investment focus · data economic growth momentum is sustained. unemployment ticks up to 4.0%. job...

FOCUSINVESTMENT

July 2018

INVESTMENT POLICY REVIEW AND STRATEGY ALIGNMENT

1HARMAN WEALTH MANAGEMENTFor Advisor Use Only

WEALTH MANAGEMENT | INVESTMENT MANAGEMENT | FINANCIAL PLANNING

The Woodlands Houston Austin Phoenix

© 2018 | Harman Wealth Management, L.L.C.

IN FOCUS REPORT: July 18

T A B L E O F C O NT E NT S

SECTION 1 DEVELOPMENTS OF THE LAST MONTH 3

SECTION 2 2018 INVESTMENT THESIS 11

SECTION 3 PORTFOLIO POSITIONING 25

SECTION 4 MARKET/ECONOMIC TRENDS 40

SECTION 5 CLIENT CONVERSATIONS 50

SECTION 6 INVESTMENT PROCESS 53

SECTION 7 APPENDIX 60



DEVELOPMENTS OF THE LAST MONTH1


SECTION

DEVELOPMENTSOF THE LAST MONTH

IN FOCUS REPORT : July 2018

© 2018 | Harman Wealth Management, L.L.C. 4

EVENTS● OPEC meeting. ● Trade talks with China.

DATA● Economic growth momentum is sustained.● Unemployment ticks up to 4.0%.● Job growth at 213K jobs last month.● Crude oil at ≈$73/bbl. Highest point since 2004.● VIX closes at 12.77 on July 9th.

POLICY● Fed meeting: 6/13. Raised Fed Funds Rate. (7th time)● Tax Cuts and Jobs Act (effective 2018).● NAFTA deadline looming.● China Trade Negotiations Taking Place.


Unpacking the Correction


Where Do Markets Stand?




Where Do Markets Stand?

Index Since January 26th YTD 12 Months

S&P 500 TR -1.84% +5.57% +17.35%

DJIA -6.38% +0.81% +16.40%

NASDAQ +3.38% +12.40% +25.63%

Russell 2000 +6.23% +11.20% +21.96%

MSCI EAFE -7.57% -1.07% +8.14%

MSCI Japan -9.98% -2.86% +10.91%

MSCI Europe -7.19% -0.30% +7.76%

MSCI Emg. Mkts -14.79% -5.82% +8.50%

Performance since January 26th and YTD?

Updated through 7/10/18




What’s Preventing Markets from Recovering Faster?

The Story? The Last Month?

1Bond Proxy Reversal

• When fixed income rates pushed too low, dividend oriented stocks were a substitute source for yield.

• That is now unwinding as yields have moved higher

The Sell-off is potentially finished?

2 Trade

• Uncertainty in NAFTA, China trade relations

• Investors worried about a sudden shift.

• Therefore, investors are waiting for more clarity.

Trade concerns have been quiet over last

month.

3 Continued Tightening

• Corrections are usually associated with easing conditions

• Since Jan. 26th yields are higher and inflation is creeping up.

US 10-Yr climb has slowed since Feb. 22nd

What’s It mean for Markets?

• S&P 500 up 8.85% since April 2nd

• R2000 Up 14.2%


Fund Performance: Sectors in June


Updated: July ‘18

Sector Performance in June


Fund Performance: Sectors in Q2


Updated: July ‘18

Sector Performance in Q2


Rising Dollar


Updated: July ‘18

Dollar trends

+6.5% Since Feb bottom


INVESTMENT THESISFOR 20182


SECTION


First Half Themes


Stoked by Tax Cuts, U.S. shows superior trends in core Growth and Earnings.

• Growth has rolled over for peers.

1

2

3

Clouds of Uncertainty hang over markets because ofTrade Disputes.

• Policy decisions can instantaneously change the economics or earnings outlook

Long-end Rates have resisted moving up.

• In spite of more supply, rates have flattened since February.

• Global bond buyers are hungry for U.S. bonds at 3%.

• Leading to a stronger dollar.

• Leading to a compressing yield curve.


Mid Year Themes


Stoked by Tax Cuts, U.S. shows superior trends in core Growth and Earnings

Year over year earnings increase at first quarter 2018:

24.8%


Mid Year Themes


Clouds of Uncertainty hang over markets because of Trade Disputes.


Trade War and Tariffs


Looking at Key Issues.

It’s Not All About Tariffs. South Korea received an exemption on tariffs. In exchange, S. Korea agreed to quotas.

