Monthly Archives: February 2018

Covenant Weekly Market Synopsis for February 23, 2018

February 26, 2018

In a holiday-shortened week, domestic stocks tacked on modest gains, though most remain negative for the month. Absent substantial increases over the next three days, the S&P’s streak of consecutive positive months will end at 15 months in February – a remarkable run. Global stocks indices were mixed last week. The Nikkei’s decline of 1.1% dragged on the broader international Europe Australasia Far East (EAFE) Index (which fell 0.8%), even as European stocks rose by 0.3%. China’s 2.6% gain was the standout regional performer, yet the country’s leading index remains down nearly 5% month-to-date. Fixed income yields were volatile as the 10-year US Treasury yield rose to 2.95% intra-day on Wednesday, before settling at 2.87% (a decline of 0.1% from the previous week’s close). Precious metals declined (gold -1.4%, silver -0.7%), while prices of energy commodities increased with WTI Crude rising 3.8% to $67.29 per barrel.

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

Inflation and Stock/Bond Correlations: It is often considered an investment axiom that stocks and bonds are uncorrelated and therefore a portfolio that includes each will be well diversified. While it is fair to say that over long periods of time stocks and bonds tend to have a low correlation to one another, a closer examination of historical data reveals that the correlation relationship is unstable. That is to say, there are periods when bonds are a less effective diversifier to equities than in other times.

The correlation between the two tends to be lowest during periods when deflation is of more concern than inflation. Conversely, when inflation becomes of more significant interest, stocks and bonds prices tend to have a higher correlation. The chart below highlights the changing dynamic of stock and bond correlation.

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Source: Bianco Research, L.L.C.

In this chart, the rolling 5-year correlation of stock and bond prices is lowest from 1954 to 1966 and, more recently, since 2001. The recent period is most straightforward to remember, which includes the Financial Crisis and the Fed’s aggressive response to stave off a deflationary economic cycle. True to form, both of these periods of deflationary concerns were accompanied by low (and even negative) stock/bond correlation. Conversely, the shaded region of the chart from 1966 to 2001 was a period when inflation was a primary concern for financial markets. During this period, the correlation of stocks/bonds was positive, and as a result, the diversification benefits of bonds were of lower value.

The changing relationship (“non-stationary” to use a technical term) between bond and stock prices in different market regimes is important. This is especially true at inflection points when market concerns shift from one regime to another. At present, the market appears to be transitioning from a deflationary regime to one that is more concerned with inflation. For example, the chart below shows the 15-day percentage change of the total return of the S&P 500 (x-axis) and the total return of the 10-year (y-axis). The red circles on the chart highlight how unusual the trading has been since the stock market peaked on January 26, 2018. According to Bianco Research, “…stocks and bonds have not declined in unison like this since the dysfunctional days of the global financial crisis in late 2008.”

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Source: Bianco Research, L.L.C.

Many factors are contributing to a change in investor sentiment regarding inflation, including stronger global growth and very low unemployment levels in the U.S. Moreover, as the chart below highlights, inflation is finally picking up in the Developed Markets. After an extended period of average year-over-year inflation of less than 1% in Developed Markets, it is now approaching 2%.

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Source:  JP Morgan

Keep in mind I’m not suggesting we are on the cusp of a hyperinflationary environment. Rapid inflation is not the requirement for bonds and stock prices to become more correlated. My point is that if the market has transitioned from a deflationary mindset to an inflationary one, investors who rely solely on fixed income and equities in their portfolios can expect a more volatile period ahead.

Be well,

Jp.

Covenant Weekly Market Synopsis for February 16, 2018

February 19, 2018

Following a tumultuous seven days to kick-off the month of February, financial markets regained their footing in the second full week of trading and posted substantial gains. Domestic equities rose 4% or better, and the tech-heavy Nasdaq gained more than 5%. International developed markets appreciated by 3.4% (as measured by the EAFE Index) while Emerging Markets held the upper hand rising 5.3%. Fundamental corporate earnings look solid, with a nod to tax reform impacts, 2018 earnings estimates for the S&P 500 have been revised higher by 7%. While a portion of the tax savings is destined for capital expenditures, a decent chunk will also go to stock buybacks and dividends. Indeed, CNBC reported that corporate buybacks are now at a year-to-date record of $170.8 billion. Stock buybacks provide a tailwind to the equity markets as it reduces the number of shares outstanding (i.e., “float”), improving earnings per share. In the land of fixed income investing, yields at the front end of the curve moved higher, while the yield on the long bond (the 30-year treasury) fell modestly by 0.03%. Commodities, in general, enjoyed upward pricing pressure as gold rose 2.3%, silver 1.7%, copper 7.1% and WTI Crude 4.2% (to $61.68 per barrel).

