Christmas is a time when kids tell Santa what they want and adults pay for it. Deficits are when adults tell the government what they want and their kids pay for it. – Richard Lamm
Last Week Today: November’s budget deficit was the largest on record for the US at $205 billion (vs. $129 billion a year earlier), as government spending jumped 18% with little change in receipts. | China signaled they would reduce retaliatory tariffs on imported US autos from 40% to 15% on January 1st, a positive (though in no way definitive) step in defusing the trade tensions between the US and China. As a reminder, the 90-day window for the US and China to make progress on the trade war expires March 1st. If no progress is made, the US is expected to levy additional tariffs on imported Chinese goods. | As anticipated, the European Central Bank announced it would end its Quantitative Easing program, but will continue to reinvest principal and interest payments. In other words, the ECB will cease expanding its balance sheet, but not yet begin reducing it. This is the same path followed by the Fed when it ended QE back in 2014. | Retail sales in November were well above consensus estimates, rising 7% year-over-year on a nominal basis, or 4.8% on a real, inflation-adjusted basis. Low unemployment and higher wage growth continue to support consumption, and while a positive indicator for economic growth, these types of data points give the hawks at the Fed more ammunition for continuing to raise interest rates.
Another volatile week in equity markets left the three major US stock indexes in a ‘correction’ (i.e., down more than 10% from a high). Despite the correction moniker, on a year-to-date basis, the S&P 500 (-0.9%), the Dow Jones Industrial Average (-0.3%) are barely below water on a total return basis, while the Nasdaq is up +1.2% (inclusive of dividends). For detailed weekly, month-to-date and year-to-date asset class performance, please click here.
FOMC – The Federal Reserve Open Market Committee, aka “The Fed,” will convene its final meeting of 2018 this week. In addition to announcing a decision on the current Federal Funds Rate (it is widely expected they will raise it by 0.25%), the committee will also update their interest rate forecasts. Previous Fed forecasts indicated a median prediction of four rate hikes (including one this week) by the end of 2019. Economists currently predict a total of 3 rate hikes. But those who invest money for a living and have real risk on the table via investing in interest rate futures, are only pricing in two more rate hikes. Heretofore, the risk takers have proven more accurate than the Fed or economists when it comes to forecasting the level of the Fed Funds rate, so the messaging around this Wednesday’s interest rate announcement will garner heightened attention.
Investor Sentiment – If the market moves this year, but more specifically in the last three months have taken their toll on your psyche, you are not alone. The ratio of Bulls to Bears (or those with a positive market outlook vs. a negative market outlook) is at lows rarely witnessed. The last time the ratio plumbed these depths was in early 2016 when the S&P 500 was in the midst of a correction (that began in late 2015), crude oil was bottoming at $26 per barrel, and fears were mounting that China’s economic slowdown was spinning out of control.
Sources: Bloomberg and Covenant Investment Research
This corrective phase may not be over, and while the signal is noisy, extreme negative investor sentiment is often a contrarian indicator that marks the bottom (or near bottom) of a stock downturn.
Not Unusual. The chart below shows the history of the VIX Index, which is a market-based measure of near-term expected volatility in the S&P 500. Specifically, it represents the market’s expectation of 30-day forward-looking volatility, based on price inputs of S&P 500 Index options. The VIX Index is also known as the “Fear Index” because an elevated VIX Index indicates stress in the market which typically leads to lower equity prices.
Sources: Bloomberg and Covenant Investment Research
This chart includes a lot of data, but there are a few important takeaways:
- The VIX Index itself is volatile. The annualized standard deviation of the VIX Index is approximately 70%, which is nearly 5x as high as the S&P 500’s annualized volatility level of 14.7.
- Since 1990, the average level of the VIX Index has been 19.3 (depicted as “Average(1)” in the chart). Even when eliminating the outlier period surrounding the Great Financial Crisis, the average VIX Index level is 18.3 (shown in the chart as “Average(2)”.
- A one-standard-deviation move in the VIX Index is 7.8 points, meaning that 68.3% of the time the VIX Index is between 27.1 and 11.5 (the grey-dotted lines). When considering two-standard deviations, 95.5% of the time the VIX Index is less than below 35.
