Monthly Archives: March 2017

Covenant Weekly Market Synopsis as of March 24, 2017

March 27, 2017

One step forward, two steps back. In a week that President Donald Trump approved the controversial Keystone XL project (a 1,179-mile pipeline running from the oil sands of Alberta, Canada to Steele City, Nebraska), speaker of the House Paul Ryan’s healthcare plan to repeal and replace the Affordable Healthcare Act (“ACA”) failed. Equity markets seemed to track the ebb and flow of news about the ACA vote, but ultimately on Friday when the vote was pulled markets surprisingly rallied into the close. For the week, domestic and developed equity markets experienced modest declines of 0.7% – 1.4% (domestic stocks are now negative for the month of March), whereas emerging markets posted gains of 0.4%. The yield on the 10-year US Treasury bond declined to 2.41%, after reaching a 52-week high of 2.63% only two weeks earlier. Reflecting some of the uncertainty surrounding the Trump Administration’s ability to push through future legislation, precious metals rose on the week (Gold +1.2%, Silver +2.1%) and the VIX Index (a measure of expected S&P 500 volatility) jumped nearly 15% (though it remains at a low level of approximately 13).

While markets were relatively stable last week despite the mixed legislative news, it appears that a larger cohort of investors got cold feet over the weekend. Global equities are in the red this morning and as of this writing, with the S&P Futures are down about 1%,

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

 

Math – When you multiply two or more values that are less than 1 by each other, the product is a smaller value than either number on its own – it’s just math. For example, the probability of flipping a fair coin and getting a “head” is 0.5 (50%) per coin flip. The probability of flipping a fair coin twice and getting two heads in a row is 25% (= 0.5 x 0.5). For fun, let’s apply the same math to the stock market and its reaction to President Trump’s election. Trump ran a campaign based on deregulation, healthcare reform, and tax reform. When he won, risk assets took off in anticipation of a greatly improved business environment and business sentiment indexes made historic jumps higher. However, what is the probability that all three of these campaign promises will pass (not to mention the timing of their implementation or their effectiveness). Does each one have a 90% probability, an 80% probability, or a 50% probability? If each has a 90% probability, then the collective probability of all three passing is 72.9% (= 0.9 x 0.9 x 0.9). But at a probability of 50% each, the collective probability is only 12.5% (= 0.5 x 0.5 x 0.5). The truth likely lies somewhere in between those values (except for healthcare which may now be addressed sometime in the future), but the market reaction to Trump’s election seemingly priced in a 100% probability that all three campaign platforms would come to fruition. Investors’ assessments of these probabilities (and how closely they are tied to equity market valuations) are important at this stage of the cycle as a shortfall in one or more of these signature policies will likely result in disappointment.

 

Populist Playbook – The topic of a global populist movement has become increasingly prevalent in the media over the last eight months beginning with the lead-up to BREXIT and culminating with the U.S. Presidential election. Both during those events and carrying forward from today, the political doctrine of populism is likely to impact key European elections this year and U.S. Congressional elections in 2018 and beyond. As the term populism has become increasingly common in general conversation and through the media’s coverage of important elections, so have Google searches for the word as shown in the chart below. As you can see, the search term “populism” reached its zenith in January 2017, in between the election and inauguration of President Trump.

 

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Source: Google Trends

 

Per Ray Dalio, founder of Bridgewater Associates (the world’s largest hedge fund with $160 billion in assets) and an outstanding thinker, “…populism’s role in shaping economic conditions will probably be more powerful than classic monetary and fiscal policies.” Dalio and Bridgewater recently released a 50+ page study on populism, which includes a “Populism Index”, that shows populism is currently at its highest levels since the 1930s. The index is constructed by evaluating the share of votes received by populist parties or candidates in national elections for developed countries, including the US, UK, Japan, Germany, France, Italy and Spain. What the chart shows is that although coverage of populism by the media is a relatively recent phenomenon, the rise in populism as a political movement is in the midst of a multi-year trend.

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Source: Bridgewater Associates

 

As a refresher, a populist movement seeks to address a perception that the common people are being exploited by a privileged elite. It is, in essence, a rebellion against the “elites” and the system they control.

Bridgewater’s report evaluates populist leaders in 10 countries since the 1920’s in an attempt to identify common character traits and prevalent trends from their policies. What they find is that populist movements are accompanied by elections of “strong” leaders that are both confrontational and exclusive. The policies of these leaders engender a positive feedback loop of increasing disorder both within the country they govern and in international diplomacy (as this tends to increase support for the leader who is viewed as doing what is best for his people). Bridgewater found that common populist economic policies include protectionism, nationalism, increased infrastructure building, increased military spending, and greater budget deficits.

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Source: Bridgewater Associates

 

If Dalio’s prediction comes to fruition, it will fundamentally alter the trajectory of global politics and commerce. It would lead to less cooperation between countries and the potential for an increase in the number of armed conflicts. It would also reverse, or at least slow, the global commerce trend, therein negatively impacting economic growth of emerging market countries as well as developed market countries.

While many have labeled President Trump a populist, Bridgewater points out that it is far too early to tell if he will, in fact, follow a populist leadership doctrine. However, even when excluding President Trump from the conversation, the growth of political factions such as UKIP (UK), AfD (Germany), National Front (France), Podemos (Spain), and Five Star Movement (Italy) indicates that populism is indeed on the rise and will play an increasingly important role in global economics, diplomacy and financial markets.