Even as the initial bout of market volatility settled some last week, it is unlikely to be clear sailing from here. Events like those that took place the week of February 5th are rarely isolated. Another 100%+ rise in the VIX Index may not be in the cards, but the days of the VIX Index languishing around 10 (as it did for much of 2017) are most likely behind us.  In other words, last week’s events were the first step into a new paradigm of elevated volatility.

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

Economic Data Takeaways:  Within the raft of economic data released last week, the key takeaways were higher inflation and lower consumption. The Consumer Price Index (CPI) rose 0.5% in January, which was 0.2% ahead of expectations. However, that was the same rate of growth in January of 2017, so the year-over-year growth rate in the CPI remained at 2.1%. Similarly, Core CPI (excluding energy and food prices) rose 0.3% in January but was unchanged at 1.8% year-over-year.

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Source: Bureau of Labor Statistics and FTN Financial

The Producer Price Index also came in higher than expected with the headline index rising 0.4% and Core PPI increasing 0.4% (vs. 0.2% estimate). Much of this rise was likely due to a weaker dollar, which tends to push commodity prices higher. Regardless, the inflation data should keep the Fed on track to raise rates at least three times this year – any strengthening of the inflation data could push the Fed to raise rates 4x – a pace of rate hiking that is not currently priced into the market.

The retail sales report was just plain ugly. Not only did retail sales fall 0.3% in January (vs. the +0.2% consensus estimate), but the report for December was revised downward from +0.4% growth to unchanged at 0.0%. It’s too early to tell yet if this marks a trend toward lower consumption, but this is one of the risks to higher 2018 GDP growth we cited in our Q1 Economic Review and Outlook. For the last two years consumers, in aggregate, have spent more than they earned. Over this period consumption has been financed through increased borrowing and reduced savings. Consumer debt as a percentage of personal disposable income is at an all-time high and savings reached a new cycle low of 2.4% in December 2017 (vs. a long-term average of close to 7%). February is the first month in which the new tax reform deductions will be reflected in labor force paychecks. Lower tax rates will increase take-home pay for the majority of U.S. workers, so it will be interesting to see if February’s retail sales data improves as a result.

Be well,

Jp.

Covenant Weekly Market Synopsis for February 9, 2018

February 12, 2018

It was a volatile week both in terms of stock prices (S&P 500: Mon. -4.1%, Tues. +1.74%, Wed. -0.5%, Thur. -3.8%, Fri. +1.49%), and specifically for the VIX Index which experienced its largest move ever on Monday afternoon jumping 115% (a lot of that move occurred in the last 30 minutes of trading).   The intraday equity market swings were something to behold as well.  Reminded me of the saying about Texas weather, “if you don’t like the weather now, wait 15 minutes” as markets swung between positive and negative performance multiple times many days of last week. On Thursday, the S&P 500 closed 10% below its record high, making the market move an official “correction”. By the time the bell rang to close the markets on Friday afternoon, the losses on red days clearly overmatched the gains on green days pushing most global equity indices into negative territory for the year. Picking through the rubble, Chinese equities stood out declining 10.1% for the week and most global equity indices declined by 5% or more. Bonds didn’t offer much help either, with yields rising in all but the shortest maturity issues. Gold fell 1.3% and the price of WTI Crude declined 9.5% on the week ($59.20 per barrel).

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

A View from the Edge (of the abyss) – Declines of 10% in the market are normal, but the “feel” of this one is magnified because it comes after a year of historically low volatility. The chart below shows almost 40 years of data, illustrating that steep intra-year declines are normal and do not always result in negative equity market performance. In the chart, the red lines represent the largest peak-to-trough intra-year declines.

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Source: Dimensional Fund Advisors

It’s also worth noting that on Friday afternoon, the S&P 500 bounced strongly off its 200 moving day average.  That is generally a good technical sign, but probabilities are on the side of equities even if the bounce proves to be short-lived and stocks fall further.  There have been 16 drawdowns of 10%+ since 1976, and only five occurred around a recession.  During the other 11 non-recession corrections, the S&P 500 declined by 15% – implying this market move may not yet be done.  Trying to time the bottom isn’t worth it.  Indeed, there is no reason to try and pick the exact bottom as research from Goldman Sachs indicates an investor who bought the S&P 500 10% below its peak without waiting for a bottom would have experienced positive 3-,6- and 12-month returns in 75% of corrections. It would be hard to make the case that equities are a screaming buy, but it is worth noting that the combination of tax-related earnings upgrades and the stock sell-off have pushed the forward P/E multiple for the S&P 500 from approximately 20 in mid-January, to 16.5 today. This is not a recommendation to buy stocks – this perspective is offered in the context of advising investors to stick to their asset allocation plan.

Economic Data Update – While the investors struggle to figure out the correct price for securities, the US economy continues to show signs of strength. The ISM non-manufacturing index hit 59.9 in January, its highest reading in nearly 15 years.