When viewed in a historical context, the recent volatility does not appear as unusual as it might feel. Indeed, the low level of volatility experienced in 2017 is far more uncommon than the current volatility we are experiencing. What is also evident in this chart is that volatility is somewhat cyclical, with periods of low volatility (e.g., the mid-1990s and mid-2000’s) followed by periods of elevated volatility. We expect this pattern to hold. Following a period of mostly low volatility since 2014, financial markets are likely to be noisier going forward. As such, it will be important for investors to approach the market with a solid investment plan for navigating choppier seas.
Unusual. While the level of volatility is not particularly surprising based on 30 years of data, 2018 is an unusual year for a different reason. In the absence of a strong rally in either the stock market, the Barclays Aggregate Bond Index, or both, 2018 will be only the second year since 1988 in which cash has outperformed these investment stalwarts.
Sources: Bloomberg and Covenant Investment Research
If there is good news from the rather fallow investment landscape of 2018, it is that these types of years are highly uncommon. Thus, while the markets may be more volatile going forward, investment returns on risky assets are likely to be higher.
Last Week Today. After HSBC’s anti-money laundering compliance group reported a series of suspicious financial transactions, China-based Huawei Co.’s CFO was arrested for alleged violations of US sanctions on Iran. Her arrest came only days after presidents Trump and Jinping’s described their trade talks as successful. | Over the weekend, China summoned the Canadian envoy (the country responsible for her arrest) and the U.S. ambassador (the country that ordered her arrest) to protest the situation, stating U.S. actions have violated the “legitimate rights and interests of Chinese citizens and are extremely bad in nature”. If the CFO is extradited to the U.S., it will surely complicate any further progress on the trade front and is quickly escalating into an international incident with unknown consequences. | Despite President Trump’s suggestion via Twitter that the “world does not want to see, or need, higher oil prices!” OPEC agreed to cut oil production by 1.2 million barrels per day.
Equity and Fixed Income Markets. Although it was an abbreviated trading week (US markets were closed on Wednesday in honor of the passing of President George H.W. Bush), there was no shortage of fireworks in financial markets. After gaining +1.1% on Monday, the S&P declined by -3.2% on Tuesday when investors began to doubt the veracity of President Trump’s claims about the success of his trade talks with China’s President Xi Jinping. However, after the markets closed on Tuesday, China released a statement backing Trump’s claims about the trade talks. The following day the market was closed, but when they reopened on Thursday, the S&P fell an additional -2.9% by 11:30 am ET. A WSJ article suggesting the Fed may be pausing interest rate hikes following their December meeting is at least partly credited with turning the market around, which rallied to close down only -0.15% on Thursday. Then on Friday, the S&P 500 seemed determined to return to the previous day’s intraday lows and nearly did so, closing the day down -2.3%.
For detailed weekly, month-to-date and year-to-date asset class performance, please click here.
Equity markets are notoriously obstreperous, and as the chart below highlights, market pullbacks are not unusual… even in the period of relatively low volatility we’ve witnessed since the Financial Crisis. Although conditions remain favorable for more volatility ahead, it’s worth noting that “volatility” does not necessarily mean stocks decline in value, as sharp movements higher count as volatility as well. For example, the VIX index rose from approximately 15 in 1993 to a peak of 25 in 1998 and the S&P 500 annualized returns of 20% over that period (Source: BAML).
Sources: Bloomberg and Covenant Investment Research; Note: drawdown values are estimated.
Anything can happen in financial markets, and no one knows if this recent move is the beginning of a bear market or just another example of a short-term pullback in the context of a more extended bull market. However, the situation would be more concerning if the economic data were deteriorating rapidly and the Fed was messaging a hard line on monetary policy tightening. Neither of those conditions exists at this point, though we are paying close attention. Although the fundamental data implies economic growth is slowing from the sugar rush of the tax cuts, the economy is still expected to expand by 2.5% or more this quarter and track towards its post-Crisis growth rate of about 2% in 2019. We are in no way wedded to this view, and if the data changes, so will our forecast.
