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.
It was another rough week for risk assets. Below are a sampling of headlines:
· Dow Falls 391 Points, Oil Closes Below $30 for First Time in 12 Years
· Cramer: Don’t bother buying, preserve your capital”
· ’Much more’ selling could follow rout
· It Took 7 Months to Unwind 2 Years of Global Stock Gains
There were likely more sensational headlines out there, but no need to look further as these bear witness to just how tough it was. In fact, The S&P 500’s 8.8% decline was the worst three-week performance since the depths of the Financial Crisis in October 2008. Likely factors for the stock market swoon include a combination of concerns about China’s economy, the price of oil, and geopolitical tensions. Anyone miss mid-2015 when the headlines were dominated by concerns that Greece (which contributes 0.3% of Total Global GDP) might leave the EuroZone?
Additional asset class performance detail can be found here.
Compared to the relative tranquility that investors enjoyed from 2012 through 2014, it is understandable that many investors feel like we are entering a redux of the Financial Crisis. However, at this point the data does not support that dire scenario. The Financial Crisis was borne of an asset bubble created by an over-levered private market, which is different than the current situation. Global debt has certainly not declined since the Financial Crisis, but it has been shifted to government balance sheets which, generally speaking, have the means to eliminate the debt through repayment or monetization. An over-levered global economy will constrain economic growth rates and likely lead to lower investment returns on risk assets. However, absent China imploding, a major military conflict or some other significant exogenous, event, it seems unlikely that we are on the cusp of another global financial crisis. Of course, if the data changes, so will our opinion.
This is not a recommendation to buy stocks now – i.e. this is not a call for “the bottom” of the market. Equity markets may move lower from here, perhaps meaningfully lower. It’s possible that broad US stock indices will decline 20% or more and enter a “bear market” as is the case with some European stock market indices. Bear markets are a normal part of investing – we just haven’t seen one in a long time because of the extraordinary monetary policies of central banks around the world. However, lower asset prices serve to improve valuations in certain pockets of the market and create pricing dislocations in others that can be exploited for longer-term investment gains. Once again, a diversified allocation is your friend. For example, per the headline mentioned above, a portfolio invested exclusively in global equities has given up two years of investment gains in just the last seven months according to Bloomberg.
The Power of Punch: The chart below shows how a variety of assets have performed since the Fed pulled the proverbial “punchbowl” and raised the Federal Funds Rate in mid-December. Investments in US Treasuries, Gold, and hedge funds are about the only widely held investments that have tempered losses from risky assets.
Sources: Bloomberg and Covenant Investment Research.
Economic Data Release Summary: December’s report for Retail Sales was disappointing as the control group (retail sales excluding autos, gasoline and building materials) declined 0.3% month-over-month (“m/m”) vs. expectations of a 0.3% gain. Industrial Production data for December was also weak, as warm weather resulted in a 2.0% m/m decline for utilities. US Consumer Confidence improved in January, with the University of Michigan index rising to 93.3 (from 92.6). It is also worth noting that the Expectations Index rose to 85.7 from 82.7, signaling that lower gasoline prices and a healthy labor market offset concerns about the stock markets at the start of the month.
The New Year did not bring an end to the financial market weakness witnessed in the final days of 2015. Last week was a poor one for risk assets due to renewed concerns about the Chinese economy and a certain diminutive dictator detonating a nuclear device. Add to these problems the deteriorating political situation between Saudi Arabia and Iran and 2016 is off to a rocky start. In a global economy beset by slow growth, January has thus far provided a good reminder that economic shortfalls (especially in the second largest global economy) and geopolitical tensions can inflict significant damage on the psyche of already nervous investors.
With regard to the selloff, developed market equities declined around 6%, Chinese equities fell nearly 10%, oil plunged 11% (to just shy of $33/barrel) and high-yield credit spreads continued to widen. On a relative basis, hedge funds held up well, but aside from U.S. Treasuries, gold and cash, there were few places to hide. Reflecting the gloomy market conditions, the VIX Index jumped 48% to 27 (a large percentage increase, but not yet a level that implies severe market stress).
Additional asset class performance detail can be found here.
Warning Sign? November trade data released last week showed that the trade deficit narrowed to an eight-month low. Regrettably, the gap narrowed because imports declined, not because exports increased. Specifically consumer goods imports fell by 5.7% month-over-month implying a slackening in domestic consumer demand. Combined with lower than expected vehicle sales figures for December, the all-important consumer is looking increasingly vulnerable. If weakness in consumption (the single largest input into US GDP and perhaps the healthiest economic sector at the end of 2015) carries over to 2016, GDP growth will end-up well below the current 2.5% consensus growth estimate.
Positive Omen? To add balance to the generally bearish sentiment of the first part of this communiqué, I offer the following.
Source: Bloomberg and Covenant Investment Research
This chart compares performance of the MSCI All Country World Index for the years 2011 and 2015, highlighting how similar they were to one another. The chart then transitions to show daily performance for the first week of trading in the subsequent years (2012 and 2016, respectively), which also look fairly similar. Finally, the chart shows full year performance for 2012, which at 13.4% was quite a good year for stocks following a poor showing in 2011 and the first week of 2012. While a double-digit gain in stocks for 2016 is not our baseline forecast (we would be quite happy with mid-to-high single digits), this chart offers a case, however tenuous it may be, for the optimists.
Economic Data Release Summary: At 55.3, ISM Non-Manufacturing Survey data for December was slightly lower than expectations (56.0), yet remains solidly in expansionary territory (i.e. a reading above 50). Looking a little deeper into this survey, business activity, new orders and employment sub-indices all rose from their November levels implying the services sector is on solid economic footing. On the other hand, the manufacturing sector continues to struggle with the December ISM Manufacturing Survey reading coming in at 48.2 (i.e. the sector is contracting). The manufacturing sector continues to be hurt by feeble global demand and a strong USD, two conditions that will likely not abate in the near term. December Nonfarm Payrolls data was very strong as 292k new jobs were added (well above the consensus estimate of 200k). In spite of the job gains, the headline Unemployment Rate remained at 5% as the labor force expanded. The increase in the labor force is a positive for the economy because it is an indication that disillusioned workers who had given up on finding a job are again actively seeking employment.