The NAFTA deadline is Approaching. Republicans want a BIG win for mid-term elections. NAFTA will go through Congress, and will take months to approve.

With China, it about more than the trade deficit. Counterfeiting. Intellectual property theft. Cybertheft of U.S. companies. Obstructionism for foreign companies wanting access to Chinese markets.

Going Deeper on Trade


Mid Year Themes



Feb. 2nd

2.82%


Rising Dollar


Updated: July ‘18

Sector Performance Since January 26th


Mid Year Themes



Spread between 10 yr. and 2 yr. Treasury

29 bps


INVESTMENT THESIS FOR 2018


Business Cycle Staging: Pushing into the Late-CYCLE phase.

The expansion is pushing into a late stage environment.

Exceeded “Full” Employment

Economy is at “full capacity”, with a positive output gaps

INVESTMENT CONTEXT

Risk

Rewarded

Less

Risk

Rewarded

More

Recession Early Recovery Mid-Cycle Late-Cycle Recession

9.0 yrs. into expansion




In a maturing expansion, structural risks increase, growth eventually slows…but markets deliver.

FUEL over FUNDAMENTALS

2018 Investment Thesis

MARKET MATURING




Finding BALANCE: Good for Now/ Caution of LaterWe are juxtaposed with positive support presently against what naturally comes next.

Structural risks are rising under the surface. The maturation of the cycle is inevitable and weakening the capacity for future growth.

Lots of good, strong, developments at play… strong manufacturing, solid consumption, tax cuts, etc.

Good for Now Caution for Later




Maturing Fundamentals• Eroding term premium

• Fed Rate Hikes into a Compressing Yield Curve

• Full Employment

• Wage Inflation

• Lending Exhaustion

• No further improvement in NPLs

• Tapped out borrowing base.

• Higher Valuations

• Systemic Inflation Rising

Market Fuel• Global Synchronized Growth

• Strongest US Manufacturing in 14 Years.

• Positive Earnings Trend

• Recent Surge in Employment

• Tax Cuts

• Greater Consumption

• Corporate Buybacks

• Lack of Market Fear

FUEL over FUNDAMENTALSMARKET MATURING


Macro 2018 Outlook


Outlook on U.S. Stocks

S&P 500 returns: Less than + 8%

• Cyclical growth slows early and moves sharply into soft growth.

• Growth teeters on the contraction line in the last half of 2018.

• Inflation pushes to 3% early and persists.

• The Fed moves 3 times by September. Yield curve inverts.

• Job growth falls below 150k/month.

• Non-performing loans increase due to higher rates.

S&P 500 returns: Greater than + 14%

• Strong growth trend extends well past mid-year reinvigorated by increased consumption levels and new employment.

• Job growth accelerates instead of declining.

• TCJA attract USA first investing.

• Inflation fails to climb and pressure lending.

• Increased cash flow delays credit deterioration. Banks remain loose.

• The Fed stays accommodative with only two moves due to waning inflation

• Euphoria appears under a buyback-driven market surge.

Likeliest Outcome

BASELINE

LEFT-TAIL RIGHT-TAIL

Lesser Outcome Greater Outcome

S&P 500 returns: + 8% to +14%

• Strong growth rate slows on a modest trajectory but still remains resiliently in growth territory.

• Earnings support positive investor mood.

• Buyback activity increases.

• Inflation remains modestly below 3.0%.

• Fed moves 3 times, starting in the summer.

• Credit gradually tightens.

• Job growth remains above 150k/month.

S&P 500 at +4.95%at 6/12/18


Macro 2018 Outlook


Outlook on U.S. Fixed Income

Risky Credit Returns = “Yield Minus” High Quality Fxd. Income = Yield

• Strong growth rate slows on a modest trajectory but still remains resiliently in growth territory.

• Yield curve compresses. Long-End moves up modestly, while short-end gets pushed by Fed rate hikes.

• Inflation climbs modestly but avoids reaching above 3%.

• Job growth slows remains above $150k/month.

• Fed moves 3 times, starting in the summer.

Risky Credit Returns = “Yield Minus” Quality Fxd. Income = “Yield Plus”

• Cyclical growth slows early and moves sharply into soft growth.

• Slowing growth leads to flight away from risky credit.

• 10-year Treasury Rate is unresponsive to inflation; and, instead, sees downward pressure due to slowing growth.