Fixed income markets were no less interesting than equities last week, and market pundits were tripping over themselves to report that the yield curve inverted for US Treasury bonds maturing between 2 years and those maturing in 5 years. The “kink” in the yield curve is shown in the chart below, which also highlights the significant decline in yields (the green line) from one week ago (the yellow line). While “yield curve inversions” have signaled impending recessions in the past, the most accurate forecasting metric of an imminent recession is the yield differential between the 3-month T-bill and the 10-year T-bond. Although the yield differential has declined since November, the spread remains 0.47% wide. With an increasing number of Fed officials signaling a slowdown in the rate hiking cycle, it is unlikely the Fed will continue to raise rates beyond December’s meeting if it causes an inversion in the portion of the yield curve that matters most.
Sources: Bloomberg and Covenant Investment Research
Independence Day. For the first time since possibly the early 1900s (during the first Texas oil boom), US crude oil exports exceeded imports. This phase of independence will likely be short-lived, according to analysts, but many predict sustained oil independence within the next two years. Never discount the creative ingenuity of the American Spirit, which led to the development of unconventional drilling (aka “fracking”) and a new chapter in America’s role in the global energy marketplace.
MONTHLY CRUDE OIL PRODUCTION
Last Week Today. The first of two revisions for Q3 GDP matched expectations of 3.5% and was unchanged from the original estimate. The trailing four-quarter GDP growth average is 3% – well above the 2.1% trend since the Financial Crisis, but likely heading back to trend once the effects of fiscal stimulus fade in 2019. | President Trump threatened to cut subsidies to General Motors (following GM’s decision to close some US plants) and announced he is again considering auto import tariffs on Europe. | At the G-20 meeting over the weekend, China and the U.S. agreed to a cease-fire in the trade war, with the U.S. postponing plans to increase tariffs from 10% to 25% on $200 billion come January 1st. Reportedly, the truce includes an agreement by the leaders to enter negotiations on China’s forced technology transfer, intellectual property protection, non-tariff barriers, and cybertheft. Should the talks fail, the White House said the 25% tariffs would be implemented after 90 days. Look for lots of twists, turns, and associated market volatility as this situation evolves, as the two sides are far from a permanent trade agreement. | On the sidelines of the G-20 meeting, Russia and Saudi Arabia decided to extend their agreement to manage the oil market, setting the stage for a production cut at this week’s OPEC meeting in Vienna.
After serving up a turkey of performance during the Thanksgiving holiday week (S&P 500 -3.8%), risk assets rallied last week with the S&P 500 jumping +4.8% for its best weekly gain since December 2011. Global equities lagged the U.S., though they were positive on the week as developed international markets rose +1.0% (as measured by the EAFE Index) and emerging markets gained +2.7%. It was also a good week for traditional fixed-income investors as yields fell across the curve, with the 10-year bond finishing the week below 3% for the first time since mid-September. Crude oil ended a nightmare of a month with a +1.0% gain but declined -22% in November (a tough month for many energy traders, but a positive one for the U.S. consumer as lower oil prices will translate into reduced gasoline prices).
Federal Reserve Update. Since the Fed Chair Powell’s comments on Wednesday had an undeniable impact on the markets (S&P 500 +2.3%), let’s take a moment to review the change in the messaging. Unsurprisingly, Fed Chair Powell’s comments on Wednesday were a preview of the minutes from the Fed’s November meeting released the following day – the market interpreted both Powell’s comments and the minutes as dovish. Back in October, Powell communicated that the Fed Funds Rate was “a long way from neutral” (the Fed Funds rate which is neither restrictive nor stimulative to the economy), but on Wednesday he changed his language to interest rates are “just below the broad range of estimates” of the neutral rate. The market took the updated language as a suggestion the Fed may deliver fewer than the three additional interest rate hikes included in their current 2019 forecast. The Fed will move rates higher by 0.25% (to 2.5%) in December of this year, but the change in the Fed’s tone provides greater policy flexibility next year. Speaking of flexibility, beginning in 2019 the Fed will host a press conference following each meeting (rather than every other meeting as has been the case), meaning that all eight Fed confabs in 2019 will be “live” meetings in which the Fed can adjust their target interest rate in an effort to engineer a soft landing for the economy.
