Monthly Archives: May 2019

Last Week Today. German Bund yields went negative (again), reaching a 1.5-year low of –0.106%. | President Trump and his team began moving pieces on the global trade chessboard for countries not named “China”: tariffs on European and Japanese autos delayed for at least six months; steel/aluminum tariffs removed for Canada and Mexico; Turkish steel tariffs cut to 25% (from 50%). | China instituted retaliatory tariffs on $60 billion of US imports and increased their rhetoric against the US Indeed, the government is even allowing nationalistic voices to rise in the tightly controlled media for the first time in this standoff, a move that will complicate trade negotiations for both sides as “saving face” will become a more prominent theme for China.


Global risk assets took it on the chin Monday as negative trade headlines caused investors to head for the exits (Global Equities -1.9%, S&P 500 -2.4%). However, investors digested the evolving situation, and by the end of the week, equities had rallied back to regain much of Monday’s losses. Developed International Markets closed the week in positive territory, while domestic equity indices ended the week down less than 1%. At the half-way mark in May, equities are in negative territory with US and International Developed Market stocks down 2.4% – 2.8%, while Emerging Market equities are bearing the brunt of the pain at -7.6%, owing to their China exposure. Considering the risk-off mood, investors moved to the haven of US Treasury Bonds, pushing yields down across the maturity curve. The yield spread between 10-year and 3-month bond maturities went slightly negative mid-week (i.e., “inverted”) again, as bond traders continue to believe the Fed’s monetary policy is too tight.

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

157. This is the 157th edition of the Weekly Synopsis. Why mention the number? Well…. truth be told, we didn’t notice when we crossed the 100th edition. Our hope in writing these pieces (nearly) every week is to offer a resource for improving financial literacy with regards to current market events, the economy, investment principles, investment strategies, and such. Our intentions are not purely altruistic, as we learn by studying and writing about the various topics each week, including the ones that don’t make it into the weekly missive. We will continue sharing our thoughts and research and hope you will keep reading (and please share with anyone else you think would be interested) because intellectual curiosity and lifelong learning are genuinely about the journey and not the destination.

Passive vs. Active Management Part Deux. We wrote about this topic, back in April. However, given the continued large flows out of active and into passive investment strategies, it’s worth revisiting. This discussion of Active vs. Passive is more detailed as it’s informed by a recent analysis from Fidelity, which supports our original thesis, but provides a more robust analytical framework.

Since 2014, investors have pulled more than $500 million from Active strategies, while Passive strategies gained some $1.5 trillion in assets. The reason for the flows is rather evident as investors are prompted continuously by factually accurate, but technically weak, charts, and graphs like the one below that highlights passive investing’s superiority.


Source: Fidelity Investments

A few things to note on this chart:

  • The benchmark is the S&P 500 Index (gray bars). As we pointed out in our April piece, you cannot invest in an index. You can only invest in a vehicle that provides investment results that are intended to track an index. Indexes are “paper portfolios” – they exist in theory, but do not incur the frictional costs of investing, including buying/selling securities, accounting, administration fees, etc. Even vehicles with no management fees (e.g., the latest ETFs) typically lag their respective benchmarks because they are subject to these real-world costs.
  • More importantly, in the chart above, Active Management is represented by the “Average” fund. Who invests in average funds? While one may not be able to consistently select the top decile or quartile funds, with a little effort, it’s relatively easy to avoid the bottom quartile funds which drag the average down.
  • This chart and, indeed, most of the industry research is limited to data on Passive vs. Active strategies investing in U.S. Large Cap stocks. From this limited data set, investors (aided and abetted by most forms of media) make the leap of logic that if Passive outperforms Active in U.S. Large Cap stocks, it must be true everywhere else.

Fidelity’s research corrected for some of the common deficiencies cited by the media and included a couple of simple assumptions in filtering the universe of Active strategies: exclude strategies with the highest fees in each category (i.e., in the top quartile); and eliminate strategies with a Morningstar rating of only 1 or 2 stars.

