Monthly Archives: December 2016

Covenant Weekly Market Synopsis as of December 16, 2016

December 19, 2016

 

The Fed threw a little sand in the gears of the post-election stock market rally last week. Although the 0.25% rate hike announced following their final meeting of the year was fully priced into the market, the Fed struck a modestly more hawkish tone that included an increase in their forecast for the number of rate increases in 2017 from two hikes to three. In response to the announcement equities fell by about 1%, the US Dollar jumped 2% and the Treasury yield curve shifted higher by about 0.1%. For the week, domestic equities closed marginally lower, while the stronger dollar negatively impacted emerging market stocks which declined by a little more than 2%. Amongst developed nations, European and Japanese stocks stood alone in positive territory gaining about 1%. It is worth noting that on a month to date basis, developed market equities are putting up another strong month of performance with gains of 2% – 3% or better.

Yields on US Treasuries ticked higher, particularly in the front-end of the curve (2-10 year maturities) while the spread on high yield bonds shrank to its lowest level of the year (3.56%) intraweek, before nudging higher to 3.64% (as measured by the Credit Suisse Barclays Index). Precious and industrial metals declined, while crude oil rose 0.9% to $51.98 per barrel.

For a detailed view of weekly, month-to-date and year-to-date asset class performance click here.

 

Red Tape: The chart below compares average annual GDP Growth against the amount of government red tape (represented by the number of pages in the Federal Register*) under each presidential administration since Harry Truman. Over the last 70 years and through 10 administrations the number of pages in the Federal Register has increased by more than 7x, while annual GDP growth has declined from an average of 4.7% (pre-1969) to 2.7% (post-1969). Is this spurious correlation, or proof positive that more government leads to reduced economic growth? Like most things in life, and especially in economics, the answer is not entirely clear.

 

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Source: FTN Financial

The chart presents a very clear picture of declining economic growth in the midst of rising government regulation. Of course, economic growth cannot be tied to any single factor as it is influenced by myriad variables (demographics, global growth, monetary policy, etc.). Yet, we are about to witness a test of the hypothesis that smaller government equals more efficient capital distribution and higher economic growth. Aside from President-elect Trump’s own stated interest in reducing the number of laws on the books, he is assembling a cabinet that appears to be uniquely qualified to reduce Big Government:  Scott Pruitt (Environmental Protection Agency), Rick Perry (Department of Energy), Andrew Puzder (Department of Labor) and Tom Price (Health and Human Services) will be heading up organizations that they have publicly chastised as wasteful. Time will tell if Trump’s policies to reduce the role of government in business lead to a higher growth rate, but the chart above and academic research would indicate he is on the right path.

 

Trading Partners: “International trade” is a commonly used term in economics that measures the value of goods and services that various countries buy and sell with one another. Most people are likely familiar with the term, but the concept is somewhat abstract. Yet, international trade is an important aspect of global prosperity as it represents a significant share of Gross Domestic Product for most countries. To help convert an abstract concept to a more tangible one, data visualization expert Max Galka created an interactive map to illustrate how goods and services flow around the world. The map (available here), allows the user to zoom in/out, rotate the model, etc. to gain a better understanding of the current state of international trade, including the location of the largest trading hubs, areas of low international trade, and trading relationships between countries.

 

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Source: http://www.visualcapitalist.com/interactive-mapping-flow-international-trade/

Here are a few points and hints on how to use the map, quoted directly from the website:

  • When looking at the globe as a whole, trade is concentrated into obvious hubs. The United States, Europe, and China/Japan are the most evident ones, and they are all lit up with color.
  • There are also obvious have-nots. Take a look at most of the countries in Africa, or click on an individual country like North Korea to see a lack of international trade.
  • In fact, North Korea is completely vacuous, except for one lonely dot floating to China every so often. After taking a quick look at the data, it seems China takes in over 60% of North Korea’s exports, which are mostly raw materials such as coal, iron ore, or pig iron.
  • Now click on South Korea, and the situation is completely different. By the way, South Korea exports $583 billion of goods per year, while the hermit nation does just $3.1 billion per year.
  • This map also shows how dependent some countries are on others for trade. Look at Canada, a country that sends close to 75% of its exports to the United States. Mexico has a similar situation, where it does most of its business with the U.S. as well.
  • This is a stark contrast to Cuba, which doesn’t trade enough with any one partner to have it visualized on this scale at all. Cuba has exports of only $1.7 billion, and its largest trading partner is China, which only takes in $311 million of goods per year.

 

Weekly Economic Data Summary: After a string of firmer data points, November economic activity reported last week had a more tepid tone in several categories as Retail Sales, Industrial Production, housing starts and building permits were all below expectations. The November Core Consumer Price Index (CPI) remained stable at 2.1% year-over-year. The Atlanta GDPNow forecast now indicates Q4 GDP growth of 2.6% (vs. 3.6% at the end of November), though this forecast moves around quite as data is updated throughout the quarter.

I hope you and your family have a holiday season, filled with cheer, joy, and memory making encounters. Happy New Year.

