Monthly Archives: August 2016

Covenant Weekly Market Synopsis as of August 26, 2016

August 29, 2016

On the surface it was a relatively calm weak for equity markets, albeit with a negative bias, as most bourses recorded modest declines. Friday provided some fleeting excitement for equity bulls as markets reacted positively to Fed Chairman Janet Yellen’s speech at the Jackson Hole monetary policy symposium. However, immediately following her speech Vice Chairman Stanley Fischer struck a more hawkish tone in a CNBC interview, which reversed the positive momentum as the S&P 500 fell more than 20 points.



Sources: Bloomberg and Covenant Investment Research

One takeaway from Friday’s market action is that investors’ interest in equities remains highly correlated to the continuing availability of loose monetary policy. But how have the prospects for tighter monetary policy impacted US Treasuries? The answer is that the front end of the yield curve (USTs maturing in 1 to 10 years) have shifted up, while the backend of the curve (USTs maturing in 30 years) has remained static. The chart below illustrates this point by comparing the current yield curve (green) to the yield curve as of June 30th (yellow).


Sources: Bloomberg and Covenant Investment Research

While the Fed can influence the front end of the yield curve, it is very difficult for them to influence the backend of the curve. And this “flattening of the yield curve” (i.e. short-term rates higher, long term rates stable) implies that longer-term investors are not concerned about higher inflation levels that would accompany breakout economic growth, at least not yet.

Speaking of economic growth, Q2 GDP was revised downward slightly from a real annualized rate of 1.2% to 1.1% last week. As such, the US Economy expanded at an average real annualized rate of less than 1% over the first half of the year and only 1.2% on a year-over-year basis. As can be seen in the chart below, elevated consumption levels saved the economy from recording negative growth in the second quarter.


Our chief economist (Sean Foley) does not see a repeat of those heady consumption levels occurring in Q3: 2Q real consumer spending rose at a 4.4% annualized rate sequentially, but was up just 2.7% YOY in 2Q.  In other words, there is nothing in the data that suggests consumer spending in 3Q will repeat anything like the 4.4% 2Q growth rate.  July’s retail sales were up 2.3% YOY, consistent with the steady but not great YOY trend.  Further, consumers in 2Q drew down savings and went on a credit card binge.  Could that happen again in 3Q? Sure, but is it likely?  Not in my view.

While we expect there will be an improvement in the overall GDP growth rate in Q3, we do not see the economy sustaining a growth rate much better than 2% – 2.5% for the foreseeable future. This is the crux of our “good, but not great” economic theme. A growth rate of 2%+ for world’s largest economy is not bad. In fact, it is the envy of our developed market counterparts such as Japan and the Euro zone. And while it is a lower growth rate than what most of us are accustomed to, we should get used to it.

Please click here to view detailed asset class performance.

Be well and Godspeed,


Covenant Weekly Market Synopsis as of August 19, 2016

August 22, 2016

It was a fairly quiet week in the markets. The S&P 500 pushed modestly upward on Monday (+0.3%) to a new high, but finished the week up only 0.1%. Stocks on the international stage were mixed with European and Japanese equities falling just under 2%, while Emerging and Frontier Markets edged higher by about 0.1%. Interest rates bounced around during the week as dovish FOMC minutes were counterbalanced by hawkish comments from a couple of FOMC members – the Fed could use a good PR-firm to ensure they are communicating a consistent message. On that note, Fed Chairman Yellen will be speaking this Wednesday at the annual monetary policy conference in Jackson Hole, Wyoming. Though no major announcements are expected, investors will be tuning in to see if she provides any hints about the Fed’s interest rate plans for the balance of the year. WTI Crude rose 9% last week and is now up more than 20% in the last two weeks to $48.52 a barrel. The US Dollar declined by 1.3%, while the VIX Index is below 12, signaling investors are showing little concern about near-term market volatility.

Please click here to view detailed asset class performance.

The Natural Rate of Interest – Apologies in advance for delving into an esoteric economic term like “Natural Rate of Interest”, but it is an important concept to understand, at least at a cursory level.

First, what is it?   The Natural Rate of Interest is the inflation-adjusted interest rate required in a country to maintain stable inflation and it is something that Central Bankers use as a target when implementing monetary policy.

