Monthly Archives: June 2016

The UK’s referendum to exit the European Union (aka “Brexit”) shocked the world – full stop. As it became clear that the referendum would pass late Thursday evening, financial markets began to convulse, primarily because most investors were positioned for it to fail (more on this below in the “Ocean’s 11” section). Taking a step back however, while Friday’s equity market losses were large, in most cases they simply gave back some or all of the gains that had accrued over the previous five trading days.


Source: Bloomberg and Covenant Investment Research

That’s not to say that equity markets have reached a long-term equilibrium – they likely have not. I just thought I would put Friday’s equity market movements into context. Financial markets dislike uncertainty and the UK referendum results have injected a huge amount of uncertainty into the markets that will have far reaching reverberations on politics, central bank policies and, of course, financial assets as this whole process plays out over a multiple year time horizon.

While the equity market swings were large, currency markets were even more volatile as the British pound declined 11.9% upon news of the referendum, and ended the day slightly better off by 9%. Yields on fixed income investments were squeezed tighter as investors sought cover from the storm: 10-year UST 1.56% (from 1.77% the day before), German 10-year Bund -0.05% (+0.09%), Japanese JGBs -0.19% (-0.16%).

Please click here to view detailed asset class performance.

Brexit – maybe, maybe not: What is interesting about last week’s vote is that the referendum does not have any legal consequences and that withdrawal from the EU will require an act of British parliament. According to BCA Research, it is entirely possible that the UK will hold a second referendum once the UK completes negotiations with the EU (likely more than 2 years away). So while most of the media outlets were acting as if the Brexit was effective last week that simply isn’t the case.

Ocean’s 11 Brexit style: Stick with me on this one as it is a tad long, but understanding this rumored financial-market “con-job” requires context.

Background. In the run-up to Brexit two types of data sources were regularly used to predict the outcome of the referendum: traditional polls (telephone and in-person) and online gambling sites. The former implied that the vote would be too close to call, while the latter (where real money changed hands) indicated a high probability Britain would remain in the EU. During the 2014 Scottish referendum to separate from the UK (ironically) gamblers correctly predicted Scotland would remain in the UK, even though the polls strongly suggested otherwise. Drawing a parallel to the Scottish referendum, media pundits (and apparently a lot of investors) were confident that Bremain would triumph over Brexit.

The Set-Up. (a website for people who wager on political events) estimated that about $30 million was being wagered on the outcome of the referendum. Of that $30 million, 75% of the total money bet had been placed on Bremain, however 75% of the individual bets were placed on Brexit. In other words, 3 out of every 4 bets (though small in size) were on Brexit, with only 1 of 4 bets on Bremain. Collectively the size of the bets on Bremain were much larger than the bets on Brexit. As a result, less than 24 hours before the actual voting began the gambling odds were overwhelmingly pointing towards the UK remaining with the EU.

The Payoff. A hedge fund manager friend related to me early on Friday morning (after the votes had been counted and Brexit was confirmed) that a rumor was circulating through the industry that a firm or a person used the online gambling sites to spoof the market and media into believing that Bremain was nearly a sure thing. At the same time this individual or firm positioned their portfolio to profit from a Brexit. If true, it was a brilliant play: bet $15mm – $20mm to skew the gambling odds towards a Bremain outcome to make 10x that amount or more in the financial markets on Brexit. This is the type of arbitrage that a great risk taker like George Soros might structure – that is not an indictment of Mr. Soros, merely a nod to someone who has made a lot of money from shorting the British Pound in the past.

Words?:  Brexit, Grexit, Frexit (France leaving the EU), the word mashups keep coming. When did bastardizing the English language become a cool thing to do? My bride says the first entry into the English lexicon was when power celebrity couple Ben Affleck and Jennifer Lopez became “Bennifer” (source: Michelle Pawl). No doubt a Texas secession from the U.S. would be called a Texit, but if Donald Trump fails to win the Presidential election will it be called a “Trumpit”? (sorry, that’s pretty bad).

