Last Week Today. The number of market-moving events was low last week, but there were two significant developments. Minutes from the January Fed meeting were dovish as expected, highlighted by a near unanimous decision to halt Quantitative Tightening (QT) by year-end. The pause in rate hikes and lower forecast QT have reconciled the Fed’s outlook and that of the market. | President Trump met with China’s top trade negotiator last week and, citing “substantial progress” in a trade deal, announced on Sunday afternoon that he would extend the tariff truce beyond the impending March 1st deadline.
In what has become a theme for 2019 (at least thus far), the Dow Jones Industrial Average and Nasdaq indices recorded their ninth consecutive week of gains, the longest winning streak since May 1995 (Dow Jones Market Data). Global equity markets joined in the bullish parade, and while developed international markets paced domestic markets with a gain of 0.7%, emerging markets led the way posting a 2.8% gain on the reduction in trade tensions.
It’s also worth noting that along with the impressive run in global equities, market-based measures of fear are melting. The VIX Index declined for the ninth straight week and, at 13.5, the volatility of S&P 500 Index options is less than half of its December peak (36.1). The MOVE Index (a measure of US Treasury bond volatility) has followed its equity-based cousin, declining from 68.3 to 47.2. Retail investor sentiment, as measured by the American Association of Individual Investors survey shows a distinct shift as well. Often referred to as a contrarian indicator, the percentage of Bullish investors doubled from 20% in mid-December to 39% last week, while the Bearish bunch has been cut in half from 49% to 25%. The market will require some good news to keep these trends going (e.g., continued progress in the trade deal with China or a reversal in the recent spate of weak economic data), but even then, it would be unwise to extrapolate the current pace of stock gains too far into the future.
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Q4 GDP Preview. On Thursday we will finally get a look at the Q4 GDP report, which has been delayed by the government shutdown. The Atlanta Fed’s GDPNow forecast for Q4 growth is looking anything but rosy, having fallen off a cliff after the abysmal December retail sales report. Last week’s weak durable goods report subtracted another 0.1% from the estimate, bringing Q4’s estimated real, annualized growth rate to 1.4% – well off the 3%+ average growth rate from the preceding three quarters and below the post-Financial Crisis trend growth rate of approximately 2%.
Having said that, the GDPNow forecast is highly volatile compared to the Blue Chip consensus GDP forecast owing to the forecast construction methodology. Whereas economists in the Blue Chip consensus estimates base their projections on anticipated growth rates for the entire quarter, the GDPNow forecast is “built” as actual data is released. The algorithm then extrapolates those data points to create a quarterly forecast. Hence surprises to the upside or the downside in key economic data releases during the quarter can whipsaw the forecast, as can be seen in the jagged green line in the chart below. As more data becomes available throughout the quarter, the forecast generally becomes more accurate.
What’s different this quarter is that the December Income and Consumption levels have not been released yet. With consumption making up roughly 70% of the economy, the lack of data in this key category renders the GDPNow forecast less reliable than it would otherwise be this late into the quarter. Even in periods without data release delays, the Atlanta Fed warns “..the forecasting error can still be substantial…” before the release of the GDP estimate. Suffice to say, Thursday’s actual GDP report will be watched closely for indications of whether growth is stabilized in December or deteriorated further.
The “Mendoza Line”. In Major League Baseball, a player that consistently hits below “200” (i.e., reaches base safely by putting the ball in play at least 2 out of every 10 opportunities at bat for a batting average of 0.200) is generally considered an offensive liability. No matter his defensive prowess*, the inability of a professional baseball player to consistently reach base is a harbinger to getting fired from a team. The term “Mendoza Line” originated in 1979 with Mario Mendoza of the Seattle Mariners. Mendoza had a history of poor performance at the plate, having hit below 0.200 in four of the five previous seasons. During an uncharacteristically slow start to the year, famed slugger George Brett’s teammates teased him “Hey, man, you’re going to sink down below the Mendoza Line if you’re not careful.” Brett shared the story with ESPN’s Chris Berman, and it stuck as a way to describe someone in a hitting slump.
Similar to a minimum batting average threshold in baseball that allows a player to remain in the major leagues, there are financial market metrics that serve as early indicators of economic growth troubles ahead. One such metric is the difference (aka, “spread”) between the yields on 10-year US Treasury and 3-month US Treasury bonds. When this spread has turned negative in the past, a recession has followed within twelve months on average. In the last 50 years, this simple parameter has predicted the previous seven recessions (the red shaded sections in the chart), with only one false positive.