Jp.

 

*The Federal Register is the main source for the U.S. federal government agencies: proposed new rules and regulations, final rules, changes to existing rules, notices of meetings and adjudicatory proceedings, and Presidential documents including executive orders, proclamations and administrative orders.

Covenant Weekly Market Synopsis as of December 9, 2016

December 11, 2016

Another week, another record. Equity markets continued to push higher around the world on hope and faith in the future Trump administration’s economic policies. Those positive vibes were buttressed by firmer domestic economic data and an accommodative message from European Central Bank President Mario Draghi last week. The Dow Jones Industrial Average, although representing only a thin slice of corporate America, is a hallmark of stock market performance given its long history and now sits less than 250 points away from 20,000. The number itself is arbitrary, but investors seem to like round numbers so there is a lot of buzz about “Dow 20K”. However, it is the Russell 2000 Index that has been the real star amongst equity indices. Investors expect that a lower corporate tax rate and reduced regulations will be of particular benefit to these smaller companies that tend to derive more of their revenue from domestic sources. Last week the Russell 2000 tacked on another 5.6% bringing its six-week total to 16.5% (vs. 8.9%) for the Dow.

Over the last several years, strong equity market performance has been accompanied by strong bond market performance as the prices of both asset classes rose together. That correlation has broken down of late, resulting in painful losses for investors holding long duration (i.e. interest-rate sensitive) investments. Yields on longer-dated US Treasury bonds ticked up again last week (meaning the prices of the securities fell), while the yield on the 2-year UST remained unchanged as the yield curve continues to steepen. Price changes in the commodity complex were mixed, while the US Dollar rose another 0.8% and the VIX Index (a measure of expected market volatility aka “the fear index”) plunged by nearly 17% to 11.75.

For a detailed view of weekly, month-to-date and year-to-date asset class performance click here.

 

Debby Downer or Realistic Rick: In light of all the well-deserved euphoria around recent stock market performance (more than 50% of the S&P 500 year-to-date gains have come in the last six weeks), it is worth taking a step back to evaluate the move in the context of economic fundamentals. Investors can (and do) move markets well abroad of fundamentals, and markets can remain detached from fundamentals for extended periods of time. Eventually however fundamentals reassert themselves which is why you see valuation metrics such as the price-to-earnings ratio expand and contract over time, but generally mean revert around their average level. On this point, the chart below of the Shiller PE Ratio* illustrates the current valuation of the S&P 500 based on average earnings over the last 10 years.

 

Shiller PE Ratio

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Source: multpl.com

Keep in mind that the Shiller PE Ratio is not intended to be a market-timing signal, although market events have been associated with it. Rather the metric has demonstrated strong predictive capabilities for future, long-term stock market returns. A high ratio implies lower than average long-term average returns and vice-versa. Currently the ratio stands at a level that has only been exceeded on two previous occasions, one of which was the highly unusual Dot-com Bubble. There are many critics of this metric and it is not a perfect forecasting tool. That being said, while markets may continue to rise in the short term to even higher valuations, history suggests that (absent an acceleration in corporate earnings growth) equity market returns over the next 5-10 years are destined to be muted relative to historical averages…and certainly lower than those experienced recently.

 

Caught in the Act: China is a currency manipulator, just as president-elect Trump and the media have long claimed. Importantly though, China’s manipulation is not intended to reduce the value of the Renminbi to make their exports more competitive in the global marketplace (the typical reason for central banks to reduce the value of their currency), but rather to prevent the value of the currency from plunging. If China’s currency were allowed to float, unhindered by China’s central bank, the currency would quickly devalue and wreak havoc on the Chinese economy. This, in turn, would be extremely negative for the global economy. As the chart below illustrates, since 2014 China has spent nearly a trillion dollars (25% of their available foreign reserves) supporting the Renminbi. The decline in foreign reserves reflects asset sales (including US Treasuries, of which China is the largest foreign owner) which China uses to fund purchases of the Renminbi, therein supporting the price. So, while China is certainly manipulating their currency, their intent is not as nefarious as posited by the media. Now China’s restrictive trade policies are a different matter for a different time.

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Sources: Bloomberg and Covenant Investment Research

As an aside, every central banks acts to manipulate the value of their country’s currency in an effort to increase or slow economic growth. Since the Financial Crisis the major central banks have adopted a “race to the bottom” approach to help their countries grab a larger portion of the shrinking global economic pie. Witness the negative interest rate policies in Japan and the Eurozone, or the long-held zero-interest rate policy in the United States. It is what it is… currency wars are a post-Financial Crisis version of “The Cold War” in which no shots are fired, and central banks do not publicly acknowledge their intent, but their actions are very real.

 

Economic Wrap-Up: It was a relatively slow week for economic data releases, but there were a couple of nuggets. The October Job Openings and Labor Turnover (JOLT) survey provided further evidence of a stable/mature labor market. Job openings, at 5.5 million remain high, but little changed from the level seen one year ago. It is worth noting that the number of people quitting their jobs (2.2%) relative to the number people being laid off (1.1%) is the highest since 2007. These metrics indicate that job-hopping is becoming more prevalent as employees have sufficient confidence to quit their jobs to seek better opportunities elsewhere. The ISM Non-Manufacturing Index for November rose to 57.2 (well above expectations) and is at its highest levels since October 2015.

