Monthly Archives: November 2018

In a holiday-shortened week, we diverge from our usual Market Synopsis format to focus on two investment assets making the majority of headlines: equities and crude oil.

Equity Market Update. There was not much to be thankful for last week in the land of risk assets, particularly in the US:

  • S&P 500: -3.8% / -2.74% month-to-date
  • International Developed: -1.1% / -1.05% MTD
  • Emerging Markets: -1.72% / +1.43% MTD

Volatility has increased, but following last week’s decline the S&P 500 is only a touch over a 10% retrenchment and is essentially flat on the year (+0.18% when including dividends). Though the mention of “normal volatility” may appear to be putting lipstick on a pig, thus far equity markets are not a pig that requires lipstick.


Sources:  Bloomberg and Covenant Investment Research

Bottom Line: As has been remarked previously in the weekly synopsis, the volatility “feels” awful compared to 2017’s tranquil gains of more than 20% and, in general, the majority of the post-Financial Crisis recovery period.  However, from a historical perspective, this type of volatility is not terribly unusual. Going forward we expect volatility to remain elevated as we press further into the latter stages of the business cycle and the Fed attempts to engineer a soft landing for the economy amid protectionist trade actions, fading fiscal stimulus, and tightening monetary policy.

Crude Oil Update. The price of crude oil, whether measured by the cost of Brent or West Texas Intermediate (WTI), has been hammered of late. Since reaching $76.41 per barrel in early October, WTI has plummeted 34% to $50.42 per barrel as of Friday’s market close (Brent is down 32% to $58.80 per barrel). The chart is ugly, but what caused this sudden sell-off and what does the future likely hold for oil prices?


Sources: Bloomberg and Covenant Investment Research

In short, the market appears oversold with regards to supply and demand fundamentals. However, before touching on the fundamentals, let’s quickly visit the reason for this selloff. The market was bracing for the Iran oil-export sanctions from the Trump Administration to remove as much as 1.7 million barrels per day from the global oil supply in early November. As a result, global crude oil prices rose even as Saudi Arabia and Russia ramped-up production to offset the expected impact from a loss of Iranian oil. However, just before the sanctions were scheduled to take effect, President Trump granted waivers to eight countries allowing them to continue their oil purchases from Iran for 180 days. Suddenly, the market was confronted not with a shortage, but rather an oversupply of crude oil. There were other factors at play (e.g., slowing global economic growth), but by and large the Trump Administration’s about-face on Iran oil-export sanctions transformed the path toward $90+ oil in Q1 2019 into a 2018 oil bear market.

While the waivers created excess short-term supplies, the global market remains susceptible to a negative supply shock as OPEC spare capacity as a percentage of global demand is near an all-time low at 1.5%.


Furthermore, even with slowing global economic growth, the demand for oil is expected to increase by 1.5mm barrels per day in 2019 (Source: BCA Research). This level of demand is projected to exceed supply by about 1 million barrels per day, leading to a decline in stored oil inventories.


Source: BCA Research

Bottom Line: Although the long-term path for oil prices appears to be higher based on fundamental supply and demand forecasts, the short-term price will be determined by the upcoming OPEC meeting on December 6th. If the OPEC countries agree to cut production by 1 million or more barrels to offset the additional supply from the Iran-sanction waivers, the price of WTI crude should recover to the mid-$70 per barrel range in the coming months. If, however, OPEC maintains the current production level, crude prices will remain in a bear market unless, or until, there is a supply disruption.

Be well,


“For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” – Winston Churchill

Last Week Today. The results of the midterm elections, while exciting in certain local races, concluded as expected at the national level with a divided Congress (Democrats control the House and the Republicans the Senate). Correspondingly, prospects for a second round of tax cuts are likely dead in the water, while the chances of a government shutdown over budget negotiations increased. | The Federal Reserve met last week and surprised no one by leaving interest rates unchanged. The only noteworthy change in their subsequent statement was an acknowledgment of slower business investment in the third quarter. Nevertheless, strong economic growth and a tight job market make a December rate hike a near certainty as the Fed reiterated in their meeting notes their intent for “further gradual increases in the target range for the federal funds rate.”

U.S. equity markets rallied smartly following the midterm elections as domestic political uncertainty was put temporarily to rest. Although domestic markets gave back some of the gains on Friday, they closed the week solidly in the black as the S&P 500 gained +2.2%. International developed equity markets (as measured by the EAFE Index) rallied in sympathy, but to a lesser degree at +1.1%. Although yields on long-dated US Treasury bonds declined modestly on the week, mortgage rates continued to rise topping 4.8%, which is the highest level since 2011. To investors, higher mortgage rates translate into lower home affordability, and homebuilder stocks have been summarily throttled – the iShares US Home Construction ETF is down -33% since January.

Crude oil declined for ten consecutive days and is officially in a bear market, falling -21.2% from $76.41 per barrel in early October to $60.19 on Friday. The price decline is blamed on oversupply as the Saudis and Russians increased production to compensate for an expected US sanction-induced decline in Iran’s exports, which never came to fruition.

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

Q3 Earnings Update. Through last week, roughly 90% of S&P 500 companies reported Q3 earnings and results were strong. Earnings per share rose by 27%, and revenue growth was 12%. Management teams took full advantage of the new tax laws, exceeding analyst estimates as the effective corporate tax rate fell to 19%(!) in Q3 vs. analyst consensus expectations of 21%. Importantly, companies were able to grow efficiently as pretax earnings rose 14% year-over-year, two percentage points more than revenue growth… in other words, lower taxes were not the only driver of higher profits.

No Country For Taxed Men (or Women). Through the first nine months of 2018, states with a lower tax burden created new jobs at nearly twice the pace of high-tax states. This trend began in the first quarter of 2018 following changes to the Federal Tax code, which, amongst other actions, eliminated the State and Local Tax (SALT) deduction. According to the Bureau of Labor Statistics, low-tax states (such as Texas, Arizona, Nevada, and Florida) created 2.15% new private sector jobs, while high-tax states (e.g., California, New York, and Illinois) only experienced job growth of 1.18% over the first nine months of the year. Said differently, job growth in low-tax states was 87% faster than in high-tax states.

By comparison, in the 18 months before the tax cuts, the job growth variance between low- and high-tax states was only 30% in favor of low-tax states. The tax reform package incentivized a transfer of investment capital from high-tax states to low-tax jurisdictions where businesses can earn higher after-tax profits and laborers pay less to local governments. Not coincidentally, states with high tax burdens are seeing residents migrate to low-tax states.


Source: Professor Steve Hanke (Johns Hopkins University)

The population exodus presents a problem for high-tax states as fewer residents result in a smaller tax base. Lower tax revenue exacerbates thorny budget issues, which is the reason the states implemented higher taxes in the first place (see Churchill’s quote above on the sagacity of this approach). It’s a complex, positive feedback loop that will be difficult for high-tax states to reverse. However, the situation presents a competitive advantage for low-tax states – a steady flow of new workers at a time when labor markets are incredibly tight.

Bullish? Historically, the S&P 500’s performance improves following mid-term elections. The gray area in the chart below depicts the performance range leading up to and following the 11 mid-term elections since 1974; the blue dotted line represents the median performance.


While a decline in the S&P 500 over the next seven months would not be without precedent, history favors the bulls. Of course, if history were always a perfect guide to the future, the SEC would not require investment managers to plaster the phrase “Past performance is no guarantee of future results” across all of their marketing materials.

Be well,