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A QUARTERLY INVESTORS REPORT FROM THE VECTOR GROUP AT MORGAN STANLEY
JULY 2016
E X E C U T I V E
S U M M A R Y
Second Quarter 2016
■ Brexit? Schmexit! Financial Markets shrug off dire predictions after the UK voted to
leave the EU.
■ The U.S. Federal Reserve Board, reversing the reversed, reversed their stance and now is
widely anticipated to raise rates once again this year.
■ After a brief rally, volatility pulled back and as of this writing is touching two-year lows.
■ At the end of the second quarter, the S&P and the DJIA were on the way to making alltime highs with the NASDAQ finally challenging a high not seen since March of 2000.
■ Large emerging equity markets are all putting in highs for 2016 (China, India, Brazil &
Russia).
■ While most of Europe is recovering from an initial plunge, price levels are still below highs.
■ Oil ended the quarter at $48.33/barrel WTI, up significantly from the quarter’s open of
$37.32/barrel.1
■ Gold gained $94/oz. for the quarter while the U.S. Dollar gained modestly.2
Outlook (no change)
■ Economic news improved slightly (housing and employment) in the second quarter.
We expect that pace to accelerate through the rest of the year.
■ We continue to believe the Fed will remain guarded in future interest rate moves, but think
there will be at least one hike this year.
■ We maintain our U.S. equity call. An unanticipated uptick in growth with participation
led by industrials and financials could prove the right medicine for a tepid outlook.
“Darkness cannot
drive out darkness;
only light can do that.
Hate cannot
drive out hate;
only love
can do that.”
—Martin Luther King, Jr.
IN THIS ISSUE:
2016: A Year of Populism
Bond Strategy for the Next Six Months
THE VECTOR GROUP at MORGAN STANLEY
1290 Avenue of the Americas, New York, New York 10104 • 212 893-7516 • www.vectorgroupfinancial.com
Un
Tactical Ideas for Consideration
for the Appropriate Investor
ASSET CLASS CHOICE
SUB CLASS
IDEAS
Equity
Attractive
Large & Mid
Attractive
Sectors: Industrials,
Information Technology,
Consumer Discretionary
Attractive
Europe
Unattractive
China, India & Brazil
Attractive
Long Duration
Unattractive
Municipal Bonds
Medium Duration
Attractive
High Yield Debt
Various
Attractive
US Dollar
Negative
Commodities: Energy
Crude
Attractive
Precious Metals
Gold
Attractive
Mid-Stream Energy:
Natural Gas/Petrol
Attractive
US Equity/Debt/
Cash
US Equity Size
Equity Investment
Developed Int’l
Equity
Emerging Market
US Gov Bond
Market
Currencies
MLPs
CONVICTION1
NOTES:
1
Lowest,
Highest [Increasing number of top hats indicates increasing conviction to the idea]
If you are interested in exploring any of the ideas mentioned above, please call. We will discuss if it is
appropriate for your specific situation as well as the different investment choices available to gain exposure.
2
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
2016: So Far…
Just as we thought it couldn’t get wilder: Brexit, the summer
of terror, attempted coup in Turkey and financial markets that
appear numb. The second quarter of 2016 was another in a
series of interesting periods. Again, here we sit at the end of
the quarter (and beyond) with gains in oil, gold and stocks
for 2016.
However, more seems at play here as there appears to be a
significant shift in equity selection into other segments of the
market. We call this sector rotation and it suggests a change
in thinking on new money allocated to equities. As well,
allocation to the smaller capitalized end of the market likewise
suggests a more authentic “risk-on” trade.
S&P 500 - Sector Performance through 6/30
MARKET ACTION
US Equity Market
S&P 500 - Second Quarter 2016
…And 6/30 Through 7/15
We gained a bit of momentum through the quarter with oil
rising and general economic data showing moderate growth.
In several ways, a British Exit (or “Brexit”) was somehow being
written into the equation. This endured until the week of the
vote in which certain bookmakers pushed the possibility of an
exit to under 30%, which caused an unexpected rally in risk
assets, including equities.3 As can be seen in the chart above,
the run up to the vote was significant. Once the result was not
as expected, selling began and lasted for two days, only to see a
complete reversal (and more in early July) in subsequent days.
Looking at the US equity market, this makes some sense: if
investors fear an economic impact or financial problem in the
EU/UK, where better to seek safety that in US equities where
impacts should be somewhat muted, at least for the time being?
This appeared to add on to the already poised-for-flight capital
of the Far East and economically distressed emerging markets.