Sources: Bloomberg and Covenant Investment Research.
This particular metric is so effective because it’s based on market participants’ assessment of whether Fed monetary policy is too tight. The Fed can control the front end of the curve through adjustments to the Federal Funds interest rate, but monetary policy doesn’t directly impact the yields of bonds that mature further in the future — those are set by investors buying and selling of bonds. Since the beginning of 2017 the Fed has raised interest rates eight times for a total of 2.00%. The yield on 3-month US Treasury bills has increased lockstep, rising from 0.47% to 2.40% over that period. Meanwhile, the yield on the 10-year bond began 2017 at 2.44% and currently stands at 2.65%, for a rise of roughly 0.20%, or 1/10 the amount of the increase in short-dated bond yields. The compression in the spread signals bondholders believe Fed monetary policy is getting too tight, leading to slower economic growth and continued inflation below the Fed’s target of 2.0% (inflation and associated higher interest rates is the most significant risk to US Treasury investments). Since economic growth and inflation are expected to remain low, investors are currently willing to accept a lower yield on their investment in longer-dated bonds.
As the chart highlights, the 10-year/3-month US Treasury Yield spread has been in decline since shortly after the Financial Crisis. However, it is only in the last year or so that the spread is reaching the critical threshold of going negative, i.e., falling below the “Economic Mendoza Line.”
Although the trend is concerning and is yet another data point indicating a deceleration of economic growth, it’s entirely possible that the spread widens out again. The Fed surely noticed the tightening yield curve spread, which contributed to their recent pivot from confidently hawkish to decidedly dovish. If the Fed’s rate hiking campaign has not already gone too far, or they cut rates soon, we may see the trend reverse as it did in the mid-1990s, a topic we will explore in Covenant’s upcoming Economic Review and Outlook. In the meantime, keep in mind that Mario Mendoza lasted in the Major Leagues for another couple of years after the term “Mendoza Line” became popular, and this economic expansion may not be done yet either.
* Pitchers, notably, are not held to any standard in batting as their value to a team is determined almost exclusively by the ability to get opponents out.
Last Week Today. January’s inflation data indicated that widespread pricing pressure continues to be a non-issue, supporting the Fed’s decision to lay down their interest-rate-hiking guns. | Retail sales fell 1.2% in January, pushing down the Atlanta Fed’s estimate of Q4 growth from 2.7% to 1.5%… a significant slowdown from the second and third quarter’s respective growth rates of 4.2% and 3.4%. December’s retail sales data were so shockingly poor that some economists dismissed them as inaccurate and expect a sharp upward revision in the coming months.
Reports on China/ US trade negotiations were positive, though non-specific, leading President Trump to announce he may extend the March 1st deadline for implementing new tariffs. | Congress and President Trump reached a border wall/budget compromise and averted another government shutdown that would have begun Friday. However, legal battles started percolating when President Trump declared a national emergency on Friday to reallocate funds to building a larger wall than the budget provided for, and these battles are unlikely to be resolved anytime soon. Indeed, dozens of court cases from President George W. Bush’s Secure Fence Act of 2006 that authorized the construction of about 700 miles of barriers along the border are still unresolved.
Despite the lackluster economic data, the Dow Jones Industrial Average gained 3.1% marking the 8th consecutive week of gains for one of the oldest, most well known and concentrated (30 stocks) stock indices in the world. The Dow is in the midst of its longest winning streak since 2017, which (if you recall) was one of the least volatile years on record for stocks. The following year, by contrast, saw two 10%+ stock market declines culminating in a nearly 20% decline for the S&P 500 in Q4. That 2018’s volatile Q4 would spawn eight weeks of consecutive gains would have seemed inconceivable on Christmas Eve, but ever since Santa Claus has been filling investors’ stockings as the U.S. stock market value has increased by $4.9 trillion (Wilshire Associates).
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Mind the Gap. Consumer Confidence (as measured by the Conference Board) appears to have peaked in late 2018. While the overall level remains elevated on a historical basis, a closer look reveals a troublesome trend. Before highlighting the cause for concern, it’s important to point out that this closely monitored measure of consumer confidence consists of two sub-indexes:
- The Present Situation Index – consumers’ assessment of current business and labor market conditions
- The Expectations Index – consumers’ short-term outlook for income, business and labor market conditions.
