Monthly Archives: October 2017

Covenant Weekly Market Synopsis for October 27, 2017

October 30, 2017

In what was shaping up to be a down week for domestic equities, blowout earnings announcements in the technology sector by Amazon, Alphabet (aka Google) and Microsoft on Thursday afternoon catalyzed a strong rally on Friday.  The S&P 500 jumped 0.8% on the final day of the week, which by all accounts is a good day, but pales in comparison to the tech imbued Nasdaq Index which rose 2.2%.  Friday’s rally pushed weekly gains on the S&P up 0.2% and 1.1% for the Nasdaq — both indexes closed at all-time highs.  Speaking of highs, Jeff Bezos is reported to have made $7B on Friday (Amazon stock appreciation).  That single day’s reward is higher than the International Monetary Fund’s (IMF) 2017 projected GDP for nearly 50 countries, placing Bezos’s one-day windfall somewhere between the annual national output of Guinea and Tajikistan.  Considering his total worth (some $93B), “Bezosistan” would rank about 63rd (of 191 countries) on the IMF’s list of annual economic output, between the GDP of Ukraine and the Slovak Republic.  Simply remarkable.

In international markets, European (+0.8%) and Japanese (+1.2%) stock indices were the best performers for the week, while Emerging Markets fell -0.8% (even though Chinese stocks gained +2.3%).  Like last week, defensive oriented assets were in low demand as the prices of US Treasuries declined (causing an upward shift in yields across the curve).  Precious metals also moved lower: gold (-0.6%) and silver (-1.0%).  WTI Crude, staged a strong rally gaining 5.3% for the week (to $54.19 per barrel), boosted by comments from Saudi Prince bin Salman in support of continued supply-side controls. 

In other important news, the House Republican tax reform bill will be unveiled this week on Wednesday (Nov 1) providing the long-awaited first view by the public look at the plan.

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

 

Good, But Not Great+ – The US economy expanded at a real annualized rate of 3% in the third quarter, a solid 0.4% above consensus expectations.  While we have characterized growth in the real economy since the Financial Crisis as “Good, but not Great”, two quarters in a row of 3% growth (in Q1 annualized real GDP expanded by 3.1%)is worthy of an upgrade to “Good, but not Great+”.  As the chart below highlights, lower consumption (the blue shaded portions of the bars) from the previous quarter was offset by growth in inventories (red) and an increase in net exports (grey – thank you cheaper US Dollar).   On a year-over-year basis, GDP growth was a more subdued 2.3%.

image

Sources:  Bureau of Economic Analysis and FTN Financial

 

About the consumer… consumer spending rose only 2.4% in Q3, well off the 3.3% pace of Q2.  Some of the decline in consumer spending may be related to weather disruptions (i.e. hurricanes), but overall the consumer remains in a precarious spot.  A decelerating rate of Personal Income growth and a plummeting savings rate don’t make particularly fertile ground upon which higher consumption levels organically sprout.  Remember, absent accelerating income growth, consumption levels can only grow through a drawdown in savings accounts or increased borrowing – neither of which can go on indefinitely.  In fact, savings as a Percentage of Disposable Personal Income has been declining from a recent high of better than 6% in 2015 to only 3.4% as of the end of September (the long-term average savings rate is closer to 7%).

image

Source: Federal Reserve Bank of St. Louis

Above trend growth may stick around for a few more quarters, especially if domestic tax policy is modified.  Yet, the relatively weak positioning of the consumer, to our way of thinking, will weigh on economic growth thereafter (consumption is approximately 70% of the economy).  Therefore, we believe Good, but not Great+ growth is only a transitory economic pulse and that the economy will slip back into the Good, but not Great growth theme within a few quarters.    