The complete Bridgewater report is entitled Populism: The Phenomenon

Be well,

Jp.

Covenant Weekly Market Synopsis as of March 3, 2017

March 6, 2017

Equities moved modestly higher on the week, thanks, in large part, to the jump start provided by President Trump’s speech on Tuesday night. While there is a lot of controversy swirling around President Trump, investors focused on explicit and implicit promises contained in his speech and bought with both hands on Wednesday pushing domestic stocks up nearly 1.5% to new highs for the S&P 500, Nasdaq and Dow Jones Industrial Average. Global stocks moved higher by nearly 1%, and as is apt to happen when investors are buying stocks, US Treasuries were sold pushing yields slightly higher as the yield on the 10-year UST edged closer to 2.5%. While the yield on the 30-year long bond also edged higher, the move was smaller than that of the 2-year and 10-year USTs, flattening the yield curve ever so slightly and indicating, once again, that long-term bond investors are not concerned about accelerating economic growth leading to high inflation. Precious metals fell about 1% on the week as did WTI Crude, which currently trades at $53.23 per barrel.

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

 

Lower Highs, Lower Lows: During the last 10 years, the Fed has raised rates in fewer instances than in any decade since the British Invasion of the 1960’s (music invasion that is… as in The Beatles, The Rolling Stones, and The Who). Everyone knows rates are low, but what is interesting and something investors should pay attention to, is that the pattern of Fed interest rate increases has formed a rather distinct trend as shown in the following chart.

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Sources: BofA Merrill Lynch Global Investment Strategy and Covenant Investment Research

 

The story has yet to be completed for this business cycle, but if the four-and-a-half-decade trend remains intact we can expect that the Fed will raise rates fewer times than they did in the 2000’s before they reverse course and begin loosening again. What causes the Fed to stop raising interest rates once they begin? Typically, the Fed raises rates until there is a financial event, brought on by the tighter financial conditions produced from rising rates or some exogenous event, as illustrated in the chart below.

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Source: BofA Merrill Lynch Global Investment Strategy, Global Financial Data

 

Note this chart illustrates a similar trend to the bar chart shown previously, but this time in the dimension of the level of rates. That is, how high the Fed’s Funds Target Rate reached before a “financial event” compelled the Fed to begin lowering the target rate. Again, here we see a clear trend of lower highs and lower lows. There is also a pattern of increasing frequency of events since Alan Greenspan took over as Fed Chairman in August 1987…but that is a story for another day.

So why is the number of rate increases and absolute level of rates declining over time? In truth, the two are high correlated as the Fed tends to take a measured approach to adjusting rates by increments of 0.25% or 0.50% (at least that has been the case since the 1980s). The most likely explanation for why hiking cycles have become increasingly abbreviated is that the Natural Rate of Interest aka “r*” has been declining. A more detailed description of r* can be found in a blog from August 2016. In short the Natural Rate of Interest is the inflation-adjusted interest rate required to maintain stable inflation. Central Bankers use the Natural Rate of Interest as a target when implementing monetary policy, typically in the form of raising or lowering interest rates.

Natural Rate of Interest

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

 

For a variety of intertwined reasons (including a declining velocity of money, low capital investment and declining productivity levels) the Natural Rate of Interest has been falling. This implies that a lower Fed Funds rate is required to sufficiently tighten financial conditions to put the brakes on the economy and keep it from overheating.

What does this mean on a go-forward basis? That the Fed is unlikely to raise rates very high before having to lower rates again to ease monetary conditions in reaction to a recession. In fact, the Fed’s median target interest rate forecast for 2019 is only 2.9% (for context the target rate was 5.25% prior to the Financial Crisis). Paradoxically, one reason that several members of the Fed have been eager to raise rates (move away from the “zero interest rate boundary”) is to provide the “dry powder” necessary to reduce rates again when tough times develop. An analogy is drinking poison just so you can take the antidote. To be clear, I’m not suggesting that the Fed is pining for a recession. The Fed merely wants a tool to address the next one because business cycles are not extinct.

While accelerating economic growth could increase the Natural Rate of Interest, it doesn’t appear that the economy is on the verge of breaking out into above trend growth. Indeed, the Fed’s median forecast for real (inflation-adjusted) economic growth is a modest 2.1% in 2017, 2.0% in 2018 and 1.9% in 2019. Even a massive, beautiful fiscal stimulus plan is unlikely to generate sustainable above trend GDP growth. However, fiscal stimulus could generate higher levels of inflation and the Fed is ever vigilant on the inflation front.

The Fed is, and will remain, between a rock and hard place. Economic sentiment is at very high levels, however, hard economic data has yet to materially improve creating a large gap between expectations and economic reality. The Fed is walking a fine line in that gap. On one hand, if economic growth accelerates to meet expectations inflation would likely rise materially (this is not our baseline scenario). On the other hand, with a lower Natural Rate of Interest, by acting too quickly or aggressively, the Fed could inadvertently interrupt a longer economic recovery. Godspeed to Chair Yellen and her crew as they attempt to navigate these uncharted waters.

Be well,

Jp.