MONTHLY COMMENTARIES. August Monthly Commentaries Overview CROSSMARKGLOBAL.COM
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1 Page 1 of 5 CROSSMARKGLOBAL.COM August 2018 MONTHLY COMMENTARIES Monthly Commentaries Overview July broadly turned out to be a better than expected month for U.S. risk assets as investors tussled between two opposing market narratives: one of stronger than anticipated corporate earnings and continued U.S. economic growth vs. one cautioning new U.S. sanctions, EM contagion, and an imminently escalating trade war between the US, China, Europe, etc. In the end, the strong corporate and U.S. economic growth narrative won out in July as investors shifted their attention away from the macro and to the micro deluge of corporate earnings season. In July, 296 S&P 500 companies reported quarterly results that delivered +24% year-over-year quarterly earnings growth, though 7-8% of that growth was due to a lower U.S. corporate tax rate implemented with the 2018 Trump tax cuts. Nonetheless, corporate quarterly earnings for those companies reporting in July still beat consensus expectations by an aggregate +5%. One underlying earnings call theme worth noting given the context of this overview: while management teams were broadly concerned over unintended consequences of ongoing trade frictions, relatively few management teams have altered their pre-existing long term capex plans due to the heightened trade war fears. All in, the S&P 500 finished July up 3.72% (total return), the VIX which started the month above the 16 handle finished below the 13 handle, while U.S. investment grade and high yield corporate bond total returns each notched a positive 0.7% and 1.1%, respectively. As of this writing in mid-august, the two market narratives mentioned above still remain, and much to the benefit of financial asset prices domiciled within the U.S. as Emerging Market economic contagion (most recently Turkey) make U.S. investment that much more attractive for the time being. However, with corporate earnings season almost over, we wouldn t be surprised to see macro worries creep back to the forefront of U.S. investor minds a setup which, according to our Covered Call Income commentary, is typically consistent with rising equity volatility (commentary below for details). As discussed in our Large Cap Core Growth commentary, while the S&P 500 has traded between record highs made in late January and YTD lows in mid-february, underlying conditions could allow the S&P 500 to again test and even break to new price highs in coming months. Switching to fixed income, our Taxable Fixed Income commentary briefly lays out the underlying dynamics keeping 10yr US Treasury rates range bound between the %, while our Municipal Bond commentary takes the other side of a commonly held muni bond supply narrative. As always, you can find the unabridged copies of our monthly commentaries from each of our portfolio managers in the pages below. Until next Month!
2 Page 2 of 5 Covered Call Income Commentary Covered Call Income: July in Review Second quarter earnings season proved to be very strong throughout the month of July as almost 90% of companies beat expectations. The strength of corporate earnings was enough to send equity markets higher across the board. The S&P 500 gained nearly 4% in July and good economic news also propelled the 10-year U.S. Treasury yield to 3%. Consumers also remained optimistic about the near term future of the markets as retail sales grew over 6% year over year for the month of June. That percentage being the fastest pace of spending growth since Corporate confidence and strength in the markets can also be observed in the labor market as jobless claims recently hit a level not seen in over 4 decades. The Fed continues to seek some kind of balance within the markets as well. The Feds most recent meeting resulted in no action on rates as expected. However, futures are pricing in a rate hike in September. Interesting rhetoric coming out of the Fed seems to show that future moves will be more reactionary to economic developments, which will more than likely produce more volatility in the markets. Trade tensions continue to persist which will lead to increased volatility. Volatility is advantageous to covered call strategies and overall is healthy for the markets in general. The Covered Call Income team took advantage of volatility the first part of July by strategically placing option trades to generate additional income. VIX Trailing 12 months Source: Bloomberg Covered Call Income: Looking Ahead The month of August historically has been one of the worst performing months of the year with increased volatility and market uncertainty. Even though earnings and the U.S. economy remain strong, trade concerns, midterm elections and monetary policy issues will continue to pose additional risks. Historically we are pushing towards the time of year that has been rough for stocks. As we look forward, trade disputes will have a continued effect on volatility as we move from the summer months and into Fall. The Covered Call Income strategy is well positioned for the uncertainty that lies ahead.