Economic Data Wrap-Up: Existing Home Sales for May rose in line with consensus estimates to a 9-year high 5.5mm annual rate. The market for existing homes remains tight at 4.7 months, the sixth consecutive month under 5. Reflecting that tightness, the median home price rose 4.7% year-over-year. New Home Sales declined following a large print in April, but remain in a solid upward trend. Moreover, leading indicators such as number of homes for sale and an increase in months’ supply, augur for continued sales growth through the summer. Durable Goods Orders fell more than expected in May, as a strong US dollar and weak global demand continue to pressure the manufacturing sector. 

Be well and Godspeed,


Worried, scared, flummoxed…  Any or all of these adjectives could be used to describe investor psyche last week as Britain’s referendum and the FOMC’s reduced rate guidance engendered a variety of negative emotions.  It wasn’t a terrible week for risk assets in terms of magnitude, but with the S&P declining on 4 out of 5 days, investors did not see a lot of reasons for positive thinking.  To that end, the yield on the 10-year German Bund finally succumbed to the powerful vortex of negative interest rates on Tuesday when its yield crossed into negative territory (for the first time ever) and continued to fall as the week wore on.  U.S. Interest rates declined as well, with yields on the 10-year and 30-year bonds closing the week at 1.61% and 2.42%, respectively (it may be time to consider refinancing your mortgage if you haven’t done so recently).  Precious metals were up on the week, as seemingly they are no longer being considered an inflation hedge, but rather a hedge on central banker credibility.  WTI Crude closed the week down 1.7% (at $48.26 per barrel), but experienced a lot of volatility falling more than 4% on Thursday, and then reversing that loss by rising more than 4% on Friday.  Please click here to view detailed asset class performance.

This morning, however, the sun rose anew and with it a major rally in global risk assets: European equities are up nearly 4% and U.S. stock futures are up 1.3%. Could the reason for the rally be that Dustin Johnson won his first golf major and the Cleveland Cavaliers captured their first NBA title on the same day? Unlikely, though both Johnson and the Cavaliers put on impressive performances. In fact, the rally is the result of a new poll taken over the weekend which gives an edge to Britain remaining in the EU. Keep in mind that nothing has been fixed in the Eurozone (or the global economy for that matter), but markets dislike uncertainty and they unquestionably didn’t appreciate the uncertain ramifications of Britain leaving the Eurozone. Opinion polls were notably inaccurate about Britain’s 2015 election, but for today the weekend poll is being taken as gospel. The actual referendum vote is on Thursday.

Fallibility: The Federal Open Market Committee (FOMC) meeting last week was a bit of a shocker. Not because of the actions taken by the Fed (unsurprisingly they held the target Fed Funds rate at 0.5%), but because Chairman Yellen admitted she and her fellow FOMC participants are human. OK, she didn’t use those words, she said there is a great deal of uncertainty around “…each individual’s [FOMC participant] assessment of the appropriate level of rates, particularly as we go further out in the forecast horizon and when we come to the long term”. That is to say, that aside from the usual disagreement amongst the participants about the path of rates, each participant is increasingly unsure about his/her individual forecast. That comment pierced the veil of central banker omnipotence and was a refreshingly candid remark. Chairman Yellen and the FOMC participants are human beings (very smart humans, but human nonetheless) that rely on economic data and well-researched financial models to forecast the future. However, the financial models they employ have never encountered this type of environment and, as a result, their predicative power have declined precipitously (Source: FTN Financial). Two examples include:

  • GDP and the Labor Market: The Fed’s model assumes faster economic growth will result in a quicker reduction in the unemployment rate. However, because productivity has slowed, the unemployment rate has fallen quicker than anticipated in spite of slow GDP growth.
  • Labor Slack and Inflation: The Fed’s model assumes inflation will accelerate when the economy reaches full employment. However, the faster than expected decline in the unemployment rate since 2010 has not generated higher than expected inflation.


The Fed’s forecasts for rate increases have been off for years (for example two years ago the median estimate for the Fed Funds rate at the end of 2016 was 2.5% – it is currently at 0.5%) causing them to lose credibility. At least in admitting last week that they are fallible the FOMC has taken a step in the right direction toward gaining back some of that credibility. From an investment perspective, a confused Fed is less likely to do anything out of concern they might act too quickly and choke off whatever modicum of economic growth that exists. Rates will be lower for longer.