Be well and Godspeed,

Jp.

 

* The cyclically adjusted price-to-earnings ratio (“CAPE”) is defined as price divided by the average of ten years of earnings, adjusted for inflation. It is also known as the “Shiller Ratio”, named for Robert Shiller, who won a Nobel Prize for his research into the metric.

Covenant Weekly Market Synopsis as of December 2, 2016

December 4, 2016

Following two weeks of relentless buying, risk assets slowed their flow last week. Domestic stocks declined by approximately 1% while developed international bourses fell by 0.2%. Emerging market equities, which suffered post-election, continued to slide, albeit modestly by 0.3%. Interest rates ended the week relatively unchanged, after rising sharply in the month of November (the 10-year rose more than 0.5%). Precious metals were mixed (gold down, silver up) for the week, while crude and natural gas prices spiked by more than 10%. The latter rose due to impending cold weather, while the former rose when members of the Organization of Petroleum Exporting Countries (“OPEC”) agreed to reduce oil production levels as described below.

For a detailed view of weekly, month-to-date and year-to-date asset class performance click here.

November in Review: This is the time of year when traders and pundits begin talking about a seasonal rise in the price of stocks known as the “Santa Claus Rally”. However, some portion of that rally may have been pulled forward to November as domestic large cap stocks (as measured by the Russell 1000 Index) climbed nearly 4%, while small cap stocks (i.e. Russell 2000 Index) jumped a remarkable 11%. International equities did not enjoy the same robust returns, while rising interest rates cut the YTD performance of traditional fixed income assets in half. It is also worth noting that the US Dollar was down on the year coming into the month, but a 3.1% rise in November pushed it back into positive territory YTD. While valuations are pretty full in domestic stocks, barring some exogenous (i.e. non-market based) event, it would not be all that surprising to see domestic equities continue to climb in December given seasonal factors and asset managers reorienting their portfolios to reflect an administration focused on fiscal stimulus.

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Sources: Bloomberg and Covenant Investment Research

‘Tis the season…for surprises: Traders were still catching their breath from the one-two punch of Trump’s dramatic victory and the market’s surprising bullish reaction, when OPEC confounded the skeptics by agreeing to reduce oil production by 1.2 million barrels per day. The cut, the first since 2008, required some pretty extraordinary compromises including Saudi Arabia approving more favorable terms for Iran, and Russia (a non-OPEC country) agreeing to curtail production. Saudi Arabia is clearly bending to the impact that low oil prices are having not only on their economy, but on the valuation of state-owned Saudi Arabian Oil Co. (aka “Aramco”) of which they plan to sell shares to the public through an IPO in 2018. Quoting the Iranian Oil Minister, “It’s possible to be in the midst of rivalry and intense political differences and yet cooperate.” While the members of OPEC are notorious for fudging actual production volumes and the cuts are not scheduled to take place until January, the market reacted immediately as it is apt to do. The price of WTI Crude shot up more than 12% in two days topping out at $51.80 per barrel. Meanwhile, shouts of “Mortimer, we’re back” could be heard throughout the shale patch here at home from exploration and production companies that have a new lease on life with oil above $50 a barrel.

Economic Wrap-up: Domestic economic data over the last two weeks has been fairly strong showing rising prices and consumption levels. Speaking of which, real annualized Q3 GDP Growth was revised to 3.2% (from 2.9%) last week on the strength of improved Consumption. While 3.2% represents the best quarterly growth rate in two years, keep in mind that 0.8% of Q3’s growth came from a spike in soy bean exports that is unlikely to be repeated any time soon, meaning that run rate growth for Q3 was closer to 2.4% which is only slight above the post-Financial Crisis average. Nevertheless, early Q4 data suggests the economy is on reasonably sound footing with Personal Income rising 0.6% in October (vs. expectations of 0.4%) and Consumption rising 0.3% after being revised upward to 0.7% (from 0.5%) in September. Core Personal Consumption Expenditures (aka “PCE”, the Fed’s favored measure of inflation) in October held steady at 1.7% year-over-year. The November ISM Manufacturing Index rose to 53.2 (vs. expectations of 52.5), but it may be difficult to sustain this upward momentum in light of the recent rise in the US Dollar. The Unemployment rate fell to 4.6% in November. Although 160,000 new jobs were added, the bigger story was that 226,000 people dropped out of the labor force (bringing the two-month total to 446,000) causing the downward spike in the Unemployment rate. Nevertheless, with supportive economic data and the Fed of the opinion that the economy is reaching (or has reached) full employment, it is almost a certainty that the Fed will hike rates at their next meeting on December 13-14. The real question is what forward guidance will they offer as to the pace of rate hikes in 2017.

Be well,

Jp.