Although it is a little hard to read in the above charts, outside
of energy (Turquoise), the three best performing sectors
through the end of the second quarter of 2016 were Utilities
(Purple), Telecom (Dark Green) and Staples (Black). Since
then, however, Industrials (Bright Green), Materials (Pink),
Financials (Orange) and Technology (Blue) have begun to
outperform. We will see how this further develops.4
One might think this would play into the same theme we’ve
seen this year, that is, investment in large, identifiable names
with stable revenue (and dividend) streams: namely, consumer
staples and utilities.
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
3
Energy Market
West Texas Intermediate Crude (shown above)
shows a healthy rebound in the oil complex.
This continues to be an extremely fluid story
that seems to have helped equities in the second
quarter. As mentioned last quarter, signs are
pointing to oil having bottomed in February.
Recent fundamental data points show healthy
demand and not an overabundance of supply.
Other Equity Markets
While the Emerging Markets Index (and
indeed each of the major countries) has shown
resilience this year, the developed world outside
of the US (including Europe and Japan) has
been less thrilling. As well, the recovery after
Brexit appears still impaired.
WTI Crude Price/Barrel - Q2 2016
Emerging Markets - Through Q II 2016
In light of these observations, which corroborate
our comment last quarter, it appears that new
allocations to the emerging equity markets may
merit some examination.
Our concern about the EU, because of not
only internal discord, but also external forces
including immigration issues will hold sway for
the next few months.
4
EAFE - Through Q II 2016
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
Dollar and Gold
The US Dollar staged a late quarter rally due to Brexit and has
continued to climb as of this writing. Interestingly, gold has
maintained its higher valuation suggesting several things may
be afoot.5
Bond Markets
Ten Year Treasury Yield Second Quarter 2016
U.S. Dollar - Second Quarter 2016
As one might expect, Treasury yields declined late the quarter,
as investors sought safety6…
Gold Spot - First Quarter 2016
…but high-yield bonds appreciated for the quarter.7
High-Yield Corporate Debt Second Quarter 2016
It may very well be that a renewed interest in gold globally
is affecting demand, and therefore, prices. No wonder given
opposing scenarios of weakness in Europe and possible rate
hikes in the US.
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
Again, we seem to be in a rather divided environment. Here
risk-on thinking kept the liquid issues of the junk market
moving higher, helped in part by yield seekers with a declining
interest rate environment.
5
2016: A Year of Populism
Austria’s Freedom Party, Slovakia’s People’s Party, Pawel Kukiz
of Poland, Brexit, Bernie Sanders, Donald Trump and Howdy
Dowdy. What do all of these things have in common and not
in common with the attempted coup in Turkey? Populism!
we seem in economic irons and directionless. Add to this a
completely ineffective government that has made no progress
on recharging our financial system or fostering a positive
environment for capex. Without guidance, investors and
financiers alike have largely sat on the sidelines rather than
borrow and invest.
Well, Howdy Dowdy aside, it’s been an eye-opening response
to years of frustration. Frustration at lack of government action.
Frustration at under-representation. Frustration at dilution
of personal and cultural ownership. Frustration at general
economic malaise. This can be reduced to demographics and
economics (or lack thereof ), but nobody wants to talk theory
when they have an immediate need.
For people out of work waiting for the next cycle of
employment, which is usually ushered in with next business
enterprise or investment, the wait is proving too long. In
addition, once we begin griping, we might as well bring up
every injustice we can. Underlying issues of inequality due to
income, race, culture have broken through the surface once
again.
When the architects of the recovery of the “Great Financial
Contraction” (GFC for those in the know), i.e., the politicians
and the central banks, set about their work, they knew that
they would not want anything looking like a depression, given
the impending financial and economic displacement on the
near horizon. Therefore, to prevent this, they exchanged a
potentially shorter, more painful economic adjustment for a
more certain longer-term cap on growth and disincentives to
invest. Keeping interest rates low and propping up the financial
apparatus greatly allows for the healing process to work, but
for an extended period of time.
The cure for the financial crisis also came at a time when more
and more jobs are shifting, changing or just plain leaving.
This has made it even more difficult to move back to a more
“normal” environment.
While the initial goal seems to have been accomplished (no
painful deep depression), the result is a period during which
6
There is evidence of wage growth and “green shoots” as they are
called in the economic data. This seems to be happening on its
own and without the aid of politicians and banks. Ironically, if
this persists, the next administration could find itself accepting
credit for a new phase of US growth regardless of new policies
or political initiatives.
—MDS
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
Bond Strategy for the
Next Six Months
The dance around low rates, managing risk and a trend toward
illiquid bond markets is a slow waltz with which investors have
become accustomed. The Vector Group’s fixed income hydraapproach to capture monthly income with an aim to limit
volatility has been flexible as markets are on edge. Low US
rates and negative global interest rates coupled with an itchy
Fed ready to raise rates cause anxiety and uncertainty. We feel
rates will stay in a tight, low range for the near future.