The general pattern for these two indexes is that during periods of economic recovery, the Expectations Index will be higher than the Present Situation Index, as consumers anticipate better times ahead. On the other hand, in the mid-to-late stages of an economic cycle, the Expectations Index tends to lag the Present Situation Index as consumers grow increasingly skeptical about the future. While both data series are volatile, wide gaps between the Present Situation Index and the Expectations Index have presaged economic recessions.
We recently highlighted the growing spread between these indexes in our 2018 Mid-Year Review and Outlook. Since then, Expectations have continued to deteriorate even as confidence in the Present Situation has remained reasonably stable, pushing the difference to a level not witnessed since the turn of the century. This variance was highlighted in a tweet by DoubleLine Capital’s founder and noted market soothsayer Jeffrey Gundlach: “The most recessionary signal at present is consumer future expectations relative to current conditions. It’s one of the worst readings ever.” Indeed, the difference between the two surveys has only been wider three times in history going back to 1967.
In January, the Present Situation Index was virtually unchanged from last month suggesting economic conditions remain favorable. The Expectations component, however, declined sharply as Q4 stock market declines and the government shutdown soured consumers’ view of near-term future business conditions, job availability, and wage growth. Indeed, since October, the Expectations Index has plunged 24%, blowing out the spread to -82.3.
We caution that these indices are poor timing tools as the spread between consumer confidence in present conditions and expectations can remain wide for extended periods before economic growth turns negative. However, this situation bears watching because a confident consumer is imperative to economic growth since consumption is responsible for approximately 70% of the U.S. economy. If nothing else, the sentiment gap underscores the reality that the economy is growing at a much slower pace than it was last year.
Last Week Today. Senators Bernie Sanders and Charles Schumer announced a plan to introduce a bill limiting corporate stock buybacks. This bill suggests that the government knows better than management teams how to allocate scarce capital in the most productive capacity. I wonder if the esteemed senators have read Ayn Rand’s Atlas Shrugged? | In the “Are they negotiating or is this real?” category, Larry Kudlow and President Trump made pointed comments on negotiations with China. Kudlow said there was a “pretty sizeable distance” in trade negotiations between the U.S. and China. Meanwhile, President Trump announced he does not intend to meet with Chinese President Xi Jinping before the March 1st deadline to reach a trade deal. The market disliked the former and was indifferent to the latter. | Former Fed Chair Janet Yellen appeared on CNBC, offering support for the Fed’s newfound monetary policy patience, “If global growth really weakens and that spills over to the United States, or if financial conditions tighten more and we see a weakening in the US economy, it’s certainly possible the move is a cut, but both outcomes are possible.”
Domestic equities eked out a small gain for the week, while slow growth in the Eurozone and talk of “technical” recessions in Germany and Italy dragged down overseas stocks. Pulling back the camera a bit, the global equity market rally since Christmas Eve has been impressive, erasing most of the December swoon as shown in the chart below of the MSCI All Country World Index. However, the rally has yet to overcome losses sustained in the first bout of Q4 volatility from October. The message here is that while equities looked attractive back in December, and have rallied nicely since then, further gains are unlikely to come as fast. Closing the gap from early October to make new highs will require some combination of positive geopolitical news, improved economic data, or better earnings outlooks, none of which occur overnight.
Sources: Bloomberg and Covenant Investment Research.
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Reading Tea Leaves. The relatively modest gain for the S&P 500 belied the intraday moves that threatened to take the index lower. On Thursday the S&P 500 declined by 1.6% before an end-of-day rally pushed the index to close down less than 1%. On Friday, the market was in the red all day long until the final minutes pushed the index into positive territory. Friday was the seventh day in a row that the S&P 500 rallied during the last hour of the day (Bespoke Investment Group). Some see the pattern of late-day buying as a bullish indicator. They reason that trades made at the start of the day are based on emotional reactions to the overnight news and that trades later in the day are less emotionally driven. Wall Street trading-lore is filled with these types anecdotes and investors are welcome to trust their money to these ephemeral patterns. However, no trading pattern will trump fundamentals in the long-run. That is, ultimately stock prices are based on the present value of future cash flows whether you buy the stock at the end of the day or the beginning.