The results of Fidelity’s work run counter to the media’s narrative, as highlighted in the chart below. In this chart, Active strategies are represented by the “green” dots and Passive investments by the “blue” dots. The horizontal line at 0% represents the benchmark index for each category; thus, the area above the line represents outperformance relative to each category’s benchmark.


Source: Fidelity Investments

Active management outperformed Passive in 11 of the 19 investment categories. From the results, certain investment categories offer a better opportunity for Active management to outperform. These categories share characteristics such as high dispersion (i.e., the stocks within the category tend to move independently of one another by a significant amount), lower competition, and/or less analyst coverage.

On the flip side, it’s not surprising to see that Active Management struggled to outperform Passive in U.S. Large Cap stock categories (e.g., Large Growth, Large Blend, and Large Value). Remember, this is the same category from which the media has been drawing its conclusions regarding the superiority of Passive over Active investing.

Finally, Fidelity’s research concluded that the performance tradeoff between Active and Passive is highly cyclical. Interest rates and the economic environment are likely contributing factors as the data implies that Passive strategies tend to outperform in periods where the economy is reasonably stable, and interest rates are low and/or falling. In these periods, companies’ cost of capital is low obfuscating the differences between good businesses and bad businesses. By contrast, in more challenging economic environments, or when the cost of capital is rising, investors are better able to differentiate between the wheat and the chaff.

Indeed, the last 10-year period of declining rates and a generally stable economic environment has been tailor-made for passive strategies. Consider that 37% of all Russell 2000 Index companies are not profitable ten years into a bull market (Source: Fidelity Investments). It stands to reason that if the cost of capital begins to rise, or the economy turns south, an Active strategy that differentiates between profitable companies and unprofitable ones will outperform a Passive strategy that purchases all 2,000 names in the Index.

In summary, Covenant’s position in the Active vs. Passive debate is to rely on Passive management for the most efficient markets but to consider Active management options in sectors or geographies where markets are less efficient. However, a lack of market efficiency only offers a clue for where to begin searching for Active strategies. Because Passive strategies offer exposure at a low cost, any Active manager that makes it into a portfolio must exceed high standards. While historical performance is an important consideration, it is only one part of the selection process. Qualitative assessments of the strategy, investment process, buy/sell disciplines, and the people involved play a more significant role than is generally recognized.

Be well,


Synopsis 2019.05.10

Last Week Today.  Trade negotiators for China and the U.S. failed to reach an agreement last week, an event well-covered by the media. However, on Sunday White House economic adviser Larry Kudlow revealed President Trump’s cognitive dissonance on tariffs when he conceded that China is not paying the duties as the President regularly asserts. Instead, American companies purchasing goods from China pay the tariffs, which is in effect a tax increase that is often passed on to the consumer. | The widely anticipated initial public offering of ride-hailing superstar Uber Technologies, Inc. was a disappointment. The IPO priced at the low end of the offering range (not a good initial sign) and then fell 7.6% on Friday, its first day of trading. Of course, one day does not determine the future of this stock, but it is a good reminder that the friendly stockbroker calling with an offer to sell you IPO shares does not make for a risk-free investment.

Although media outlets produced provocative headlines on Friday varying on the theme “Worst Week for Stocks Since December 2018”, the damage was rather light. The S&P fell 2.1%, International stocks (MSCI EAFE) declined 2.9%, and the antagonist in the trade negotiation saga, China dropped by 4.7%. It could have been a lot worse, save the on-again, off-again trade talks ended the week in the “on” position as in “we’re continuing to speak.” For all the intraday whipsaws, the S&P 500 ended the week only 3% off its all-time high. That interim low will be tested this week as encouraging words on Friday gave way to finger-pointing between China and the U.S. over the weekend. Unless investors detect some encouraging news on the trade front, this upcoming week could be a rocky one for risk assets. Speaking of which, volatility is back in vogue, as the VIX Index is averaging 16 with a peak of 23 thus far in May vs. an average of 13 and a peak of 14.4 in April.