Second, why discuss it?  As the chart below shows, following the Financial Crisis the Natural Rate of Inflation has moved sharply lower, to near zero for the United States and less than zero for the Euro area.  In other words, the Financial Crisis fundamentally altered the natural, steady state of the economic engine.


Source:  Holston, Laubach, and Williams (2016); data are four-quarter moving averages.

Third, is this important to us?  Yes it is, because in a letter published last week San Francisco Fed President John Williams contends that in a low natural rate environment monetary policy is ineffective, leaving the Fed powerless to fight the next US recession — the European Central Bank and Bank of Japan are in even worse positions relative to their economies.   As a result, if the Natural Rates of Interest do not rise, we can expect weak expansions and deep recessions because monetary policy will not be able to stimulate the economy.  We are already witnessing the limits of monetary stimulus in the U.S., Euro zone and Japan where a tsunami of accommodative monetary policies have failed to accelerate real economic growth.

Mr. Williams suggests several strategies to increase the Natural Interest Rate in the U.S., including combining fiscal stimulus with monetary stimulus.  This approach was also suggested by then Fed Chairman Ben Bernanke following the Financial Crisis when he admonished Congress that the Fed cannot solve all of the country’s economic problems.  However, that plea fell on deaf ears, or at least ears that could not cooperate to put forth a true fiscal stimulus bill.

Will the next administration be able to change the political narrative and take action to right the economic ship in the U.S.?  Given the divisiveness both between and within the major political parties, the odds are unfortunately long.  For example, in 2010 the Obama administration attempted to implement a fiscal stimulus package, but he had his knees cut out from under him by Nancy Pelosi, his own party’s House Leader.  The resulting negotiations eviscerated the impact of what was once a near-trillion-dollar infrastructure bill.

As policy makers come to grips with the limits of monetary policy, will the market be far behind?

The Big Ten – We all know that when we go to the grocery store in this country the food options are nearly limitless. What I didn’t know, until I came across this infographic, is that 10 companies including PepsiCo, General Mills, Nestle, and Coca Cola own the vast majority of those food options. I’m not a “foodie” nor a “nutritionist”, but I do recognize that a common thread amongst these brands is that they consist of highly processed foods. I suspect that is a requirement when mass producing food products and one of the reasons that farmers’ markets and buying local have becoming increasingly popular options for shoppers seeking diversity in their foodstuffs.


Source: Oxfam International

Economic Data Wrap-Up: Industrial Production increased by 0.7% in July, the second consecutive month of expansion. Manufacturing, which makes up nearly 80% of total production, rose a higher than expected 0.5%, a nice bounce, but a sustainable recovery in Manufacturing remains elusive. Speaking of elusive, July’s Inflation data supports our notion that the recent increase in inflation measures are not indicative of building inflationary pressures in the economy. The Core CPI rose only 0.1% in July, with Housing costs a key source of the gain.

Be well and Godspeed,


Covenant Weekly Market Synopsis as of August 12, 2016

August 15, 2016

Unlike action in the Olympiad last week, international outperformed Team USA by 1% or more (in equity land). Domestic stocks did close the week in the black, but only by the slimmest of margins. US Treasury yields grinded lower, with the 10-year yield declining from 1.59% to 1.51% for the week, but well within the 1.4% – 1.6% range it has been trading the last two months. Precious metals were relatively flat on the week, while WTI Crude rose 7% to $44.72 per barrel, mostly on the hopes that Saudi Arabia will play ball with OPEC and agree to reduce production if oil prices remain weak. We’ve seen this movie on multiple occasions since the price of oil began its decline, but perhaps with a planned IPO of state-owned Saudi Aramco in 2017 or 2018 the Saudis will be incentivized to create an environment of higher sustained oil prices to maximize valuation. Yet, a meaningful reduction in the oil supply will require cooperation between Iran, Iraq and Russia – an unlikely, though not impossible, outcome.

Finally, the US dollar declined by 0.5%, while the Volatility Index (i.e. VIX) remains below 12 signaling extreme complacency amongst investors. Please click here to view detailed asset class performance.