SOME POINTS
Although most fixed income asset classes have performed well
in 2016, we are avoiding Emerging Market bonds, Global
Sovereigns and long-term US Treasury bonds in order to
reduce volatility.
We are thoughtfully watching for changes in:
1.Infrastructure
2.Federal Reserve steps (missteps) that rely on
dot-plot strategy
3.A flat Treasury yield curve
4.Wage increases that might suggest inflation
1. High-quality Municipal Bonds is at the core of our bond
strategy. The Vector Twist combining high coupon, callable
20-year bonds with 10-year zero coupon bonds should
work well if rates stay low for longer.
5.Wild currency swings
2. Floating rate bonds work well in an increasing rate
environment. However, because rates have dropped so low,
these bonds are out of favor and prices have drastically
dropped allowing investors to pick up value with a longerterm tactical eye.
The bonds in this five-headed style influence the ability of
individual strategies to generate returns, but they also pose
challenges in managing portfolios with a multi-asset class
investment style. Using this approach, bond investors should
be prepared to capitalize on a variety of outcomes.
3. High-yield corporate bonds can provide current income,
and investors might pick up 3-4% over their high-grade
counterparts. A slow moving US economy has kept
defaults low. Careful security selection in the B and BB
range continues to be rewarding.
As a result, the tools investors use in their portfolios require
another look and there are two attributes that investors need to
evaluate when selecting platforms to support today’s market:
flexibility and reliability.
4. Sprinkle in European corporate bonds as “Brexitmania”
insecurity has created possible opportunity. We are
reassured by the European Central Bank (ECB), which
formally started its Corporate Sector Purchase Program
(CSPP).8 Market behavior has changed because ECB
purchases provide a soft price floor.
6.Volatility in equity markets that may reallocate more
money into bonds
—MJB
5. High-quality mortgage-backed bonds might offer steady
income and lower volatility. We would look at both
Residential and Commercial asset classes.
7
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
NOTES:
1 Thomson ONE (2012). Thomson Reuters. Available at: Subscription Service. Market
Overview: Commodities. (Accessed July 1, 2016).
2 Thomson ONE (2012). Thomson Reuters. Available at: Subscription Service. Market
Overview: Commodities & Forex. (Accessed July 1, 2016).
3 Strategas Research Partners. Strategas. Investment Strategy Report, “Defensive Sectors
Outperform During Periods of Yield Curve Flattening.” Authors: Jason DeSena Trennert and
Ryan Grabinski. Available at: Subscription Service. Published Monday, June 13, 2016.
4 StockCharts.com, Inc. (2016). Available at: StockCharts.com. Market data provided
by: Interactive Data Corporation. PerfChart of S&P Sector ETFs. Top Chart Period:
12/30/2015 – 06/30/2016. Bottom Chart Period: 06/30/2016 – 07/15/2016.
5 Thomson ONE (2012). Thomson Reuters. Available at: Subscription Service. Market
Overview: Commodities & Forex. (Accessed July 7, 2016).
7 StockCharts.com, Inc. (2016). Available at: StockCharts.com. Market data provided by:
Interactive Data Corporation. 10-Year US Treasury Yield Index as of 06/30/2016.
7 StockCharts.com, Inc. (2016). Available at: StockCharts.com. Market data provided
by: Interactive Data Corporation. SPDR Barclays High Yield Bond ETF (JNK) as of
06/30/2016.
8 European Central Bank. Press Release, “ECB Announces Details of the Corporate Sector
Purchase Programme (CSPP).” Released on 21 April 2016. Available at: https://www.ecb.
europa.eu/press/pr/date/2016/html/pr160421_1.en.html
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
8
THE VECTOR GROUP
at MORGAN STANLEY
M. David Sherrill, CFA®, CMT®
Managing Director,
Senior Portfolio Management Director,
Financial Advisor
212 893-7515
[email protected]
Kamesh Nagarajan
Senior Vice President
Senior Portfolio Management Director
Financial Advisor
212 492-6750
[email protected]
Michael J. Belsky
Senior Vice President,
Senior Portfolio Management Director,
Financial Advisor
212 893-7600
[email protected]
Michael Pellman Rowland, CFP®, ADPA®
Senior Vice President,
Portfolio Management Director,
Financial Advisor
212 705-4581
[email protected]
David J. Cote
Vice President,
Financial Advisor
212 893-7566
[email protected]
1290 AVENUE OF THE AMERICAS,
NEW YORK, NEW YORK 10104 • 212 893-7516
www.vectorgroupfinancial.com
© 2016 Morgan Stanley Smith Barney LLC Member SIPC
9
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10
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THE VECTOR GROUP at MORGAN STANLEY
1290 Avenue of the Americas, New York, New York 10104 • 212 893-7516 • www.vectorgroupfinancial.com