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

The Enemy of My Enemy.  President Trump is openly critical of the Fed, calling for lower interest rates and another round of Quantitative Easing. Though under attack for raising rates in December, Fed Chairman Jay Powell’s real enemy is a lack of inflation. Interestingly, President Trump’s move to reinstate tariffs on China will lead to higher prices for Chinese-produced goods. Although only expected to increase inflation by about 0.2%, Fed Chair Powell will take it in an effort to prove their last rate hike in December was not a mistake (though it almost certainly was).

“Good but not Great Growth” Thesis in Jeopardy.  Last week we held our quarterly Investment Committee meeting. We parsed the recent economic data, challenged each other’s views, and reviewed outsiders’ perspectives.  As we sifted through the economic tea leaves it became apparent that our long-held thesis of “Good But Not Great” economic growth (i.e., sustainable real GDP growth of 2% – 2.5%) is under threat from a weak global economy, overly tight domestic monetary policy, and weakness in the cyclical sectors of the economy.  Irrespective of the 3.2% Q1 GDP print, the net effect of these headwinds is slowing economic activity.

One need look no further than the Chicago Fed National Activity Index (CFNAI) for evidence of just how much economic growth has slowed since the peak in mid-2018. The CFNAI is a weighted average of 85 monthly indicators designed to measure overall economic activity and inflationary pressure, including data from four macroeconomic categories:

  • Production and income
  • Employment, unemployment, and hours worked
  • Personal consumption and housing
  • Sales, orders, and inventories

The index is engineered to have an average value of 0 (based on the trend growth rate) and a standard deviation of 1. As economic activity is cyclical, a positive reading indicates above-trend growth, while a negative reading implies economic activity is flagging. Furthermore, readings above 0.7 suggest activity is significantly higher than the sustainable potential growth rate, which leads to inflationary pressure. Readings below 0.7 indicate increasing risk of a recession and lower inflation.


Sources: Federal Reserve Bank of Chicago and Foleynomics.

While the series is volatile, even on a 3-month moving average, the upward trend that began in early 2016 has broken down. The last two recessions (2000/2001 and 2008/2009) are evident in the data as the index falls through the bottom of the chart. We don’t believe the economy is headed for that type of slowdown, but the trend is undoubtedly concerning and somewhat reminiscent of the 2015/2016 period in which economic growth slowed but did not turn negative. As a reminder, slowing growth increases the volatility of financial assets, and in 2015 the market suffered two drawdowns of more than 10%. Those market corrections didn’t end the bull market, but if growth continues to slow investors should prepare for higher volatility and lower long-term total returns based on current valuations.

Another conclusion evident in the CFNAI chart is that inflationary pressures remain low in the economy. While data last week showed Core CPI rose 2.1% on a year-over-year basis the reading was largely due to low inflation readings from one year ago that flatter the current April reading. Indeed, on a 3-month annualized basis, Core CPI is ticking along at just 1.6% (Capital Economics), which is not what the Fed is hoping for in substantiating their December rate hike.

Bottom Line: We are not giving up on the Good But Not Great Growth outlook, but we are slightly less confident in the forecast. Although headline GDP growth in Q1 was strong at 3.2%, more than half of the growth came from transient factors such as increased inventories (~70bps) and net exports (~100bps) that are extremely unlikely to be repeated in Q2. Our “no recession in 2019” outlook relies on the strength of the consumer to overcome the current weakness in other sectors of the economy. The good news is that the Consumer is in relatively good shape:

  • The labor market is plateauing, but not shrinking
  • Wage growth is accelerating
  • Debt levels are low relative to Disposable Income (excluding Student Debt, which probably won’t be paid off in any event)
  • Consumer Confidence remains elevated

As the chart below highlights, Real PCE is running at nearly 2.9% year-over-year, supported by strength in expenditures on Services which make up almost 45% of total GDP. So long as the consumer continues to consume, a recession is unlikely.



