, income and capital appreciation. Composite returns are calculated monthly, which are described in greater detail in the firm’s Form ADV Part 2A, using the time weighted total rate of return methodology. Monthly returns are geometrically linked to calculate quarterly and annual returns. As fees are deducted quarterly, the compounding effect will be to increase or decrease their impact by an amount directly related to gross portfolio performance, and dependent on direction, magnitude, and order of returns. For example, on a portfolio with a 2% annual fee, if gross performance is 10%, and performance is equally distributed across all four quarters, the compounding effect of the fees will result in net annual performance of 7.81%. Performance presented prior to June 1, 2009 was generated while affiliated with a prior firm. The investment decision-making process has remained intact and has been applied consistently since inception. The calculation methodologies have been consistent over time. No leverage, derivatives, or shorts are used. Past performance is not indicative of future results.

There can be no assurance that the purchase of the securities in this portfolio will be profitable, either individually or in the aggregate, or that such purchases will be more profitable than alternative investments. Investment in any Global Tactical Portfolio, or any other investment or investment strategy involves risk, including the loss of principal; and there is no guarantee that investment in W.E. Donoghue’s Portfolios, or any other investment strategy will be profitable for a client’s or prospective client’s portfolio. Investments in W.E. Donoghue’s Portfolios, or any other investment or investment strategy, are not deposits of a bank, savings and loan or credit union; are not issued by, guaranteed by, or obligations of a bank, savings and loan, or credit union; and are not insured or guaranteed by the FDIC, SIPC, NCUSIF or any other agency. The composite strategy provides diversified exposure to various asset classes such as equities, fixed income, and alternatives utilizing liquid exchange traded products. Diversification does not guarantee a profit or protect against a loss.

The Blended Benchmark Growth is a benchmark comprised of 65% MSCI ACWI, 25% Citi World Government Bond Index, & 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Growth returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly into an index. A more detailed description of the benchmark's constituents is available upon request.

The Blended Benchmark Moderate is a benchmark comprised of 50% MSCI ACWI, 40% Citi World Government Bond Index, & 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Moderate returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly into an index. A more detailed description of the benchmarks constituents is available upon request.

The Blended Benchmark Conservative is a benchmark comprised of 35% MSCI ACWI, 55% Citi World Government Bond Index, & 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Moderate returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly into an index. A more detailed description of the benchmarks constituents is available upon request.

The Blended Benchmark Income is a benchmark comprised of 90% Barclay’s Global Aggregate Bond Index, & 10% MSCI ACWI, rebalanced monthly. The Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. There are four regional aggregate benchmarks that largely comprise the Global Aggregate Index: the US Aggregate (USD300mn), the Pan-European Aggregate, the Asian-Pacific Aggregate, and the Canadian Aggregate Indices. The Global Aggregate Index also includes Eurodollar, Euro-Yen, and 144A Index-eligible securities, and debt from five local currency markets not tracked by the regional aggregate benchmarks (CLP, MXN, ZAR, ILS and TRY). A component of the Multiverse Index, the Global Aggregate Index was created in 2000, with index history backfilled to January 1, 1990. The MSCI ACWI Index is a free float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Blended Benchmark Income returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly into an index. A more detailed description of the benchmark's constituents is available upon request.

The information contained in this presentation related to JAForlines represents the strategies and performance achieved prior to the acquisition.

W.E. Donoghue & Co., LLC is a registered investment advisor with United States Securities and Exchange Commission in accordance with the Investment Advisors Act of 1940.

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