• The Fed moves 3-4 times for year and moves early, resulting in an inverted yield curve.

• Non-performing loans increase. Banks uniformly tighten.

• Job growth falls below 150k/month.

Risky Credit Returns = Yield Quality Fxd. Income = Yield Minus

• Growth momentum sustains through 2018.

• Yield Spread avoids compression as long-end rates respond to economic activity.

• Consumer non-performing loans avoid deterioration

• Corporations pay down debt with tax cut savings, improve debt ratios.

• HY spread stays flat.

Likeliest Outcome

BASELINE

LEFT-TAIL RIGHT-TAIL

Less Likely Negative Outcome

Less Likely Greater Outcome


PORTFOLIO POSITIONING3


SECTION


S&P 500 Up

+16.7%in last 12 Months

S&P 500 Growth beats S&P 500

+23.4% to 16.7% in last 12 Months

S&P 500 over:• EAFE in last 12 mo.• Real Asset in last 12 mo.• Hi Beta over Low Vol

Updated: As of July 9th 2018


June Attribution


Updated: July ‘18

As of June 30th


ECONOMIC SYSTEMIC RISK INDEX MARKET STABILITY INDEX

Summary Assessment for Equities

Where Are We Now?

▪ The economic backdrop remains highly consistent with further expansion.

▪ Broad market conditions are highly stable in a historical context.

▪ Aggregate conditions lead to a broad overweight to growth assets across all portfolios.

What Would it Take to Change the Outlook?

• The growth cycle starting in Feb. ‘16 has yet to clearly peak.

• Expect falling manufacturing data to increase the Stability Index score in 2018.

Risk Control Orientation

Light Risk ControlGeneral Diversification

Moderate Risk ControlManage Beta Exposure

Robust Risk ControlPotential Exit from Equities

General OverweightFactor Tilt Equities

Neutral/Under-WeightManage Risk Assets Down

Robust Risk ControlPotential Exit from Equities

Portfolio Risk Orientation


Consistent with

Historical

Growth

Detectable Adverse

Conditions 70

80

9

0

60

50

100

Consistent With

Historical

Recessions

LOW RISK of RECESSION

INDEX SCORE

94 Consistent

with High

Stability

Some Adverse

Conditions

Consistent with

Historical

Corrections

6

0

4

2

8

10

SCOREINDEX SCORE

LOW RISKof DESTABILIZATION

3

Risk Mgmt. Method Risk Assets

Weighting

12


U.S. INTERMEDIATE GROWTH TREND EQUITY OPPORTUNITY STAGE

FACTOR LEADERSHIP Summary Assessment for Factor Exposure

Where Are We Now?

▪ The reacceleration is now at 23 months since trough in Feb’2016.

▪ Growth-oriented factors are leading: Quality, Momentum.

▪ Aggregate conditions lead to a broad tilt to growth factors across all portfolios.

What Would it Take to Change the Outlook?▪ Under normal late-stage conditions, it would take a market correction to

restore small and value strategies.

▪ Slowing manufacturing trends could shift favorable tilts to low vol and dividend strategies.

▪ Tax cuts, a commodity event, or some other circumstance could also influence factor leadership.

OPPORTUNISTIC DEFENSIVE

MARKET BETA

Price

Size Volatility

Large

Small Hi Vol

Low Vol

Momentum/ QualityValue

De-RiskingRisk SeekingRisk-Profile

Equity Factor Positioning



Fund Performance: Sectors Since the Bottom


Updated: As of July 9th 2018.

Sector Performance Since February 8th

Added to Flex Lo Vol on Feb. 7th

Added to others on April 12th

We do not own.

We do not own.

Benchmark


Equity Factor Positioning


Factor Trends

500 Pure

Growth

Top 200

Growth

500

Growth

S&P 500 Quality AQR

Defensive

Doubleline

Shiller

CAPE

Min.

Variance

500 Value

(We don’t

hold)



Top 200

Growth

500 Growth S&P 500 Quality AQR

Defensive

Doubleline

Shiller CAPE

Min. Variance

Fund Performance: Core Funds



Benchmark


PRICING OF CREDIT ASSETS CREDIT OPPORTUNITY STAGE

FACTOR LEADERSHIP Summary Assessment for Fixed Income Exposure

Where Are We Now?▪ Credit has recovered fully since the trough in Feb’2016.

▪ Credit pricing is consistent with overbought conditions and now faces downside risk consistent with a slowdown in intermediate growth.