 

Quitting:  It’s hard to do.  Especially when you’ve been at something for a long time (with the possible exception of golf, in which building frustration over an extended timeframe can ultimately make quitting rather easy… but I digress).  Take global central banks and ultra-accommodative monetary policies.  The Fed was the first to try and quit back in 2013 and it was painful.  The primary side effect was a spike in interest rates known as the “Taper Tantrum” when the yield on the 10-year Treasury shot from 1.6% to 3% in four months.  Having learned their lesson from that nasty episode, central bankers have been more circumspect when it comes to withdrawing stimulus measures implemented following the Financial Crisis.  The Fed telegraphed very clearly and very early what their balance sheet reduction program would look like.  Thus far, it has gone smoothly.  But we are only in the first month and while the Fed has reduced the amount of bonds they are buying by $10B per month, it is a rather trivial amount compared to their total balance sheet of $4.5 trillion.

On Thursday of last week, in a widely anticipated announcement, the ECB laid forth their plans for tapering their bond purchases (note the ECB is not yet at the point of reducing their balance sheet a la the Fed, they are just slowing its expansion).  The ECB will be cutting bond purchases in half starting in January, reducing monthly purchases from €60bn to €30bn.  While no definitive timeframe was provided for ending their purchase program, ECB President Mario Draghi implied it will continue into 2019. In an effort to avoid another Taper Tantrum, Draghi bookended the announcement by indicating interest rates could remain at their current low levels “well past” the end of the bond purchase program.  Clearly the market was looking for the ECB to be a little more aggressive, as the Euro declined 1.4% against the US Dollar and yields on European bonds moved lower.  This is a particularly difficult situation for European banks who are carrying negative yielding bonds on their balance sheets and will continue to do so for another two years at least.  

After nine years of ultra-accommodative monetary policy, the unintended consequences (including widening of the wealth inequality gap and the rise of Populist political candidates globally) continue to reverberate through the system.  Given the magnitude of government borrowing and the extended timeline for reversing Quantitative Easing on a global scale, the final chapter of this story is a long way off.

Be well,

Jp.

Covenant Weekly Market Synopsis for October 20, 2017

October 23, 2017

The S&P 500 and Dow Jones Industrial Average indices were a perfect 5-for-5 last week as each day brought higher prices than the day before. Most of the week’s gains came on Friday, following Thursday evening’s successful Senate vote on the budget. Importantly, the language in the bill was modified to simplify the Senate and House of Representatives’ budget reconciliation process, increasing the odds that tax reform will be implemented by year end.

Five new record closes generated respectable gains of 0.9% for the week. This, ladies and gentlemen, is what a bull market looks and feels like. It won’t always be this way, but best to enjoy the ride while it lasts. International markets were a bit choppier. Although Japan and China indices moved higher, Europe, Emerging Market and Frontier Market indexes experienced modest declines of less than 1%. As one should expect within the context of a bullish week, the prices of defensive assets such as US Treasury bonds fell, pushing yields across the maturity curve higher. However, it is worth noting that the “long bond” (the 30-year US Treasury) remains below 3%, as hints of inflation remain elusive. Precious metals, also considered a defensive asset, declined on the week (gold -1.8%, silver -2.2%), while WTI Crude rose 0.8% to close the week at $51.84 a barrel.

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

 

CPI X-ray – The following chart illustrates the various inputs into the Consumer Price Index, the widely followed measure of inflation. Research provider Foleynomics groups the inputs into three categories: Goods (prices are market driven and measurable), Shelter (prices derived from formulas and, because of that, lags current conditions) and Services (a mix of market prices and regulated costs). What is immediately apparent is that of September there were only two areas generating any meaningful inflation: Energy and Rent of Shelter (aka housing prices and rental prices). All other inputs to inflation are near the zero bound. Here’s the thing, the higher energy costs are related to hurricanes Harvey and Irma, and will likely back off. Also, the rate of growth of shelter prices appear to be decelerating. If this continues, one of the long-term primary drivers of inflation will be weakening going forward.