Speed Bumps. The European Commission lowered estimated 2019 GDP growth for the Eurozone by nearly 33% from 1.9% to 1.3%. Australia’s central bank lowered its outlook for growth. India’s central bank cut interest rates in a surprise move. Although the US economy is a relatively closed, service-oriented economy, is it any wonder that the Federal Reserve adopted a “patient” outlook given slowing growth prospects globally?
Q4 Corporate Earnings – not too shabby. To date, approximately two-thirds of S&P 500 management teams have reported Q4 2018 results. Although investor expectations were low, either due to guidance from management or general pessimism, 47% of firms have beaten consensus Earnings per Share (EPS) estimates by at least one standard deviation, which is in line with the long-term average. Consensus estimates called for a 12% increase in EPS, but thus far companies are tracking 14% growth. Highlighting the general state of pessimism, the share prices of companies that beat profit expectations have jumped an average 2.47% on the day after reporting earnings – the highest magnitude of outperformance since Q3 2009 during the Great Financial Crisis. (Source: Goldman Sachs)
Economic Data Update. The government closure delayed fourth-quarter economic data releases, but now that government has been open for a couple of weeks, the data is beginning to flow again. During our quarterly IC meeting next week, we will discuss the recent economic data in detail and the investment implications therein. In the meantime, below is a snapshot of a handful of current economic trends and how our resident economist of Foleynomics is viewing them:
- Housing remains in the doldrums. Not collapsing, but certainly not a growth driver. The best I can say is that activity levels are steady or stagnant, take your pick.
- Factory orders have been weaker, with core orders down sequentially three out of the last four months. However, we are coming off very robust spring and summer numbers that were boosted by pre-tariff inventory stocking. Current limited data suggests real GDP slowing into the low-2% area. The various surveys (ISM manufacturing and non-manufacturing for example) have been ok. It’s the global data that is concerning.
- The all-important consumer is showing signs of spending restraint. Credit card spending has been weak lately. The latest consumer confidence & sentiment data did not inspire much….confidence. Sorry, that just had to be written :). Some of this surely reflects the shutdown, how much is unknowable for now.
- Based on what I think I know, available data continues to suggest weaker but steady growth. Both the NY Fed and the Atlanta Fed have 4Q estimates in the mid-2% range, and both models are due for updates. 1Q estimates (guesses) are low-2% for now. All else equal, this morning’s trade report should boost the 4Q estimates a bit even if for the wrong reasons.
- I won’t name names, but some soothsayers are practically cheering for a recession. Let’s stipulate that eventually all of those flag-planters will be correct. If we do get a recession this year though, it will surely rank as one of the best advertised ever. As for me, I’ll stick with my slower but “ok” call for the year, at least for now.
Weekly Synopsis Notes
Last Week Today. The Government got back to work. Financial markets did not reward the re-opening, implying that investors (conditioned by past government closures) did not pay much mind to the initial government closure either. | Central Bankers expressed less optimism about the future as the ECB and the Fed both backed away from attempting to tighten financial conditions in their respective economies. | The European Central Bank’s President Mario Draghi announced the ECB might restart quantitative easing (QE), only one month after it officially ended in December 2018. | The Fed’s meeting last week reinforced their ‘mea culpa’ following the December-disaster, and not only are Fed rate hikes on pause for now, but Quantitative Tightening may end sooner than previously thought. | US and Chinese representatives met for two days in Washington D.C. and appeared to make progress on trade negotiations.
Whipsaw. After posting its worst December in 87 years by falling 9%, the S&P 500 rallied 7.9% in January. Even more impressive, at 2,706, the S&P 500 has rallied 15% from the Christmas Eve low of 2,351. For detailed weekly, month-to-date and year-to-date asset class performance, please click here.
The Four Horsemen of US Equities. At this point, it seems that the key variables determining the direction of domestic equities in 2019 will be 1) Fed policy and interest rates, 2) China’s economic growth, 3) Trade Policy, and 4) Earnings Revisions. Because financial markets are anticipatory systems (i.e., today’s prices discount future outcomes), what will matter most is the marginal change in each variable, relative to investor expectations. A summary of the current status and future expectations of each variable follows below.
