Following five consecutive weeks of gains in which global equity markets have risen about 11%, risky assets retreated last week. Global equities declined around 1%, precious metals fell a little more than 3%, and WTI Crude moved about 1.3% lower to $39.50 per barrel. This was a rather modest pullback as risky assets are enjoying a very solid month: most broad equity indices are up more than 5% and WTI Crude has gained nearly 17% in March. The price of US Treasuries moved only marginally during the week, with the yields on the 10-year (1.9%) and the 30-year (2.7%) holding stable. The US Dollar, following several weeks of declines, reversed course last week rising 1.3% (vs. a basket of trade partners’ currencies).
Detailed asset class performance data is available here.
Market Movers: The simultaneous reversal in risky assets (down) and the US dollar (up) last week, coincided with hawkish comments from several members of the Federal Open Market Committee (FOMC), the group that sets the Federal Reserve’s target interest rate level:
- James Bullard, President of the St. Louis Fed (and one of the most vocal members of the FOMC), suggested during a number of speaking appearances last week that another interest rate increase could come as soon as their next meeting in late April.
- John Williams, President of the San Francisco Fed, said that he will advocate for a rate hike in June, if not April during an interview.
- Charles Evans, President of the Chicago Fed, made comments in support of two rate hikes this year.
My belief is that the Fed is intentionally sending hawkish messages, perhaps well in advance of when they actually intend to raise rates. The reason for doing so is to allow foreign central banks (that hold large amounts of US Dollar-denominated debt) and investors that have become accustomed to ultra-accommodative monetary policies to get their respective affairs in order such that that future Fed actions have mitigated impacts on the global economy and financial markets. One indication for why the Fed might believe this hawkish jawboning is necessary is that the market is pricing in a single interest rate increase for late this year and a mere 6% chance that the Fed will raise rates in April – apparently there is doubt about the Fed’s resolve and/or ability to normalize interest rates. And while the Fed may desperately wish to normalize rates, the several trillion dollar question that has yet to be answered is whether the economy is growing fast enough to generate worrisome levels of inflation that will require higher interest rates. The economic data, thus far, seems to indicate it is not…
Slow Growth: On Friday, the U.S. Census Bureau released their final revision to Q4 2015 GDP growth which showed an improvement to 1.4% from the previous estimate of 1.0% (annualized). This was welcome news as the revision was largely due to increased Consumer spending, the primary driver of the U.S. economy. Still, even with the upward revision, the U.S. economy only expanded by 2.4% for all of 2015, which is consistent with the pace of growth experienced during the recovery from the Financial Crisis. In other words, growth in the U.S. economy is still not accelerating six years into the recovery. Offsetting some of the positive news about the upward revision is that corporate profits declined 11.5% year-over-year, the largest quarterly decline since the end of 2008. Even though the profit declines were heavily concentrated in the Energy sector, the lack of corporate profitability should serve as a reminder to the Fed that the economy remains vulnerable to shocks and tighter monetary policy will only increase that susceptibility. Moreover, it doesn’t appear that the U.S. economy is picking-up speed, as current estimates for Q1 2016 GDP growth are about 1.5%.
Economic Data Summary: Existing Home Sales data for February missed expectations, declining 7.1%, to 5.08mm. Despite the month-over-month decline, home sales were 2.2% above the February 2015 level. The bottom line is that housing still appears to be in the midst of a recovery, where tight credit, limited supply and rising home prices are the limiting factors rather than a lack of demand. February’s New Home Sales, at 512k, were in-line with consensus estimates and above the 12-month average level of 499k. Interestingly, developers are beginning to react to demand as inventory levels (at 236k) reached the highest level since late 2009. Durable goods orders for February fell about 2.8%. While the headline number was in-line with expectations, the widespread weakness is highlights the effects that weak global demand and a strong US Dollar are having on the domestic manufacturing sector.
Global equities rallied for the fifth week in a row pushing the S&P 500 to a slightly positive value year-to-date (YTD). Large capitalization stocks have been the primary beneficiary of the rally (not dissimilar from stock market performance in 2014) and while small cap and technology names have enjoyed substantial gains recently, they are not yet in positive territory as the Russell 2000 is down 2.7% YTD and the Nasdaq is off by 3.9% YTD.
International developed (with the exception of Japan) and emerging markets equities jumped last week as well. Chinese equities are now up more than 10% this month, yet remain down 15% YTD, highlighting the level of volatility present in that market as investors weigh the effectiveness of fiscal and monetary policy actions being taken to stimulate growth. In spite of the rally in risk assets, traditional fixed income assets appreciated last week (likely in response to the Fed’s inaction) and as a result the yields on the 10 and 30-year US Treasuries declined to 1.88% and 2.68%, respectively. Hard assets also rallied (in response to a declining US dollar that fell 1.2% for the week), including Copper’s gain of 2.2% on the week (+7.5% MTD) and WTI Crude’s jump of 2.2% (+16.5% MTD / +6.2% YTD). Detailed asset class performance data is available here.
