Last week was a tale of two halves, almost literally. In the first half of the week, global equities continued to slide falling 3.2% by noon on Wednesday. However, that marked the lowest point of the week as equities sharply reversed course, rallying through Friday’s close to gain nearly 4.5% and record their first positive week in the last four. Other risky assets, including oil, followed a similar pattern.
Once again the change in market direction (while a welcome respite from recent declines) was not based on a positive economic data, but rather expectations about further monetary policy easing from the European Central Bank (ECB), Japan (BOJ) and China (PBOC). Mario Draghi, President of the ECB, continued his campaign of “Whatever it takes” by stating “There are no limits to how far we’re willing to deploy our [the ECB’s] instruments” to assist the Eurozone’s recovery. The BOJ is under increasing pressure to become even more accommodative to halt appreciation of the Japanese Yen. And finally, a high-level Chinese authority said the government would “look after” investors in its stock market (which is down more than 16% YTD). The recovery in risky asset prices last week was welcomed by investors, but the reason for the rally is yet another indication that markets are being driven more by easy money than by economic fundamentals. The former is unsustainable; the latter is the ultimate arbiter of price and tantamount to gravity it is a law of nature within financial markets. As a result, absent a major quantitative easing event, risky assets are likely to appreciate at a relatively slow pace and with higher volatility compared to what they experienced from 2009 through 2014.
Additional asset class performance detail can be found here.
Canary in a coal mine – Over the last several years numerous managers have expressed concern both publicly and in private meetings that the effects of the Dodd-Frank Regulatory Reform Bill and the Volcker Rule have been negatively impacting market liquidity (i.e. the ability to easily trade financial instruments). Amongst other effects, these two rules limit proprietary trading by large banks and the amount of securities they are allowed to hold on their balance sheets (aka “inventory”). While not a perfect analogy, consider a grocery store that held more than 100 loaves of bread on their shelves prior to the Financial Crisis, being limited to holding 10 loaves of bread now – it simply isn’t as easy to buy bread. To this point, one of our managers (who has been trading for 18 years and previously was the head of interest rate and currency trading at one of the top investment banks) reported that during the recent market sell-off, the liquidity in cash macro products (e.g. interest rate futures and currency options) was worse than during the height of the Financial Crisis in 2008 and more comparable to October 1998 (when the Russian government devalued the ruble and defaulted on their domestic debt). Evidently, the concerns about market liquidity are a reality. Why should you care? You should care because a lack of liquidity is what causes markets to move to extreme levels as the market clearing price is set by fewer buyers, meaning that those that have to sell to meet margin calls may receive significantly lower prices than they otherwise would in a highly liquid market. This can act a positive feedback loop, exerting tremendous stress in certain pockets of the market that can then spread to the broader market resulting in heighted market volatility. This is one of the unintended consequences of new government regulations on banks and something investors should consider when they think about how volatile markets might become in a true stress scenario.
Panda Growing Pains – China’s 6.8% year-over-year growth in the fourth quarter of 2015 was slightly lower than the 6.9% level recorded in the previous quarter. The market views Chinese economic numbers skeptically and with many citing evidence that the Chinese economy is more likely growing at 4.5% or lower per annum. An economic slowdown in China is inevitable given the government’s desire to transition from an export-led economy to a consumer-based economy (a la the United States). The transition promises to be a rocky one, but there is no credible evidence at this time that the economy is on the brink of collapse as some have suggested.
Economic Data Release Summary: December’s Housing Start and Permit data was consistent with expectations, showing steady growth in single family housing activity. The headline Consumer Price Index fell 0.1% month-over-month (m/m) in December, largely as a result of a 4.0% decline in gasoline price. As oil has continued to fall, one should expect a larger decline in the January CPI Index reading. Existing Home Sales data for December was very strong, climbing 14.7% over a disappointing November reading and up 7.7% from the prior year. It is worth noting, that inventory levels remain tight, representing only 3.9 months of sales. This is the second lowest on record since the data starts in 1982 (source: Marketfield Asset Management), partly due to lower speculative activity from homebuilders since the Financial Crisis. Tighter inventory is contributing to higher prices for single family homes.
Please note that the Weekly Synopsis will not be distributed next week due to the combination of Covenant’s quarterly investment committee meeting and a busy travel schedule.