- Fed policy and interest rates – This past week’s news on Fed policy was more than a marginal change relative to market expectations; it was a paradigm shift. Whereas only one month ago the Fed presented an obstinate view despite financial market turmoil, including a balance sheet reduction on “autopilot” and “some further gradual increases” in rates were forthcoming, this week’s Fed revealed it would not raise rates for the foreseeable future. While the pause is welcome, the market may have gotten ahead of itself by assuming the Fed is done hiking rates this cycle. Indeed, interest rate futures are assigning an 87% probability of no hikes in 2019 and an 11% chance of a rate cut by year-end. Contrarian investors would observe that the markets, and therefore risk assets, are set-up for disappointment.
- China’s economic growth – Economic data from China indicates the economy is slowing, but still expanding at around 5% per annum (though, admittedly, Chinese data is notoriously unreliable). No one expected China’s transition (some would call it a maturation process for the 2nd largest economy in the world) from an export-based economy to a consumer-based economy would be smooth, and the ongoing trade battle with the U.S. is exacerbating growth issues. Many economists expect the Chinese government to introduce new fiscal stimulus to reverse the slowing growth trend, but recently stimulus has had mixed results and, hence, near-term risks are skewed to the downside.
Source: Goldman Sachs
- Trade Policy – This variable is best described as ‘uncertain.’ Recent press reports indicate the negotiations are yielding progress, but on what specific issues it remains unknown. In broad terms, the issues fall into two categories: the bilateral trade deficit and intellectual property disputes. The former can be cured relatively easily (e.g., China can simply purchase more soybeans from the US), but the latter issue is thornier. Most believe that either some interim agreement will be reached by the March 1st deadline or the deadline will be extended to avoid implementing the scheduled tariff increases from 10% to 25% on $250 billion of China imports and new tariffs on an additional $258 billion of imports. If the deadline comes without one of these resolutions, equity markets will be at risk.
- Earnings Revisions – 2019 S&P 500 earnings per share estimates have been cut by 2% during the past month and by nearly 4% in the last three months, reflecting slower domestic and global growth. Consensus earnings estimates for the S&P 500 center around 6% year-over-year growth over 2018. Indications by management teams of further slowing in 2019 will result in lower equity prices.
Notes From the Road. Traversing a very chilly East Coast last week, below are key observations from a variety of meetings with hedge fund masters of the universe.
- Based on conversations with corporate management teams, the economy looks pretty darn good. Slower growth, but growth nonetheless. They are nervous across the board about the ability to hire (labor availability) and cost to hire (wage inflation).
- We expect a lot of mergers and acquisitions to be completed this year because of the market sell-off in 2018. Corporate management teams are happy their stock prices are off their lows, and having been reminded about how bad things can get for their respective stock price, and many feel that now is an excellent time to sell.
- The Fed has been so admonished they will likely not do anything for at least six months. “A 2% growth economy with the Fed out of play is better than a 3% growth economy with the Fed in play”.
- In credit markets, December did not present many opportunities to add to positions. There were not a lot of weak hands forced to sell, even though some bond prices declined significantly.
- One of our largest portfolio concentrations is in small business lending. This gives us a good view of the real economy and things look fine right now, in spite of the government shutdown, China trade tensions, and slowing economic growth.
- After falling an average of 12%+ in 2018, large, diversified MLPs are attractive. They’ve become fiscally conservative since oil bottomed in 2016 and during December’s turmoil were selling at cash-flow multiples similar to where they were in the first quarter of 2009 when the entire financial system was on the brink of collapse.
- The notion that corporate debt markets lack liquidity is a myth. Yes, the Volcker Rule [a component of the broader Dodd-Frank Wall Street Reform and Consumer Protection Act] eliminated much of the proprietary trading by large banks. Nevertheless, trading volumes are at record highs as hedge funds have replaced banks as the liquidity providers. Moreover, because banks don’t own the paper, the systemic risk from corporate defaults is lower than in the past.
- We haven’t raised a distressed debt fund since 2009, but we are now. We don’t see another 2007 in the future because that was a systemic banking problem. However, Fed-induced low rates have encouraged investors to buy risky corporate debt with thin covenants. The animal spirits that have driven corporate debt prices higher in the last few years will reverse when people begin asking themselves what have I been buying for the last five years? When that happens, corporate bond bonds will sell off and, since banks are not a meaningful player anymore, the prices won’t stop at 90 because buyers like us won’t step in with a bid until the prices reach 70 or 80-cents on the dollar. This is the opportunity we are seeking to capture with our new distressed debt fund.