Easy Money: At last week’s Federal Open Market Committee (FOMC) meeting the Fed chose to hold the Federal Funds target rate steady at 0.25% – 0.5%, as was widely expected. Moreover, the Fed’s now infamous “dot plot” (a chart that shows the FOMC members’ expectations for future interest rate levels) indicates that Fed is likely to raise rates only twice this year (down from the 4 times signaled in December’s dot plot). Clearly, the Fed is not overly concerned about inflation at this point in time, in spite of the recent firming of Core inflation levels. The Fed’s view may be informed by a recognition that we are now lapping weak inflation data from early 2015, so the recent increase in annual Core inflation data (on a year-over-year basis) has been anticipated (see Economic Wrap-up section for more detail). This view is supported by the markets, which are now pricing in only one more interest rate hike in 2016. Notably, the markets have had a better forecasting record on future interest rate levels than the Fed’s dot plot.
While it received less coverage domestically than the FOMC decision, the Bank of England (BOE) also held interest rates at historic lows last week. Once believed to be on the verge of raising rates along with the U.S., the BOE is now more concerned about uncertainty of the June 23 referendum on the UK’s membership in the European Union. With the Bank of Japan, European Central Bank, and the People’s Bank of China in easing mode, and the Fed and BOE on hold for now, global monetary policy remains highly (and unusually) accommodative which has helped risk assets largely recover from a historically poor start to the year.
Rising Drug Costs: The January US Wholesale Inventory report may have offered a glimpse into how quickly healthcare costs are rising in the U.S. The report revealed that pharmaceutical inventories, at $53.58 billion, are now the largest constituent of Total Wholesale Inventory, having increased from 9.2% in Dec ’13 to 12.4% of total Wholesale Inventory levels. One can reasonably assume that the increase in inventory levels is one of valuation not volume. That is to say, we suspect that the price of medication has risen, rather than a spike in the amount of medication held in storage. One implication of rising healthcare costs is a reduction in discretionary purchases by consumers. We have suggested in our recent Economic Review and Outlook quarterly letters that the rise in healthcare costs is a likely a contributing factor in the disappointing growth in Retail Sales as consumers are forced to direct an increasing portion of their paychecks to healthcare.
Economic Data Summary: Retail sales data released last week disappointed market expectations twice over: 1) January Retail Sales growth was revised down from +0.2% month-over-month to -0.4%; 2) February’s estimate suggests an additional decline of -0.1% from January’s already depressed levels. The decline in Retail Sales will negatively impact Q1 GDP growth, which is now estimated to be less than +2% annualized. That being said, when viewed on a year-over-year basis, the data isn’t all that bad with Core Retail Sales rising by +3.8%. Inflation data was mixed with February Consumer prices falling by -0.2% (in line with consensus estimates) and up only +1% year-over-year. However, Core CPI (which excludes food and energy) rose +0.3% in Feb and +2.3% year-over-year (the largest increase since the Great Recession). The increase in Core CPI was largely due to upward pressure from housing and medical care (specifically, health insurance inflation, which rose from +4.8% to +6%). However, it should be noted that we are now lapping weak inflation data from early 2015, so an increase in year-over-year Core Inflation data is not all that surprising.
Mario Draghi and the ECB ventured further into unchartered monetary policy territory on Friday unleashing a new round of quantitative easing. The updated measures included pushing deposit rates deeper into negative territory (-0.4%) and increasing bond purchases by 20 billion to 80 billion euros ($89 billion) per month. There were also a couple of new twists, including the ECB’s commitment to purchase corporate bonds (as there is a shortage of sovereign debt to purchase) and paying banks to make loans.
Risk assets responded favorably to the ECB’s actions and the ensuing rally propelled global equity markets to their fourth consecutive week of gains. Developed and international market equity indices advances were more tempered than the previous week, but given that 100% of the weekly gains came on Friday, no one headed into the weekend unhappy. The yields on US Treasury bonds moved higher with the yield on the 10-year UST rising 0.1% to 1.98% (a level last visited from above when yields were contracting from 2.27% at the end of 2015 in response to the 5%+ decline in equity markets in January). The long-bond (30-year UST) also rose 0.1% to 2.75%. The price of West Texas Intermediate (WTI) Crude rose another 7.2% on the week (+14.1% MTD) and broke the surface into positive territory for the year at $38.50 per barrel. Detailed asset class performance data is available here.