▪ Risky credit offers little upside over higher quality.

▪ Risk is shifting from duration risk to credit risk in the back half of 2018.


▪ Under normal late-stage conditions, it would take a market correction and bond sell-off to create opportunity in risky credit.

Fixed Income Positioning


OPPORTUNISTICPriced attractively for growth in

an upside reversal.

DEFENSIVEPriced for downside risk should

investors become credit averse.

BETAPriced to hold and collect yield

while intermediate growth is

sustained.

AVERAGE WEIGHTED PRICE TO PAR

Priced at

Premiums

Relative Full

Value

Modest Discount

PAR VALUE

Steep Discount

Current Pricing

Range

PRICE ASSESSMENT: OVERBOUGHT

Credit Quality

Duration Sensitivity

Yield

Greater

Lesser

High Yield

Low Yield

High QualityRisky

De-RiskingRisk Seeking

Risk-Profile

High YieldBank LoansHY Muni

Inv. Grade Credit

TreasuriesMunis

CMBSABS

High Yield

99.1

Inv. Grade Corp

99.7

Bank Loans

98.0

Barclays Agg

100.5

High Yield Muni

102.4

MBS

100.7

Updated: July ‘18


Fund Performance: Core Funds



Benchmarks

Fixed Income Fund Performance: 1 Yr. & YTD


EUROPE INTERMEDIATE GROWTH TREND EUROPE vs. US TREND

U.S. Dollar Trend vs. Major Currencies Summary Assessment for Factor Exposure

Where Are We Now?

▪ The reacceleration in Europe is now at 23 months since bottoming in August, 2016.

▪ European markets have held steady with U.S. stocks. Euro stocks have benefitted in dollar terms because of a declining dollar.

▪ We may be at the intermediate peak in growth and the ECB must taper QE in 2018.

What Would it Take to Change the Outlook?• Evidence that the dollar decline is supported by global policy-makers

and anything more than just a snapback from the post-election surge.

• The ECB would choose to delay the taper in 2018.

International Equity Positioning



BASE PORTFOLIO LEVEL 1 ALLOCATION LEVEL 2 ALLOCATION

Base Portfolio Exposures


EQUITIES

U.S. Stocks• Large over Small.• Factors emphasis on growth-like

characteristics: Earnings, Momentum, etc.

International• Opportunity to buy was Jan – March.• Mostly driven by the falling dollar and

improving macro.• Too improbable to buy now.

FIXED INCOME

Risky Credit (High Yield, Bank Loans, EM debt)• Avoid.

Defensive Credit (Treasuries, High Quality Credit, Mortgages)• Rate risk is minor for now.

Equities

Fxd. Income

Overweight

U.S Stocks

Underweight

Fixed Income

60%

40%

75%

25%

U.S. Large

Cap Core

U.S. Large Cap

Growth

U.S. Multi-

SectorU.S. Core

40%

35%

15%

10%


COMMODITY GROWTH TREND OIL PRICE TRENDSTAGE

U.S. Dollar Trend vs. Major Currencies Summary Assessment for Commodity Exposure

Where Are We Now▪ Commodities have “rebalanced” since their decline in 2014 & 2015.

▪ Even with (1)the dollar’s 6 mo. decline, and (2) the global reacceleration, commodities have had little upward surge.

▪ We remain in the backside of a commodities supercycle.


• Geo-political instability could produce elevated oil prices.

• It would require global growth to outpace supply for a prolonged period to change the supply/demand balance.

Commodity Positioning



Investment Positioning


Investing in a long expansion environment

Strategy ThemesHistorical Reasoning

Fundamentals MatterStay consistent with the economic fundamentals.

Markets move “directionally consistent” with the larger economy.

Stay with TrendBe willing to stay with a rising stock market even if it is overvalued and exuberant.

Attractive stock returns have been delivered even in late expansions.

Manage Overall Risk ExposureBe cautious of taking on aggressive or reckless risk exposures.

Risky assets tend to turn down earlier and faster when adversity emerges.

Remain Watchful and DisciplinedBe prepared for when the economy turns and have a plan for what to do.

Safe haven assets are resilient and dependable.


Portfolio Summary


Working in a “Targeted Beta” mode.

• We are participating fully in the market trend.

• We are overweight U.S. stocks.

• We are targeting the higher quality, more resilient end of stock choices.

We have moved away from credit risk in bonds.

• Risky bonds face more downside risk than upside reward.

Most (≈70%) equity gains have reached LTCG.