 

image

Once again, it is worth stressing that there is inflation in the economic system, but it is benign and below the Fed’s 2% annual target. Inflation readings can be volatile and we wouldn’t be surprised to see an inflationary impulse over the next couple of quarters (as has happened sporadically over the last few years), especially if tax reform gets implemented. In the intermediate term however, structural headwinds of an aging population and shrinking workforce will challenge the Fed to maintain inflation at their target of 2%.

 

Beauty Pageant – The contest for the next Fed Chair is heating up as the self-imposed deadline of early November draws near. The frontrunners, Jerome Powell, John Taylor, and current Fed Chair Janet Yellen have all interviewed recently with President Trump.  For a President that has owned or co-owned three beauty pageants (Miss U.S.A., Miss Teen U.S.A. and Miss Universe) and hosted a competitive reality-TV show (The Apprentice), Mr. Trump knows a thing or two about competitions….and how to keep the audience tuned in.  While there are no talent or bathing suit competitions associated with the decision-making process around the next Fed Chair, President Trump has done a fantastic job of keeping the markets in suspense about who will assume the lead position in the world’s most powerful central bank.  Depending on who the President meets with or remarks about in press conferences, the market swings to either a hawkish (bond prices down, yields up) or a dovish (bond prices up, yields down) stance.  An online odds maker, PredictIt, placed Jerome Powell in the lead on Friday. Mr. Powell’s monetary policy views are considered to be fairly close to current Fed Chair Janet, but he may be less stringent when it comes to regulations on banks. As such, choosing Powell would result in continued dovishness at the head of the Fed (remember, Trump is a “low rates guy”), while at the same time allowing President Trump to replace someone appointed by former President Obama.

Be well,

Jp.

Covenant Weekly Market Synopsis for October 13, 2017

October 16, 2017

Halloween month is an apt time for our Gregorian calendar to cooperate by producing a Friday the 13th. Yet, nothing scary emerged this past Friday, at least not in the financial markets. Equities bounced higher with the Nasdaq Index closing at an all-time high – the S&P 500 and Dow Jones Industrial Indexes also hit new highs earlier in the week. The Fed’s boogeyman, inflation, was also a no-show as data from September showed core inflation was steady at 1.7% year-over-year. Indeed, excluding shelter costs (i.e. housing), core inflation rose only 0.6% year-over-year. It’s also worth noting that the 3-month average retail sales for September grew by only 2.6% on a nominal (non-inflation adjusted) basis. The hurricanes may have depressed that number to a degree, but reduced retail sales are consistent with our observation that after a long period of subdued wage growth, consumers are feeling the pinch from spending more than they earn. As the chart below highlights, Personal Consumption Expenditures (PCE) cannot remain above Disposable Personal Income (DPI) indefinitely as it implies consumers are borrowing, using savings or engaged in both to consume more goods and services than their paychecks provide for. Neither of these actions is sustainable. For an economy whose GDP is comprised of 70% consumption, a weakening consumer would be a spooky economic trend.

image

Sources: Bureau of Economic Analysis, Foleynomics and Covenant Investment Research

 

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

 

Party On – From the smoldering ashes of the Financial Crisis, the ultra-accommodative form of monetary policy known as “Quantitative Easing” (QE) was born. The Fed was the first central bank to adopt these measures and, as the chart below highlights, U.S. stocks (and risk assets in general) got a leg-up on their international brethren. Since the first round of QE in November 2008 through last Friday, the S&P 500 Index has produced total returns of nearly 220% vs. 120% for the Europe Australasia and Far East (EAFE) Index.

image

Sources: Bloomberg and Covenant Investment Research

The European Central Bank (ECB) and Bank of Japan (BOJ) soon joined the QE party. The three banks together injected an enormous amount of liquidity into the markets. That liquidity had to go somewhere, and much of it ended up in financial assets resulting in higher equity prices, lower bond yields, higher residential real estate prices, higher commercial real estate prices, etc. You get the picture… liquidity in, prices up. Now we are at the point where the Fed will once again be the first to act on a major shift in monetary policy, this time withdrawing liquidity from the economy by shrinking their considerable balance sheet.