Against the backdrop of the ECB’s moves, all eyes will be on the Fed this week when they gather for their second Federal Open Market Committee (FOMC) meeting of the year. The market is not expecting the Fed to raise interest rates at this meeting (according to Bloomberg the implied probability of a rate increase is only 6%), but it would not be a surprise if the Fed signals that a rate increase is in the works for April or June.
Give me Freedom! (or slow economic growth?): The perplexing decline in annual U.S. GDP growth in the last two decades has been the subject of much speculation. In the three decades from 1970 – 2000, the U.S. Economy expanded by more than 3% per year (on average). Yet, since 2000 economic growth has averaged less than 2% per year. Many theories have been put forth to explain the slower growth trajectory, including an over-leveraged federal balance sheet and lower overall labor productivity. While these are legitimate issues, what if they are merely symptoms of a systemic problem the U.S. is contending with?
That may indeed be the case according to research put forth by the Fraser Institute (a Canada-based research firm). Each year the Fraser Institute issues the Economic Freedom of the World report, which measures the degree to which the policies and institutions of countries are supportive of economic freedom. The report centers on an Economic Freedom Index (EFI) that was originally constructed with the help of famed economist (and Nobel Laureate) Milton Friedman. The index incorporates 42 data points to objectively measure “…the degree to which the policies and institutions of countries are supportive of economic freedom”, which include “…personal choice, voluntary exchange, freedom to enter markets and compete, and security of the person and privately owned property.” The Fraser Institute’s report is not purely academic as numerous peer-reviewed studies have shown that prosperity and other positive outcomes correlate tightly with the level of economic freedom available in a country. (Source: The Fraser Institute).
In the Fraser Institute’s most recent report (which includes data through 2013), the United States ranks 16th in Fraser’s EFI. This relatively low ranking stands in stark contrast to the U.S.’s typical top 3 ranking from 1970 to 2000 (amongst more than 100 countries and territories). Since 2000, the EFI score for the U.S. has fallen by approximately 0.9 points (i.e. economic freedom is waning). Academic research (Gwartney, Holcombe, and Lawson, 2006) indicates that a one point decline in the EFI is associated with a 1% – 1.5% decay in long-term GDP growth, which makes sense as the EFI is analogous to the level of capitalism in an economy. As highlighted in the chart below, U.S. GDP growth has fallen commensurately with the decline in its EFI score as predicted by the academic research, implying that restraints on capitalism are the driving force behind slower economic growth.
Sources: Fraser Institute and Covenant Investment Research
There is no easy fix to this situation, as improving the level of economic freedom will require wholesale policy changes at the highest levels of government – unfortunately, agents of true change and leadership in government are rare. That being said, it is a big election year and it is worth considering economic freedom as a path to improved prosperity when casting your ballots for leadership at all levels of government later this year.
Economic Data Summary: The latest MBA Purchase Mortgage Index (which tracks the volume of mortgage applications submitted to lenders) was 225.7. This level is at the high end of its recent range, which is a good leading indicator of near-term home sales. Initial Jobless Claims for the week ending March 4, were estimated at 259K (well below the consensus estimate of 275k) demonstrating that the labor market remains on solid footing.
Global equities rallied again last week, posting 3%+ gains in most developed markets equity indices. This was the third consecutive week of equity gains, a feat that has not occurred since October 2015. While monthly gains are broadly positive, most equity indices remain in negative territory on a YTD basis. Looking a little deeper into equity market performance, it appears that a changing of the guard in market leadership is forming as Value is outperforming Growth and Small capitalization stocks are outperforming Large capitalization stocks both MTD and YTD. While the performance differential is only about 1% YTD between these style and size factors, recent performance does represent a change from what has been the norm for the last several years.
Following (or perhaps leading) the path of the equity market, commodities continued to climb from the abyss. WTI Crude rose more than 10% last week to $36.22 per barrel, bringing its MTD gain to 7%. WTI Crude is now down only 2.2% YTD, having recovered the majority of a nearly 30% YTD decline as of mid-February.
Given the demand for risk assets, the yields on US Treasuries (USTs) have been rising, though they remain at lower levels than where they started the year. Typically safe-haven assets like USTs will decline in price (rise in yield) when there is demand for risk assets as investors will sell the former to purchase the latter. The yield on the 10-year UST remains below 2% (@1.88%) and the yield on the 30-year UST is below 3% (@2.70%). The lack of movement in UST yields combined with the rise in risk assets, implies investors are doubting the Fed’s resolve to raise interest rates four times this year. As I mentioned a couple of weeks ago, while the market may prove correct in its view, a more hawkish Fed will catch many investors on the wrong side of that bet. This is not a prediction, merely an observation based on market positioning.
Detailed asset class performance data is available here.