• The next date for LTCG is September 21st, 2018.

1

2

3


ECONOMIC & MARKET TRENDS4


SECTION


Yield Curve


Updated: July ‘18

Yield compression is normal for this

stage. Current levels were approx. 2 years from a

recession over the last three cycles.

Cross-currents are working on long-end rates.

Low-inflation is problematic for future rate increases.

INVESTMENT CONTEXT

Tightened over the last month


Inflation Trends


Headline inflation expectations are for increases in 2018.

Updated: July ‘18


Inflation Trends


Breaking Down CPI:

Apparel

Food & Beverage

Transportation

1.4%2.5%

Recreation 0.2%

Educ. & Communication 0.2%

Medical Care 2.4%

1.2%

5.6%

Housing 3.0%

CATEGORY WEIGHTING CURRENT RATE

Other Specialty CPI Categories

CPI: Commodities +2.4%

CPI: Energy +11.0%

CPI: Less Shelter +2.3%

Other goods & services

Updated: July ‘18

CPI All Items2.7%


Inflation Trends


Oil Prices:

Updated: July ‘18

Oil Prices+78.45% YOY

$74.13


Market Trends – Aggregate Volume & Beta


Volume above the line is positive

Market volume is sufficiently supportive of uptrends.


Market Action - VIX


VIX remains stable.

VIX at 12.77 Previous Month:12.23


Market Action


Beta Changes: Trend is sideways for now.


US Dollar


The Dollar has declined considerably since post-election highs.

Retracement of the “Trump

Trade”

Post-Election surge in $

Notable Change


Global Equity Snapshot


http://www.finviz.com/screener.ashxGlobal snapshot

Tic ker D om est ic US P erf (Mon t h ) P er f (3 Mo) P er f (6 Mo) P er f(YTD ) P er f(1 2 Mo) 5 0 -D ay SMA 2 0 0 -D ay SMA

OEF iShares S&P 100 ETF -0.92% 6.03% 0.55% 2.39% 14.07% 2.09% 3.69%

IWB iShares Russell 1000 ETF -0.74% 6.14% 1.62% 3.41% 14.83% 1.97% 4.13%

IJH iShares Core S&P Mid-Cap ETF -0.32% 7.30% 3.14% 4.61% 15.18% 2.66% 5.78%

IWM iShares Russell 2000 ETF 0.79% 11.90% 8.92% 10.36% 20.92% 3.89% 9.24%

Tic ker D eveloped P erf (Mon t h ) P er f (3 Mo) P er f (6 Mo) P er f(YTD ) P er f(1 2 Mo) 5 0 -D ay SMA 2 0 0 -D ay SMA

EZU iShares MSCI Eurozone ETF -4.07% -3.61% -5.90% -3.34% 4.02% -2.48% -3.67%

EWU iShares MSCI United Kingdom ETF -4.43% -0.91% -3.53% -2.43% 5.30% -1.96% -0.66%

EWJ iShares MSCI Japan ETF -5.70% -4.06% -7.55% -4.56% 7.90% -3.33% -3.17%

EWA iShares MSCI Australia ETF -0.43% 5.36% -2.46% -0.82% 6.98% 2.38% 1.64%

EWC iShares MSCI Canada ETF -0.55% 4.65% -4.80% -2.90% 7.99% 1.02% 0.69%

SCZ iShares MSCI EAFE Small-Cap ETF -5.70% -3.37% -5.01% -3.04% 9.13% -2.90% -2.12%

Tic ker Em erging P erf (Mon t h ) P er f (3 Mo) P er f (6 Mo) P er f(YTD ) P er f(1 2 Mo) 5 0 -D ay SMA 2 0 0 -D ay SMA

EEM iShares MSCI Emerging Markets ETF -7.91% -7.80% -10.88% -7.87% 5.75% -3.24% -6.17%

FXI iShares China Large-Cap ETF -13.18% -7.90% -12.41% -8.30% 7.19% -6.70% -8.30%

INDY iShares India 50 ETF -2.25% -0.40% -5.87% -5.04% 3.77% 0.70% -0.74%

EPP iShares MSCI Pacific ex Japan ETF -4.37% 0.83% -4.80% -2.97% 5.58% -0.88% -1.30%

EWZ iShares MSCI Brazil Capped ETF -3.77% -23.58% -21.87% -17.97% -2.07% -7.98% -18.37%