Powell & Trump. In last Friday’s edition of the Wall Street Journal, Nick Timiraos published an interesting article describing how Fed Chair Jerome Powell handles President Trump’s repeated (and pointed) criticism. In compiling his research for the article, Mr. Timiraos interviewed dozens of lawmakers, current and former officials from the Trump administration and the Fed, as well as business leaders. The article offers a behind the scenes look at Fed Chair Powell’s conundrum with Trump, as well as the relationships of other Fed Chairs and Presidents. Following the first rule of his playbook, Powell declined an interview request for the article.
The article can be found here, but it requires a subscription. If you don’t have a subscription to the WSJ or lack time to read the article, a summary is included below:
As has been widely covered, Fed Powell is not a trained economist, and he brings a certain skepticism of traditional economic models that have guided previous Fed Chairs’ monetary policy decisions. For example, with the unemployment rate at 3.7%, several monetary policy models point the Fed to raise interest rates aggressively. Powell, on the other hand, has guided the Fed to increase rates only gradually relying instead on financial market feedback to determine if rates are moving into restrictive territory.
The article also describes the relationships between several Fed Chairs and their respective Presidents. While not common historically, as the Fed was designed to be an apolitical agency, Powell is not the first chairman to face criticism from a President and his top officials. However, at least two Presidents went beyond publicly criticizing the Fed Chair. President Lyndon Johnson summoned then-Fed Chair William McChesney Martin to his Texas ranch to reprimand him for hiking rates beyond what President Johnson thought was reasonable. In that case, Martin held his ground, which led to his ouster by incoming President Nixon. Nixon replaced Martin with Arthur Burns in 1971. President Nixon pressured Burns to maintain low rates before the 1972 election. In that situation, Burns caved by holding rates low which fueled the great inflation of the 1970s (inflation doubled to 8.8% in 1973 and continued to gain steam peaking at 14% in the early 1980s).
In contrast to former Fed Chair Burns, Powell has developed an effective playbook for dealing with President Trump. Based on Powell’s actions, his playbook can be summarized in four rules:
- Rule 1: Speak not of President Trump.
- Rule 2: When provoked by President Trump, don’t engage.
- Rule 3: Make allies outside the Oval Office.
- Rule 4: Talk about the economy, not politics.
Thus far, President Trump’s actions fall well short of the egregious interference or Presidents Johnson and Nixon. Nevertheless, Powell is facing President Trump’s ire and will likely continue to be so long as he is raising interest rates. However, the Chairman has not cowed to the criticism and, given his extended experience in Washington, is unlikely to do so. This is critical, as maintaining the Fed’s independence will be a positive for the economy and investors in the long-term.
Eco Data Quick Hits.
- Consumer – The consumer began the fourth quarter with a bang, as spending increased in October by 0.6% vs. the 0.4% consensus estimate. October’s result brings the 12-month moving average up to a solid 4.8%. With consumer confidence measures at elevated levels, unemployment at 3.7% (the lowest in roughly 50 years), personal income growth rising, and the holiday season in full swing, consumption should remain strong through the end of the year.
- Inflation – Although many publicly traded companies cited rising input costs during their Q3 earnings calls, inflation has yet to make its way into the broader economy. Core Personal Consumption Expenditures (Core PCE) rose at 1.8% YOY in October and has been trending downward since peaking at 2.0% in July. Core PCE is the Fed’s favored inflation measurement, and since it remains below the Fed’s 2.0% target, the Fed should not be in a rush to raise rates beyond the forthcoming hike in December.
‘Tis the Season: Since 1950, December has never been the worst performing month in the year. Although the bar is pretty low in 2018 (owing to October’s nearly -7% slide), December is positive 75% of the time with gains averaging +1.6%. We’ll see if Santa Claus can deliver yet another rally in 2018. (Source: LPL Financial Research).