Pickle – Back in 2012, financial newsletter writer Harry Dent gave a speech titled “A Decade of Volatility: Demographics, Debt and Deflation”. At the time the Federal Reserve was in the midst of its Quantitative Easing program, on the cusp of announcing QE 3, and many economists and investors were concerned that ultra-accommodative monetary policies would lead to rampant inflation. Harry had a different view though, suggesting that declining consumption levels resulting from the aging Baby Boomer generation would effectively neutralize the Fed’s efforts to stimulate inflation in the economy. Thus far Mr. Dent has been correct and this has not been his only successful prediction on this topic. In the late 80’s he predicted the Japanese economy, then a global force, would enter a slowdown that would last more than a decade which proved prescient. Recently, noted economist David Rosenberg revisited the issues of demographics, debt and deflation:

  • Demographics and the big “7-0”: Over the next ten years there will be 1.5 million people from the Baby Boomer generation turning 70 annually. Because many of these people have failed to save enough for retirement they will continue to work. However, they will be focused on saving for a time when they can’t work, rather than making large purchases that would otherwise provide a tailwind to consumption levels and GDP growth. Moreover, because of their investment horizon, Baby Boomers are more likely to invest in fixed income securities than risky equities, which along with foreigners seeking better yields than are available locally, will contribute to lower interest rates.
  • Debt: Debt-to-GDP ratios for governments, businesses and households are higher now than where they were prior to the Financial Crisis. Governments cannot afford for interest rates to rise quickly as it would impair their ability to service the debt. The Fed is essentially walking a fine line in which they are hoping for normal levels of inflation (which effectively allows the government to repay debt with cheaper dollars), without materially higher interest rates.
  • Deflation: Unfortunately, low interest rates penalize savers as their nest eggs grow very slowly, forcing them to save more and consume less placing downward pressure on GDP growth.

Quoting Mr. Rosenberg, “See what a pickle we are in?”. The demographic tide is working against the U.S. and, in fact, most developed country economies. The economic effects of demographic trends are compounded by the high levels of debt that led to the Financial Crisis, but have yet to be resolved. Fundamentally, global growth is likely to remain subpar and inflationary pressures should remain at bay until central banks and governments find common ground to apply real change to their existing policies.

Economic Data Wrap-Up: The Job Opening and Labor Turnover (JOLT) survey for June supports our thesis that the labor market is maturing. Note that the JOLT survey data is lagged compared to the more current data such as Non-Farm Payrolls, however, the additional time to collect the data makes for more accurate reporting. Job Openings increased by 110,000 but following a deep decline in May, Job Openings are nearly unchanged from February. New Hires also rebounded in June, but following three months of declines are at the same level as the start of the year.  In combination, these two metrics paint a picture of stable, though not growing, labor demand. Retail Sales were revised upward in June, but July sales were flat compared to the previous month and well below expectations of a 0.4% increase. Automobile sales were a strong contributor in July, as ex-Autos retail sales declined 0.3%. While there is no doubt that Retail Sales recovered in the second quarter, we are unlikely to see the same rate of growth in Q3. Producer Price Indices (PPI) for July were also below expectations, signaling that inflationary pressures remain at bay in the supply chain.

Covenant Weekly Market Synopsis as of August 5, 2016

August 8, 2016

In a rather mixed week that saw crude oil briefly enter a technical bear market (decline of 20% from a recent high), global stocks were decidedly mixed. Equities began the week in the red, but started to recover after the Bank of England announced a massive stimulus program and then rallied hard on Friday following a better than expected jobs number in the U.S. The late week rally failed to pull most international indices into the black for the week (with the exception of emerging markets), however the rally enabled domestic stocks to post their fifth positive week in the last six. Overall the last six weeks have been good across the board with global equities rising 9.7% and the S&P 500 up 9.4%. The yield on US Treasuries increased by about 0.1% during the week, but it has been a volatile ride that saw the 10-year yield touch a new low in early July that quickly reversed with the yield jumping more than 0.25% through last week. Precious metals were down a few percentage points on the week, while the US dollar strengthened by 0.7% (against a basket of trading partner currencies).