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Source: Institute for Supply Management and FTN Financial

Combined with tax reform, deregulation and a newfound vigor in international economies, 2018 should be an above average year for the US economy (a topic we discuss in our Q1 Economic Review and Outlook).

Be well,

Jp.

Covenant Weekly Market Synopsis for February 2, 2018

February 5, 2018

After a long (15-month), virtually uninterrupted run higher, equity markets had a “challenging” week. Losses were broad and deep, with little discernment regarding asset type or geography as stocks, bond, commodities, and precious metals declined simultaneously. Last week’s price decline of 3.9% was higher than any such drawdown in the S&P 500 for all of 2017. But considering the terrific run in equities in 2018 (the S&P 500 gained 7.5% in the first 18 trading days of the year) on top of a fantastic 2017, a pullback should not have been unexpected even as it was an unpleasant reminder that risky assets are not mandated to move unidirectionally higher in price. The S&P 500 has gone 404 days without a 5% cumulative decline. I suspect that record will be challenged this week.

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

Why? It is common to want to know the reason for a market sell-off. But, rarely is there one thing that causes investors to shift their sentiment from risk-seeking to risk-averse. The pithy answer to the cause of a selloff is “there were more sellers than buyers.” But even as that is technically accurate, it is an unsatisfying explanation. So, for what it’s worth, my opinion is that the current market sell-off is the result of investors fears about higher interest rates. We learned last week that average hourly earnings increased by 2.9% in January and that sparked fear that outsized inflation is imminent and will force the Fed’s hand to raise interest rates aggressively. Combined with the pre-existing condition of stretched equity market valuations, many investors thought it would be an opportune time to take profits.

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Source: Bureau of Labor Statistics and FTN Financial

What? After evaluating the “why” of a sell-off, the next natural question to ask is what to do about it. While the market decline is likely to continue, from an investment perspective, it’s worth keeping in mind that domestic economic data remains on the upswing and that global synchronized growth conditions are intact. In other words, this is probably not the beginning of a bear market for stocks unless some exogenous event (e.g., a geopolitical flare-up) exacerbates what can be characterized as a healthy off-gassing by an overheated market. Although markets are capable of extreme moves regardless of fundamentals, if you believe in probabilities, take the under on this as the beginning of an economically-induced bear market.

How? And of course, there is the question of how to invest going forward. The nastiness of this selloff notwithstanding, of more significant concern to investors and asset allocators should be the rise in correlation between equities and bonds at a time when both are expensive asset classes.

During the last eight years, consistently falling bond yields (yields move inversely to bond prices; hence lower yields result from higher bond prices) have, with few exceptions, buffered portfolios when equities sold off. Bonds have actually played this role for much longer… ever since yields peaked in the early 1980’s, bonds have provided a very steady tailwind to a traditional portfolio mixture of bonds and equities as declining yields generated price gains in the debt instruments. Rising bond prices tempered portfolio volatility over any reasonable timeframe for the past 30 years. But as last week illustrated, at historically low levels, bond yields have a higher propensity to rise than to fall meaningfully. Moreover, the Fed is withdrawing liquidity from the system by reducing the size of their balance sheet at the same time they are raising interest rates, with a target of 3 additional raises this year. And, oh, by the way, the European Central Bank cut its bond-buying program in half in January.

At the same time that liquidity is being withdrawn from the global economy, equity market valuations are stretched.  As investors who fundamentally believe the price you pay directly influences the returns you receive, the expected returns from the stock market over the next 10 years has gone down as the price of the market has gone up.  While valuation is a lousy predictor of performance in the short-term, its clairvoyance into long-term (i.e., 10-year) returns is unrivaled – see the chart below which highlights the increasing correlation between present valuation and future returns over longer time horizons. 

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From today’s valuations (both equities and fixed income) the probability is extremely low that traditional mixes of stocks and bonds will be able to produce returns necessary to meet investor’s return requirements. In short, investors need to think differently. They can fail conventionally, or succeed unconventionally by expanding the range of assets in their portfolios, a topic we explore in this white paper.

I’m trying to free your mind, Neo. But I can only show you the door. You’re the one that has to walk through it.

–Morpheus, The Matrix

The financial markets are incredibly innovative. During the last 20 years, a number of new asset classes have been created or made accessible to individual investors, including reinsurance, absolute return strategies, private lending, private equity, and venture capital. Yes, these assets are less liquid than stocks. But, in a market rife with overvalued publicly traded assets, there is still value to be had in non-exchange traded assets. Allocators and investors need to ask themselves, is having access to daily liquid investments for 100% of their portfolios worth the price of not meeting their return objectives? Or, might they be better off investing a portion of their portfolio in asset classes with a higher expected return, even if it comes with less liquidity.

Be well,

Jp.