With the ECB and BOJ still buying assets at a combined rate of $150 Billion per month, the Fed’s initial move to shrink its balance sheet is unlikely to have a significant impact on financial markets… at least not yet. Unlike the start of Quantitative Easing, the first central bank to begin Quantitative Tightening is not the one that will have the most dramatic impact on markets. Rather it will likely be the second central bank starting Quantitative Tightening that will impact asset valuations. That central bank is expected to be the ECB. When the ECB begins to shrink its balance sheet, perhaps next year, two of the three large central banks will be simultaneously draining the proverbial punch bowl. That may be like the neighbor calling the police about a raucous party at your house – it’s not over yet, but it’s the beginning of the end.

It’s worth noting that the beginning of the end of the era of Quantitative Easing doesn’t imply the market will crash. But at that point, further gains are more likely to come on the back of improved earnings rather than higher valuations (also known as price-to-earnings multiple expansion).

Be well,

Jp.

Covenant Weekly Market Synopsis for October 6, 2017

October 9, 2017

Lather, rinse, repeat” say most shampoo bottles. So sayeth the equity markets in this historic run, evidenced by the S&P 500 recording its fourth consecutive weekly gain. In a market that keeps setting new records, the S&P 500 is on the cusp of another. Through Friday, the widely followed index had gone 332 days without a 5% cumulative decline – the second longest such stretch since the 333-day run that ended in November 1994 (Source: William O’Neil). Unless President Trump’s “calm before the storm” comment last week prophesied a market decline of 5% today, by tomorrow we will all be party to yet another record market event. Let the good times roll!

Developed Market equities started the fourth quarter on a strong note, rising 1.3% for the week (16% YTD). Performance of International Developed Market equity indices was more diverse, with European stocks adding 0.4% (+11% YTD) and Japan 1.4% (+10% YTD). Emerging Market stocks rose 2.0% (+30% YTD) and their aspiring cousins, the Frontier Markets, tacked on gains of 1.2% (+22% YTD). Yields on US Treasuries moved higher (as bond prices declined) across the curve, with the annual yield on the 10-year benchmark bond reaching 2.36% (the top end of a 2.1% to 2.4% trading range in place since the end of the first quarter). The US Dollar has rallied for the last 4 weeks, moving higher by 0.8% this past week. A stronger dollar contributed to the decline in WTI Crude (which is priced in dollars), which ended the week down 4.6% at $49.29 per barrel. As noted above, market volatility remains subdued, to say the least. After closing at a record low of 9.19 on Thursday, the VIX Index ended the week slightly higher at 9.65 (versus a post-Financial Crisis level of 16 and a 20-year average of about 20).

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

 

Thought Piece – This week’s synopsis is abridged as I spent much of last week finishing an article titled “Diversification: An easy choice, but a difficult decision”.  Admittedly, when stocks are in the midst of a historic late-cycle run this is not as catchy a title as “Dow to hit 30,000” or “S&P 500: There Is No Alternative”.  Yet, market cycles come and go and as difficult as it may be to conceive right now when the good times are rolling, this cycle too will end at some point.  Unfortunately, nobody knows when.  While equities are an important element within a portfolio allocation, it is important not to become so enamored with the asset class that one allows his/her portfolio to become overly concentrated in what has been working lately.  The article explores that concept.  Thoughts and comments, critical and/or constructive are always welcome.

Be well,

Jp.

Covenant Weekly Market Synopsis for September 29, 2017

October 2, 2017

The market is boring… equity indices click higher seemingly every day to set new records. But, of course, this is the type of boring investors like. The alternative to a boring market can take many forms from a violent move lower to choppy waters in which markets move sharply higher and lower on successive days. Perhaps the worst kind of boring would be the exact opposite of what we have today, a slow, grinding decline where each day is met with new market lows – the market’s version of water torture. Since our current reality is the happy kind of boring, let’s enjoy the ride. In other words, be patient, but not complacent (as described further in the Patience & Complacency section below).