3 Page 3 of 5 Large Cap Core Growth Commentary In July, the S&P 500 posted its fourth consecutive month of gains, rising 3.72% on a total return basis. The Russell 1000 Growth Index lagged the S&P 500 for a change, gaining 2.94% for the period. Despite trade war saber rattling, the U.S. economy continues prosper with both the manufacturing and service sectors posting PMIs well above the 50, indicating that we are still in expansion mode. As well, the stocks market continues to trade above its key 200 day moving average where it has found support since the January top in the S&P 500. A break below this average could signal a negative change in trend for stocks. Below that area, the next major support is at the February low of We don t expect the S&P 500 to break this level. It is more likely that the index will follow the tech-heavy Nasdaq and smaller cap Russell 2000 on to new highs. Corporate earnings should certainly provide a lift for stocks. Earnings are expected to be up about 24% in the second quarter with help from the tax cuts. For the year, earnings estimates now call for earnings growth of 20% or better. The twelve month forward PE ratio currently stands at 16.5x so valuations have improved since the market s January peak earlier this year, leaving room for more upside. Turning to our Large Cap Core Growth (LCCG) Model, our best performing sector was Industrials, which rose 9.06% on the strength of the economy. Financials were also strong as interest rates jumped near the end of the month. On the flip side, our weaker sectors were Energy, which declined by 0.88% as crude oil prices declined throughout the month, and Consumer Discretionary, which fell 0.39% for the period. As for individual stocks, Eli Lilly won the performance derby gaining 15.80%. The drug company announced strong earnings and a spinoff of its animal-drugs division. Harris Corp was another excellent performer, rising 14.12% on a better-than-expected earnings results. On the flip side, Polaris slid 13.72% on tariff fears and Constellation Brands fell 6.19% after it failed to meet earnings expectations. For the period we made several adjustments to the LCCG portfolio. We sold Tapestry due to poor performance and bought Ross Stores due to good earnings trends and positive momentum. We also swapped Polaris into O Reilly Automotive after Polaris was impacted by tariff concerns. Taxable Fixed Commentary The month of July continued to see the 10yr U.S. treasury caught in a trading range as the market awaited an impetus to once again push above the 3.00% level. There were opportunities with increased treasury issuance, the Fed Funds rate moving higher, continued strength in the labor market and the Bank of Japan loosening their control on their yield pegs. However, uncertainty continued to rear its ugly head in regards to tariffs and trade concerns keeping some downward pressure on the longer end of the curve. The positive contributors to outperformance for the taxable products during the month of July were income, yield curve placement and portfolio allocation. We continue to overweight the investment-grade corporate allocation which provides an elevated level of income for the portfolio a component that remains steady even with volatility in market values. Although our shorter duration positioning has proven as a positive for the portfolios on a year-to-date basis, we spent most of the month of July in the 2.80%s range for the 10yr treasury after continued closes in the 2.90% range in June. The slight move lower in yields detracted from performance but the income component proved to be a stronger force allowing for outperformance for the month of July. The corporate model was the only model that lagged its comparable index due to the duration pull as mentioned previously. With an outlook of continued rate hikes by the Fed and the potential of quantitative tightening from other central banks around the globe over the next 12 months, our conservative approach of reducing interest rate sensitivity and increasing income as compared to comparable fixed income indices will be maintained over the coming quarter. Our investment process that focuses on duration, yield curve structure, sector and security selection remains steadfast in all phases of the market cycle allowing us to utilize economic reporting, geopolitical events and our market outlook to determine an appropriate fixed income strategy for our clients. As always, we will continue to monitor the inputs to our process and adjust our strategy in an opportunistic manner as appropriate, looking forward to what the rest of the quarter may bring.
4 Page 4 of 5 Municipal Fixed Income Commentary July and August brings a common theme to the municipal bond markets: Fewer bonds being issued than maturing or called creating a shortage of bonds. Headlines pound investors to think the municipal bond market is shrinking faster than reality. It is true that the overall municipal bond market has shrunk since the peak in Austerity became the norm during the Great Recession as public officials were less interested in raising debt, even to take care of crumbling infrastructure, education or fund pension liabilities, just to name a few of the areas of need. There was a rebound in issuance in 2014 as municipalities took advantage of lower rates after the May 2013 Taper Tantrum. This brought the total issuance in the municipal bond market to around $3.8 Trillion. The market then grew slightly to $3.86 Trillion in 2017 as there was a rush to the market to beat the Tax Reform Act by year end which eliminated advance refunding. The storyline for 2018 has been how devastating the Tax Act would be to municipal bonds, both for new issuance as well as lower tax levels for individuals and institutional buyers. In reality, advance refunding was merely replacing existing bonds, which appear to be