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Job Fair: Nonfarm payrolls jumped by 255,000 in July (vs. expectations of 180,000), even as the headline Unemployment Rate held steady at 4.9% due to a surge of people re-entering the labor market. Importantly, jobs in the key first-time home buyer 25-34 year age cohort increased by 150,000, bringing the three month total to 420,000. While two consecutive months of strong job growth should overcome the chill from the weak payroll data from May (24,000 jobs added), employment growth of 1.9% year-over-year has outpaced real GDP growth of 1.2% – a very unusual circumstance. The variance can be explained by negative productivity growth, an unsustainable state that will be resolved by either a strong, sustained recovery in GDP growth or by businesses reducing their pace of hiring as profit margins are eroded. Based on the current data we suspect it will be the latter, but would gladly welcome the former.

Terrorism’s Bull Market: Back in 2014 Harvard Professor Niall Ferguson made the following statement “The black swan of international conflict is going to fly straight out of Obama’s foreign policy”. While Professor Ferguson’s comment may, or may not, have been a political statement, the following is not intended as political commentary (we are all subjected to plenty of that already). This is a sensitive topic, but it is important to understand the structural backdrop for global terrorism and why it will persist absent a concerted, coordinated effort by at-risk countries.

In a report titled “Bull Market for Terror”, BCA Research cites several structural factors that will contribute to an increasing frequency of what they term “low quality” terrorism. (Note: by low quality, BCA is referring to ISIS-inspired terrorist attacks on soft targets, as compared to Al Qaeda’s favored approach of highly coordinated attacks on hard targets.)

  • American Geopolitical Tapering – since President Obama took office, the U.S. has shifted its focus away from the Muslim world, creating instability in the Middle East, North Africa and South Asia. The resulting vacuum of power has created a golden opportunity for radical militants to expand their spheres of influence, take control of certain areas, and bolster their resources. This international policy focus is likely what Professor Ferguson was referencing.
  • Decline of Intelligence Agencies in key Middle-Eastern countries – The U.S. invasion of Iraq, the toppling of Libya’s Muammar Qaddafi, and the Syrian civil war have severely compromised local intelligence agencies. The weakening, if not outright collapse, of these domestically focused agencies has made it easier for Islamic terrorists to import sophisticated weaponry and expand their terrorist training programs.
  • Taking back territory form the Islamic State – the successful military efforts to recapture land from ISIS has a counterproductive aspect in that with less land to protect through conventional means, ISIS can direct more resources to terrorist activity in the region and abroad. Think of it this way, as someone who has sworn their allegiance to ISIS, a radical militant is indifferent to fighting in conventional warfare and carrying out terrorist activities. Quoting BCA: “In a way, the territory the Islamic State controlled in the Middle East has acted as a black hole, drawing young men and women willing to die away from the West and into a largely economically irrelevant piece of global real estate”. With fewer resources required to defend and hold a smaller swath of territory, those soldiers can be redeployed to carry out terrorism in the name of ISIS.

These structural factors are difficult to resolve and, in fact, assigning blame to any single political party is moot. Certainly the Obama Administration and Hillary Clinton (as then-Secretary of State) are responsible for the geopolitical tapering within the Middle East. However, it was the Republican Party under President Bush that created the power vacuum in the Middle East by invading Iraq and removing Saddam Hussein from power. Paraphrasing BCA, everyone and therefore nobody is to blame.

This is the situation in which we find ourselves. Isolationism on the geopolitical stage is a dangerous strategy. In fact, many contend that isolationist foreign policies by Britain (then the world’s superpower) in the early 1900’s set the geopolitical stage for World War I. Perhaps the next President of the sole remaining superpower will consider the failures of past policy decisions and develop a comprehensive strategy in concert with other nations to combat terrorism abroad. Failure to do so will lead to increased deaths of innocent people, reduced liberties, more restrictive immigration policies, less international commerce, and ultimately a decline in global economic growth potential.

Economic Data Wrap-Up: The June ISM Manufacturing Index fell slightly in July to 52.6 (vs. 53.2 in June). While a reading above 50 indicates the sector is expanding, poor readings in certain leading indicators such as new orders and orders backlogs point to further deceleration in the coming months. Meanwhile, the June ISM Non-Manufacturing Index (which measures activity in the services sector) was 55.5, only slightly lower than expectations of 55.9. Leading indicators in this index were positive, suggesting the services sector will remain a reasonably steady source of growth in Q3. The Personal Consumption and Expenditures (PCE) inflation gauge for June remained stable at 0.9% year-over-year, while Core PCE was 1.6%, well below the Fed’s target rate of 2.0%.

Be well and Godspeed,