ILF iShares Latin America 40 ETF -0.16% -17.07% -13.75% -9.86% 1.99% -3.84% -11.25%

Tic ker Hard Asset s P er f (Mon t h ) P er f (3 Mo) P er f (6 Mo) P er f(YTD ) P er f(1 2 Mo) 5 0 -D ay SMA 2 0 0 -D ay SMA

UDN Invesco DB US Dollar Bearish -0.50% -4.60% -3.07% -2.64% 0.23% -0.50% -2.64%

DJP iPath Bloomberg Cmdty TR ETN -4.77% -0.66% -2.40% -1.76% 6.25% -3.74% -1.47%

IAU iShares Gold Trust -3.30% -6.09% -5.35% -3.84% 2.21% -2.53% -3.49%

IYR iShares US Real Estate ETF 3.73% 9.23% 3.64% 1.33% 4.81% 3.75% 3.73%

USO United States Oil 13.68% 19.58% 20.94% 24.56% 60.69% 7.61% 20.65%

As of 7/9/2018 from www.finviz.com.

http://www.finviz.com/screener.ashx


CLIENTCONVERSATIONS5


SECTION


Adding Systematic Risk Controls


Guiding Rules for Managing Portfolio Risk

Above 90

Below 90 to 80

Below 80 to 70

Below 70

Remain overweight

.

Objective rules-driven approach to managing risk.

Neutral

Underweight

Trend-Following Rules

Equity Positioning

For Advisor Use Only


Where to Invest in a Recession


Where to Invest in a Recession?

For Advisor Use Only

Themes:• Safety First• Safe Haven Assets• Cash-Like with some extra

yield

Examples• Short-Term Treasuries• High Quality Corporates• Money Market Funds• High Qual. Mortgage: GNMA

Preservation Opportunistic

Themes:• Historical basis for upside

Examples• Long Volatility• Long Duration Bonds• Long/Short Strategies• Dedicated Bear Market Funds

Themes:• Safety First Balanced with

Offsetting Upside

Examples• Intermediate Term Treasuries• Volatility Hedging• Long US Dollar• Managed Futures Strategies

Conservative

Moderate

Growth

Balanced


INVESTMENT PROCESS6


SECTION


INVESTMENT PROCESS


INTERMEDIAT

E TRENDS

BUSINESS

CYCLE

ADAPTIVE TO

BUSINESS CYCLES

RESPONSIVE TO

INTERMEDIATE

TRENDS

ADJUSTS TO

CHANGING

ENVIRONMENT OF

OPPORTUNITY &

RISK

BEHAVIORALLY

COMPATIBLE

INVESTOR

BEHAVIOR

SECULAR

ENVIRONME

NT

STRATEGY &

CONSTRUCTION

INVESTMEN

T

PORTFO

LIO


FIXED

INCOME

RETURNS

INVESTMENT PROCESS


Where Do Stock Returns Come From?

STOCK

RETURNS

First Layer

Fundamental PremiumSecond Layer

Persistent Factor PremiumsThird Layer

Macro Conditional Premiums

LOW

VOLATILITY

MOMENTUM(MKT. ACTION)

SMALL(SIZE)

VALUE (PRICE)

QUALITY (EARNINGS)

PROFIT

MARGINSECONOMIC

GROWTH

CONSUMER

ORIENTED

PRO-

CYCLICA

LS

NON-

CYCLICA

LS

CYCLICALITY/BETA

COMMODITY

BASED

CONSUME

R

ORIENTED

COMMODITY TREND

CONSUMER

ORIENTED

FOREIGNDENOMINATE

D

U.S. DENOMINATE

D

CURRENCY-BASED

The “Growth” factor has primacy over all other factors.

The BUSINESS CYCLE is the key tracking mechanism to understanding growth.

All other factors matter after first getting the “Growth” premium right.

Factor premiums can be tracked and anticipated.


INVESTMENT PROCESS


Where Do Fixed Income Returns Come From?

FIXED

INCOME

RETURNS

First Layer

Fundamental PremiumSecond Layer

Persistent Factor PremiumsThird Layer


CREDI

T(QUALITY

)

VALUE (PRICE)

TERM (DURATION)

CONSUMER

ORIENTED

CONSUMER

ORIENTEDFLOATING

RATE

FIXED

RATE

RATE DIRECTION

FOREIGNDENOMINATE

D

U.S. DENOMINATE

D

CURRENCY-BASED

Current yields are suppressed and insufficient to support income.