Economic Doppelgangers: The U.S. remains the most powerful economic country in the world. Perhaps it shouldn’t be all that surprising given that each of the 50 states is a relatively strong economy in their own, comparable to that of a sovereign nation. The domestic economic engine is an amalgamation of all of those state economies. Some states have a large economic output: Texas is comparable to Brazil (the ninth largest economy in the world) and California is similar to France (the sixth largest economy in the world). The economic output of other states is more modest, such as Iowa with an economy that is comparable to that of Greece (which is still one of the top 50 economies in the world). The map below provides a breakdown of state/country doppelganger economies.




Economic Data Wrap-Up: Retail Sales in May increased 0.5% m/m (month-over-month), which was better than the 0.3% consensus estimate. Even when stripping out autos, gasoline and building materials, the “control group” sales increased by 0.4% m/m. On the other hand, Industrial Production in May declined by 0.4% m/m as the manufacturing sector continues to struggle against a backdrop of weak global demand. The headline Consumer Price Index (CPI) rose 0.2% m/m in May, slightly below consensus estimates for a 0.3% increase. The Core CPI (ex-food and energy) rose 0.2% m/m which was in line with expectations. The message on inflation is mixed at best, but there is no evidence yet that we are entering a period of sustainably higher inflation. Taking this and other data released data previously, second quarter GDP growth is tracking around 2.5%.

Be well and Godspeed,


What began as a promising week for risk assets, ended up rather mixed with most developed market equity indices declining while emerging and frontier markets rose in spite of a stronger US dollar. In fact, this chart of the MSCI All Country World Index gives visual meaning to the term “Hump Day” as equity markets rallied through Wednesday, only to give back those gains and more Thursday and Friday.


Source: Bloomberg

As equity markets ebbed and flowed, yields on US Treasury bonds grinded lower. In fact, the 10-year UST closed Friday with a yield of 1.64%, a low level not seen since May 2013. Meanwhile, the annual yield on the 10-year German Bund declined to 0.2% and Japan’s 10-year bond is yielding -0.2%. In spite of the already low rates here in the U.S., it is possible for them to move lower still given the backdrop of increasing negative interest rates globally.

Please click here to view detailed asset class performance.

Labor Market Wobbles: The April JOLTS (Job Openings and Labor Turnover Survey) revealed a still healthy labor market (at least as of one month ago), particularly as it related to job openings. Many took this as a sign of future labor market strength because as the chart below highlights, job openings (the solid blue area) tend to be a fairly reliable leading indicator for hiring (as specified by the yellow total Nonfarm Payroll level).


Sources: Bloomberg and Covenant Investment Research

However, at this point in the cycle the number of job openings is likely not as predictive of future hiring. In fact, the May Nonfarm Payrolls report showed that hiring has slowed considerably. So why is there a high number of openings and not much hiring? Two potential explanations:

  • Hiring has slowed because of a lack of qualified applicants for the open positions. We’ve discussed this dilemma in our “Quarterly Economic Review & Outlook”, but to recap: we believe the dearth of skilled labor is a vestige of the Financial Crisis which forced a large swath of the labor force out of the market. Not only did people lose their jobs, but because hiring was slow to recover, job skills atrophied creating a positive feedback loop which has made it increasingly difficult for previously skilled workers to get rehired.
  • As difficult as that scenario is, a more problematic scenario for the economy is that companies simply are not hiring (witness the disappointing May Nonfarm Payrolls report, which added only about 70,000 jobs when adding back the workers affected by the Verizon strike). As our Investment Committee economist and author of Foleynomics points out “It seems logical (and corporate experience confirms) that firms will stop hiring before they start firing. Human Resources departments can post whatever jobs they want, but the buck stops at the CFO’s desk. So we got an awful employment report, high job openings, and low jobless claims.”

You can expect that the May JOLTS report (available in June) will reflect the weakness of the recent Nonfarm Payrolls report, which is consistent with our working thesis that the best labor market data is likely behind us at this point in the business cycle. The June Nonfarm Payrolls report will be critically important in determining if May was an anomalous reading or if hiring is rapidly decelerating.

Debt and more debt: This note is already long so I won’t elaborate here, but if you are interested in subjects such as total global debt levels, country-specific debt levels, debt per capita, debt as a % of GDP, etc. The Economist’s Global Debt Clock is a very cool website.