a wash for supply. Granted, new issuance is down nearly 15 percent but that is due to the rush to issue by year end Bonds being called appear to have slowed since the Federal Open Market Committee began raising short-term Federal Fund rates beginning in December 2015 with two additional hikes projected for remainder of this year, up to three hikes in 2019 and two hikes in Historically, July and August are slower for new issuance which plays back to our common theme this time each year. With this news backdrop however, please refer to the State and local government outstanding debt chart. The municipal bond market has grown substantially since California municipal bonds are becoming so expensive that they trade richer than AAA bonds of other states and municipalities. With an upper state income tax rate at 13.3 percent, investors seek any reprieve they can find from taxation. The incredible demand for California paper has investors holding onto what they own and the state, along with the individual municipalities, looking to bring new issuance to the market with favorable pricing to the municipality. California already issued Golden State Tobacco bonds earlier this year and are scheduled to issue another offering of tobacco bonds, which are less than stellar as a safe consideration for more conservative investors. The issuer is saving money and the investor takes on the added risk. Speaking of risk, the spread between high yield municipal bonds and investment grade has narrowed to a point that there is little differentiation between the two. Reducing risk by moving from high yield to investment grade appears to be highly prudent in this current market. Reaching for yield in a period that could see increased volatility might result in a negative experience. Similar narrowing of spreads are occurring in Emerging Markets and Corporate High Yield bonds. Crossmark Global Investments continues to find value in the municipal secondary market with bonds rated A or better involved with essential services like water, sewer, power, streets, highways, school education and general obligations. The ideal maturities on the yield curve have moved to the 7 to 20 year range with a call feature between 2019 and Crossmark Global Investments continues to hold a shorter duration than the Barclay s Quality Municipal Index with a focus on higher quality municipalities. Crossmark Global Investments continues to use municipal bond market volatility to opportunistically manage the portfolios entrusted to us. Sources: Bloomberg Professional Services
5 Page 5 of 5 Large Cap Core Growth Covered Call Income Top 10 Model Holdings 1 Weight Top 10 Model Holdings 1 Weight 1. Microsoft Corp. 5.92% 2. Apple, Inc. 5.12% 3. Home Depot, Inc. 3.69% 4. JP Morgan Chase & Co. 3.63% 5. UnitedHealth Group, Inc. 3.19% 6. CDW Corp. 3.17% 7. Texas Instruments, Inc. 3.15% 8. Honeywell International, Inc. 3.07% 9. Harris Corp. 3.01% 10. Cisco Systems, Inc. 2.94% Total of Portfolio 36.88% 1. Visa, Inc. 3.82% 2. Abbott Labs 3.67% 3. Pfizer, Inc. 3.35% 4. Valero Energy Corp. 3.31% 5. Gilead Sciences, Inc. 3.26% 6. Coca-Cola Co. 3.26% 7. Nike, Inc. 3.23% 8. Activision Blizzard, Inc. 3.08% 9. Delta Air Lines, Inc. 3.04% 10. Emerson Elec. Co. 3.03% Total of Portfolio 33.05% 1 Model Portfolios are based on a hypothetical account managed during the current quarter. Actual characteristics and income may differ materially from model. As of 7/31/2018. About Crossmark s 30 Year History Crossmark Global Investments is an innovative investment management firm. The firm provides a full suite of investment management solutions to institutional investors, financial advisors and the clients they serve. We have a multi-decade legacy of specializing in responsible investment strategies for clients. Founded in 1987, the firm is headquartered in Houston, Texas. For more information contact our Advisor Solutions Group: advisorsolutions@crossmarkglobal.com Crossmark Global Investments, Inc. (Crossmark) is an investment adviser registered with the Securities and Exchange Commission that provides discretionary investment management services to mutual funds, institutions, and individual clients. Information and recommendations contained in market commentaries and writings are of a general nature and are not intended to be construed as investment, tax or legal advice. Investment advice can be provided only after the delivery of Crossmark s firm Brochure and Brochure Supplement (Form ADV Parts 2A and 2B) and once a properly executed investment advisory agreement has been entered into by the client. All Investments are subject to risks, including the possible loss of principal. These materials reflect the opinion of Crossmark on the date of production and are subject to change at any time without notice. Where data is presented that was prepared by third parties, the source of the data will be cited, and we have determined these sources to be generally reliable. However, Crossmark does not warrant the accuracy of the information presented. Information and recommendations contained in market commentaries and writings are of a general nature and are not intended to be construed as investment, tax or legal advice. These materials reflect the opinion of Crossmark on the date of production and are subject to change at any time without notice. Where data is presented that was prepared by third parties, the source of the data will be cited, and we have determined these sources to be generally reliable. However, Crossmark does not warrant the accuracy of the information presented. This content may not be reproduced, copied or made available to others without the express written consent of Crossmark. Crossmark Global Investments, Inc Memorial Drive, Suite 200, Houston, TX advisorsolutions@crossmarkglobal.com crossmarkglobal.com
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