VL Capital 2Q 2018 Newsletter

For the three months ending June 30, 2018, the VL Capital Systematic U.S. Equity Strategy returned 4.50%, net of management fees, while the benchmark S&P 500 Index returned 2.93%. Year-to-date, the Systematic U.S. Equity Strategy returned 3.77%, while the S&P 500 returned 1.67%.

The single largest contributor to performance during the second quarter was Applied Optoelectronics Inc. (NASDAQ: AAOI), which rose 79.17%. Applied Opto., a manufacturer of fiber-optic networking equipment, received ratings upgrades from several Wall Street analysts in May that helped unlock significant value in the shares. According to these analyst reports, the stock was attractively priced with a P/E of 16x and competitive pressures were overblown. Even after a nearly 80% rise in the second quarter, the company’s stock remains undervalued on a historical basis and likely has more room to run.

The single largest detractor from performance was Western Digital Corp. (NASDAQ: WDC), which fell -16.10%. Western Digital, a manufacturer of hard disk drives for computers and servers, reported strong earnings on April 26th. In the week following earnings, the stock price fell approximately 12%, which was partially driven by the company guiding to moderate margin contraction in the upcoming quarter. We view the continued growth in data centers as a tailwind going forward along with the recent pickup in PC sales. In terms of valuation, Western Digital remains attractive with a P/E ratio of 13x, which should provide further downside protection.

The outperformance of the VL Capital Systematic U.S. Equity Strategy can be attributed primarily to superior stock selection as the market has overwhelmingly favored growth stocks during the first half of 2018. With the Systematic U.S. Equity Strategy being value-focused, this growth bias has certainly been a headwind. This divergence is further evidenced by the fact that the S&P 500 Growth index rose 6.6% in the first six months of 2018, while the S&P 500 Value index fell by 3.4%. We continue to subscribe to the notion that the run-up in technology stocks cannot continue forever and eventually value-oriented names will come back into favor. At such time, the Systematic U.S. Equity Strategy should see an increased outperformance gap versus the benchmark S&P 500 Index.

The VL Capital Risk Parity Strategy returned -1.48% during the second quarter and has returned -3.56% year-to-date. Commodities continued to be the largest contributor to performance and have been the best performing asset class of 2018. Any negative impact on commodities from talk of a trade war is likely short-lived and we expect continued outperformance from this asset class throughout the second half of the year. Emerging market equities constituted the largest drag on performance during the quarter. As the Fed continues to hike rates and talk of a trade war heats up, emerging market equities have seen large outflows. It is important to note that Risk Parity is structured in a way that passively reflects the return of the world economy but does so in a manner that equally balances risk. As a result, the strategy will inevitably undergo periods when at least one asset class underperforms, and others outperform on a relative basis.

In terms of potential downside risks to the market, the pace at which the Fed continues to hike interest rates tops the list. Entering 2018, expectations were for three interest rate increases. As the economy, and particularly the labor market, have shown continued strength, the Fed decided to increase the number of rate hikes to four this year. While an additional rate increase likely will not derail the economy, a significant change to the Fed’s strategy has the potential to tip the U.S. into a recession. With that said, the VL Capital Recession Risk Index does not indicate the probability of a near-term recession in the U.S. and therefore a downturn is unlikely within the next 12 months. The other market catalyst on many peoples’ minds is the recent shift in U.S. foreign trade policy. As President Trump has stepped-up his hardline stance with trade partners, markets have become increasingly volatile. Trade relations with China appear to be of the utmost concern, but China has far more to lose in a trade war than does the U.S. This is evidenced by trade figures from 2017 wherein China exported $505 billion worth of goods to the U.S. and only imported $130 billion worth of goods. This approximately $375 billion negative trade balance for China represents a very weakened bargaining position that affords the U.S. significant leverage. From an economic perspective, tariffs are incredibly inefficient and end up hurting all parties involved. Therefore, we view the recent round of the tariffs by the U.S. simply as a negotiation tactic rather than an intended escalation of a full-blown trade war.