Be well and Godspeed,


Global equities, for the most part, could not build on the gains from the previous week as the MSCI All Country World Index (ACWI) rose a modest 0.3% last week. Domestic large cap stocks were flat on the week (though small cap names rose more than 1%), while European and Japanese equity indices declined more than 2%. U.S. Treasuries were bid, with the yield on the 10-year falling to 1.7% and the yield on the 30-year UST declining to 2.5%, a good indication of the lack of inflation fear present in the market. Precious metals climbed last week (gold +2.6% and silver +1.1%) with some suggesting that the bid for gold is being driven not by inflationary fears, but rather by investors losing faith in the omnipotence of central bankers. WTI crude recorded its first weekly price decline in a month, with a price of $48.62 per barrel. The US Dollar eased by 1.7%, while the VIX Index (at 13.5) remains near the low for the year indicating investors are either confident or complacent.  Please click here to view detailed asset class performance.

Confidence Shmonfidence: According to data from the Conference Board, consumer confidence levels vary widely by income levels as can be seen in the chart below (source: FTN Financial).  At the nadir of the Financial Crisis the confidence levels of all three income classes reached a nearly identical low. As the Fed began applying extraordinary monetary policy measures, the confidence level of consumers in the highest income bracket (income greater than $50k, depicted by the purple line) recovered quickly relative to the lower earners.


In fact, while the higher earners’ confidence levels recovered to pre-Financial Crisis levels, the confidence levels of the less well-off have only retraced about half of the 2008-2009 declines. The likely reason for the difference in the pace of recovery is that the Fed’s actions resulted in a stock market that mostly appreciated from mid-2009 through 2015. This benefited the highest earners because they tend to have larger investment portfolios than those in the lower income brackets. However, since the stock market leveled off high earners’ confidence has waned. Interestingly, only the middle earners confidence remains in an upward trend.

Lies, damn lies and statistics: When someone makes reference to a 500-year flood, they are referring to an event that is expected to happen on average once every 500 years. In other words, it is a statistically rare event. However, statistics are no guarantee of reality. A good example of the fallacy of relying exclusively on statistics was presented last week when Texas was smacked by multiple storms that caused flooding that reached or exceeded 500-year flood events. Last year was a tough year for flooding in Texas as well, including two 500-year flood events, meaning that Texas has just been hit in consecutive years by events that should only happen once every 500 years on average. While statistics can be helpful in some aspects of life, they should not be relied upon in isolation. Similar to the randomness of Mother Nature, the financial markets regularly experience events with greater frequency than would be predicted by statistics (see Nassim Taleb’s seminal work The Black Swan). Since no one can rely on statistics alone to forecast market prices, portfolio diversification remains the best approach to prudently grow capital in the face of 500 or 1,000-year market floods that occur far more frequently than once every 500 or 1,000 years (for example the S&P 500 declined more than 50% twice within 10 years (2000 – 2009).

Economic Data Wrap-Up: Consumer Spending jumped 1% month-over-month (m/m) in April, well above the consensus estimate of 0.7% recording the largest monthly increase since 2009. It is also worth noting that the Savings Rate reversed a long upward trend, declining from 5.9% to 5.4% as consumers opened their wallets. Core Personal Consumption Expenditures (Core PCE), the Fed’s favored measure of inflation, rose 0.2% m/m and 1.6% year-over-year, but remains 0.4% below the Fed’s 2% target rate. The ISM Manufacturing Index surprised to the upside (51.3 vs. consensus estimate of 50.3), but the increase was largely due to a surge in supplier delivery times which may have been impacted by flooding in Texas. On the brighter side, New Orders (a good leading indicator of future sales, held steady at 55.7 down only a tick from 55.8 in April. Nonfarm Payrolls were a huuuuge disappointment (as Trump might say), rising only 38k in May vs. consensus estimate of 160,000). Moreover, the payroll figures for the previous three months were revised downward. We have been of the belief that the best hiring numbers are likely behind us in this economic cycle, but admittedly we did not forecast such a dramatic decline in hiring this soon. May’s employment report may turn out to be a lagged effect of weak economic growth in the first quarter, but it will certainly figure into the Fed’s decision about whether to raise interest rates at their next meeting on June 14th. And if the employment report was not enough to give the Fed pause, the US ISM Non-Manufacturing Index, previously an area of service sector strength, slipped from 55.7 to 52.9 in May.

Be well and godspeed.