Therefore, greater returns are achieved by tactical exposure to riskier credit.

Loan performance and risk appetite change in dependable fashion through the

“Credit Cycle”; explaining the return patterns in higher rewarding, risky credit.

YIELD


Portfolio Construction


Source Diversifiers/ Return Enhancers

Commodity Premium

Opportunity Driven

Foreign

Defensive Stocks

Core Alpha

Equity

Core Alpha

Fixed Income

•Energy/Utilities Stock

•Real Estate

•Materials/Gold

•Natural Resources

•Small Cap

•Deep Value

•Corporate Transaction

•Cycle Driven

•EAFE

•Emerging Markets

•Commodity Countries

•Low Volatility

•Staples/Health Care

•Developed Sov.

•Emerging Mkt. Debt

•High Yield

•Preferred

•Corporate

•ABS/MBS

•Bank Loans

•Convertibles

•Treasuries

•Short Duration

Source Diversifiers/ Return Enhancers

Credit Driven Strategies

Low Rate

Sensitivity

Foreign Bonds

Defensive

Fixed Income




First Level

Fundamental PremiumSecond Level

Persistent Factor PremiumsThird Level


Economic Growth Premium Evidence-Based Factors Condition-Based Factors

Core Holdings

• Tax Efficient

• Strong performer through the

expansion

• Beta-Hugging to the S&P 500

Factor Alignment

• Alpha-generating

• Driven by intermediate trend and

cycle staging

Macro Alignment


Core Alpha

EquityS&P 500

DoubleLine Shiller CAPE

AQR Large Defensive

NASDAQ 100 Eq. Wt.

iShares MSCI Quality

iShares S&P 500 Growth

Pwrshares Pure Grw.

Factor Driven“Better” Beta Core

Core Return Enhancers

Commodity Premium

Commodity PremiumEnergy

Materials/Gold

Natural Resources

Currency Premium

Currency PremiumEurope/Asia

Emerging. Mkts.

Commodity Countries

Cyclicality Premium

Cyclicality PremiumHigh Beta/Low Volatility

Discretionary/Staples

Small Cap/Mega Cap




First Level

Fundamental PremiumSecond Level

Persistent Factor PremiumsThird Level


Yield Evidence-Based Factors Condition-Based Factors

Core Holdings

• With capable, proven managers

• Strong performer through the

expansion

• Volatility reducing

Factor Alignment


• Driven by intermediate trend and

cycle staging

Macro Alignment


Guggenheim Total

Return

PIMCO Mort.

Opportunities

PIMCO Income Fund

Inv. Grade Corporate

Asset Backed Secs.

Agency-Backed

Credit Risk Driven Currency Premium

Policy Premium

Skilled Managers

Core Alpha

Fixed Income

High Yield

Emerging Market Debt

Convertibles

Currency PremiumEurope/Asia

Emerging Mkts.

Commodity Countries

Policy PremiumBank Loans

TIPS

Core Return Enhancers


APPENDIX7


SECTION


Asset Class Alignment


Examine where Intermediate growth trend is GOING, not where it HAS BEEN.


Perspective Matters


Major-macro views add the first level of clarity. Aligning with the secular strong dollar trend and resilient cyclical growth has lead to improved outcomes.


Thinking Through Risk Across the Cycle


Risk Assets Must be Understood with Deep Context.

Risk

Rewarded

Less

Risk

Rewarded

More

RecessionEarly

RecoveryMid-Cycle Late-Cycle

UNDER-VALUED

OVER-VALUED

INTRINSIC VALUE

Recession

9.0 years into the expansion

Valuations and risk are intertwined with the business cycle and have typical patterns.


Where We Stand: Expansion Stage


The economy is still showing mid-cycle characteristics, but could look different a year from now.Maturing eventually leads to deterioration.

Unemployment ticked down to 3.8

Distress in auto lending is evident. All others are somewhat healthy


Asset Class Summary


Stocks Fixed Income Alternatives

OPPORTUNITIES

US StocksLarge growth in favor for now.Large caps should perform resiliently over small caps.Broad over narrow positioning.

International Stocks have diminishing macro risk.

Stay Diversified

US Fixed IncomeFew opportunities.High quality corporate bonds.Skilled, unconstrained bond funds.

High Yield and floating rate are fully priced. Each hold more downside risk than upside opportunity.

Foreign bonds: be cautious of currency risk.

CAUTIONS CAUTIONS

Be Skeptical

Be cautious of mutual fund Alts that offer “low correlation” but very little in return.

