While the initial leg higher in markets in early 2017 was arguably due to the expected policy bump of the incoming administration, at this point, the markets may very well wish the government would just get out of the way. And while the environment of low volatility, strong macro data, earnings growth and continued strength in risky assets does indeed suggest a “paradise”, it would be early, to say the least, to apply that term to US politics. The effort to pass a “skinny” Obamacare repeal failed on Friday after 3 Republican senators voted against the bill. The defeat came after several other alternatives put forward were also blocked.
In contrast to the healthcare legislation, the sanctions bill against Russia was swiftly approved 98-2 in the Senate. The bill also levies sanctions against Iran and North Korea and creates a new congressional oversight process which prevents the White House from easing sanctions in the future.
The Congress will now move on to tax legislation. However now that the border-adjusted tax (BAT) will not be part of the package and the Obamacare repeal has failed it’s not clear where the savings will come from. The BAT was expected to raise $1trn over the next decade.
US growth rebounded in Q2 to 2.6% after a below-trend showing of 1.2% in Q1, though this was slightly below market expectations of 2.7%. The flash Markit manufacturing PMI rose 1.2 points to 53.2 in July which was the highest reading since March. Housing prices continued to rise – the median sales price was up 6.5% yoy.
Elsewhere, business sentiment has started to come back down to earth after the post-election bump though it is still at a relatively high level.
Equities were flat this week with Treasuries and the USD slightly lower. high yield bonds, EM FX and commodities performed well. Oil neared $50 a barrel – a 10% gain on the month. Saudi Arabia confirmed a drop in export flows in August and the American Petroleum Institute registered a large inventory drawdown – the largest since September last year.
While the macro data is broadly supportive of equity prices, we think this last leg higher in the market was due to the dramatic softening in Fed’s language. A number of recent speeches suggest a drop in the conviction of a rise in the neutral Fed Funds rate over the near term. This implies that the Fed may be closer to the terminal rate than commonly believed.
While equities were broadly flat, the VIX rose on the week. A seasonality performance plot of the index shows that on average the index rises from here until the end of the year.
This week we introduce our Closed-End Fund Total Return Index which is an AUM-weighted average of all closed-end funds in our basket. The index tracks gross price returns, assuming dividends are not reinvested.
Apart from the drawdowns in the global financial crisis in 2008 and the energy crash in 2015, it is striking how stable the index returns have been since 2009. The first question is whether there is a strong diversification element behind these stable returns. And the second question is whether the apparent linear performance over the last 10 or so years is what we should expect from the asset class in the future on a consistent basis.
To address the first question we look at the 12 major sectors comprising the CEF Index to see whether their performance is widely divergent or if the sectors tend to hug each other. The answer to this question is relevant to how an investor should position his or her CEF investment portfolio. If all sectors behave in a similar way then there is less need to diversify across these multiple sectors.
The chart above shows that there is enormous divergence among the different CEF sectors. The two market stress periods exemplify this divergence. CEF sector performance in 2008 varied from 15% to 75% in drawdown terms and the figures for 2015 were even wider apart between the MLP and, for example, the muni sectors.
The first-order conclusion from this chart is that diversification matters for the health of one’s portfolio. There are other potential benefits to diversification such as rebalancing of the portfolio in line with risk and allocation targets but we leave that for a later discussion.
To address the second question of whether we should expect similar returns in the future, we look at the cumulative return of the CEF Index to date. That figure is 7.8% and is a combination of NAV, price and distributions. The average sector yield, on a lookback 12-month basis, is currently 6%. This figure is slightly overstated given the number of distribution cuts over the last few months which are not captured here, but let’s go with it for now. So, for us to hit a total return of 7.8% all we need is 1.8% return in the CEF Index which is not all that much to ask from the market, especially when the typical CEF is leveraged. However, if one views the market as overdone then further market returns may be an uphill climb and we need to look at the third component of returns – discount compression.
Unfortunately, the picture there is not promising either – the average CEF discount is now trading at a 5-year high so further performance here will be challenging.
In the coming months we plan to introduce other CEF indices such as the risk parity and high yield-to-vol indices as instruments on which we can base rational investor allocation discussions.
Overall, we believe the markets remain supportive of continued positive returns in the closed-end fund space. While we don’t expect strong equity returns from here on, we also don’t think interest rates are headed much higher. Along with our constructive stance on commodities, we think closed-end funds should deliver good returns in the near-term albeit not significantly outperforming their distribution rates.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for information purposes only and does not constitute investment advice or an offer or the solicitation of an offer to buy or sell any securities. Past performance is not a guarantee and may not be repeated. Investment strategies are not suitable for everyone and you should always conduct your own research or speak to a financial advisor. Although information in this document has been obtained from sources believed to be reliable, ADS ANALYTICS LLC does not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. ADS ANALYTICS LLC does not provide tax or legal advice. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.