The revised estimate for Q2 GDP improved by 0.1% to 3.2% real, annualized growth; the highest quarterly growth rate since Q1 2015. Even as past growth was ratcheted up, current inflation continues to wane. The Fed’s favored measure of inflation, year-over-year Core Personal Consumption Expenditures (PCE) declined to 1.3% and has been trending lower since late 2016. Europe also saw disappointing inflation data for September, causing some to question whether the European Central Bank will, or should, curtail their bond-buying program. While similar questions have been raised about the Fed’s forecast rate hikes in the absence of inflationary pressures, Chair Yellen has, thus far, done her best to make the case that deflationary pressures are transitory. As such, she has struck an uncharacteristically hawkish stance that the Fed will raise rates in December and three times in 2018. Of course, her term ends early 2018 so she may be watching the Fed decisions from the sidelines.

Equities ended the week, month and quarter higher. In some cases much higher as investors continue to ride the favorable wave of improving global economic growth combined with ultra-accommodative monetary policies from the world’s major central banks. Fixed income investments suffered as yields moved higher toward the back half of the quarter in response to the anticipated tax plan and the Fed’s monetary policy decisions and forecasts. Indeed, after a fairly smooth July and August, rates on the 10-year jumped 0.22% in September to 2.33%. That may not sound like much, but it represents a 10.2% increase for the month and the largest since November 2016 (when the yield jumped 33% to 2.38%). Higher rates are good for savers putting new money to work in fixed income investments, but not as pleasant for those who are already invested as the price of bonds moves inversely to the yield.

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

The Reformers – On Wednesday, the Big Six revealed the long-awaited tax plan, or at least a framework for it. The Big Six are the President’s National Economic Council Director Gary Cohn, Treasury Secretary Steven Mnuchin, Senate Majority Leader Mitch McConnell, Senate Finance Committee Chairman Orrin Hatch, Speaker of the House Paul Ryan and House Ways & Means Chairman Kevin Brady). The framework’s lack of details appears to be part of a strategy to keep lobbyists in the dark about which tax loopholes will be eliminated, thus reducing their influence while Congressional tax committees fill-in the details.

Gigabytes of electrons have already been spilled speculating on what the tax plan will look like and what it means for low, middle and high-income earners. But it’s too early to understand all the impacts the plan will have on any group or on us as individuals. That being said, FTN Financial assembled a clean list of what is known and unknown at this point about the tax plan. I’m sure you can pick out some individual things you like and don’t like… I know I can.

image

Patience & Complacency – In a year of records (new highs in markets, new lows in volatility), here’s one more for the books. Through September, the largest drawdown (i.e. the maximum decline in the market from a recent peak) in the S&P 500 for 2017 has been less than 3%. Should the market hold its current pattern, 2017 will set the record for the smallest maximum drawdown of all time.

image

Source: @michaelbatnick

The lack of market volatility, new records and increasingly rich valuations have caused many market analysts and pundits to suggest a significant pullback is in the offing. The fact is, while inevitable, no one knows when it will occur. It could be next week, next month, next year, or beyond. Because no one truly knows when this will occur the best thing investors can do is be patient, but not complacent. It is a fine line between the two, as both appear to involve doing nothing. An investor that has built in “circuit breakers” to their portfolio, securities and/or asset classes that will react positively (e.g. fixed income, hedges, alternative investments) to a market pullback can afford to be patient. Taking comfort that even as the equity portion of their portfolio continues to grow with the market, the entire portfolio will not be at risk when the market turns. However, the complacent investor who has not tended to his portfolio allocation should consider getting a little less patient.

Be well,

Jp.