Alts, as a whole, have overpromised and under-delivered.

Energy Stocks in the face of downside oil price pressure.

Value stock trade has faded. Need another pullback to return.


Where are We Today


Long Bull Market?

Long Expansion?

Historical P/E

Systemic Pressure

Excesses?

2nd Longest

2nd Longest

Consensus says High

Low Inflation, Low Rates

???

Maintaining a Historical Perspective on Markets


Opportunities/Risks

US inflation and Fed Tightening

• Rebalancing of commodities leads to uncomfortable levels of inflation.

Oil Supply Imbalances

• Oil still has too much supply; faces downside pressure.

• OPEC must extend production caps.

• Texas frackers are working with new lower cost constraints and increasing production.

China Disorderly Consequences

• Unsustainable growth in debt ratios.

• Problems with capital controls.

EM Debt Crises

• Strong dollar and high U.S. rates lead to severe tightening on U.S. dollar denominated debt.

Border Adjustment Tax/Corp Tax Reform

• Normalizing the changes could lead to rapid adjustments to currencies and inflation.

Convergence of supportive forces

• Better growth data

• Better earnings

• Potential pro-business policy

Improving overall sentiment

• Cash moving back to stocks

• Bonds aren’t safe.

• Too much negativity reverses in the wake of improving data/outlook.

Improving Global Growth

• Reduction of global risk benefits all equity markets as disposition of investors improve.

Corporate Tax Reforms

• Reduction of rates from 35% to 20%.

• Tax holiday of 10%.

OPPORTUNISTIC DEVELOPMENTS RISK WATCH



Thinking Through Risk Across the Cycle


Risk Assets Must be Understood with Deep Context. .

Risk RewardedLess

RiskRewardedMore

Recession Early Recovery Mid-Cycle Late-Cycle

Under-Valued

Over-Valued

Intrinsic Value

Recession

9.0 years into the expansion

Valuations and risk are intertwined with the business cycle and have typical patterns


Federal Reserve Board


Change is on the way.

Open

Open

Open

Open

Feb. 3, ‘18

FOMC Voting:• 7 Members of the Board.• 1 President of the NY Fed.• 4 of the 11 other regional presidents.

• 1 Yr term that rotates.


Balance Sheet Neutralization


U.S. Treasuries


Balance Sheet Neutralization


Mortgage-Backed Securities


Central Banks Policy Tracker


United States Federal Reserve

Key Rates:

Fed Funds: 1.75-2.00%

European Central Bank

Bank of Japan

The Peoples Bank of China

Bank of the UK

Expectations:

• Look for the Fed to make four rate hikes in 2018.

QE Status:

• Balance sheet normalization to continue as planned

Key Rates:

Refinancing Operations: 0.00%

Marginal Lending Facility: 0.25%

Deposit Facility: -0.40%

QE Status:

• Will begin tapering in January and continue through at least September 2018

Expectations:

• A rate hike is unlikely until the complete end of QE

Key Rates:

Overnight Call Rate: -0.10%

QE Status:

• Continuing to expand its asset purchase program

Expectations:

• Will seek moves to devalue the yen

Key Rates:

Bank Rate: 0.50%

QE Status:

• We are now 18 months into the 18 month extension of QE

Key Rates:

Lending Rate: 4.35%

QE Status:

• Will continue to inject more funds until liquidity begins to loosen

Expectations:

• High inflation may cause the bank to increase rates

Expectations:

• Will continue prudent and neutral policy to maintain yuan within balanced range

Bank of KoreaKey Rates:

Base Rate: 1.50%

Expectations:

• An increase in inflation beyond the projected target range could cause the bank to raise rates

QE Status:

• Will continue open market operations to sustain growth at target levels


Are We are the Peak?


How Slow Downs Historically Movedhttp://www.zerohedge.com/news/2017-10-23/one-economic-indicator-making-goldman-turn-bearish


Brexit Timeline


Brexit Timeline


Examples of Bad Research


Misses a total of 8 bear market declines since 1935.• 1981-82 Recession• 1966 Non-recessionary• 1962 “Kennedy Slide” • 1957 Recessionary• 1948-49 Recessionary• 1946 Non-recessionary• 1940-42 Non-recessionary• 1937-38 Recessionary (-54%)


Real Estate Market Cycles


investment focus · data economic growth momentum is sustained. unemployment ticks up to 4.0%. job...

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