Sources:  Bureau of Economic Analysis and Foleynomics.

Be well,


Last Week Today: China’s manufacturing PMI unexpectedly fell to 50.1 in April (from 50.4 in March) coming dangerously close to 50 – the threshold marking expansion or contraction. | President Trump and top Democrats (including Pelosi and Schumer) outlined a $2 trillion infrastructure plan focused on improving mass transit and expanding broadband systems. Bipartisan anything is a rarity in D.C. these days, but the problem is how to fund the program. | A big, busy week for economic data and below we highlight the Good, the Bad and the Ugly.

The end of April marked the fourth consecutive month of positive performance for global equities as reduced trade tensions and more dovish central banks buoyed risk assets. For specific weekly, month-to-date and year-to-date asset class performance, please click here.

However, as you are waking up this morning, the U.S./China trade deal has hit a rough patch, and global equities are selling off anywhere from -6% (China) to -2% (U.S. and Europe). Headlines are changing quickly, so anything I write now will be out of date by the time you read it. Suffice to say that if the U.S. and China fail to seal a trade deal, an outcome that has already been largely priced into equities, today’s sell-off will morph into something more serious.

Fed Update… Nothing is less. The Fed made no change to current interest rates in their third of eight meetings this year… no surprise. However, in the post-meeting press conference Chairman Powell caught the market off-guard, or perhaps “offsides” is a more appropriate term, when he made several remarks indicating that the Fed is on hold, despite falling inflation (see chart below) that many investors believed would result in a rate cut later this year.


The same “patient” stance that investors rewarded in January during the Powell pivot from hawkish to dovish was punished as investors voted with their wallets causing the S&P to decline by nearly 1% from the intraday highs. The problem with the Fed’s decision is that if they are genuinely following their recent commentary of a symmetrical approach to monetary policy (i.e., treating the 2% inflation target as an average rather than a ceiling that should be avoided) they would be cutting rates now as inflation moves further away from the vaunted 2% level.

It’s entirely possible (and unfortunate) that politics is playing a role in the Fed’s inaction. The Wall Street Journal’s Nick Timiraos shares this concern “Cutting rates could be complicated coming after President Trump has called repeatedly for the Fed to do so. Central bank officials have said politics never influence their decisions. But Mr. Trump’s comments would put more pressure on them to explain any policy changes so that doubts about their independence don’t erode their credibility in the markets.” If anywhere close to accurate, the President (who is in favor of easier monetary policy) is his own worst enemy publicly calling for rate cuts and more Quantitative Easing.

Eco Data Update. It was a busy week for economic data releases.

The Good

  • Productivity, as measured by output per worker hour, jumped to 3.6% in Q1. On a year-over-year basis, productivity rose 2.4%, which is the fastest late-cycle growth rate since the Greenspan-led Fed allowed the economy to run above potential in the late 1990s. Higher productivity is a buffer against higher inflation and enables real wages to increase as well.


  • The April jobs report showed robust hiring, adding 263,000 new jobs. The unemployment rate fell from 3.81% to 3.59%, a new low for this business cycle.


Source: FTN Financial

  • Unfortunately, some of the decline in the unemployment rate was due to a reduction in the labor force participation rate from 63.0% to 62.8%. As a result, the broader measure of unemployment (the U-6 rate) and the best predictor of wage growth, held steady for the third consecutive month at 7.3%.

The Bad

  • April’s ISM Manufacturing survey fell to 52.8 (from 55.3 in March), marking a 2.5 year low:
    • New orders fell from 57.4 to 51.7, lowest since December.
    • Production fell from 55.8 to 52.3, lowest since Aug 2016.
    • Employment fell from 57.5 to 52.4, lowest since Feb.


Source: FTN Financial

  • The ISM non-Manufacturing survey declined modestly from 56.1 in March to 55.5 in April.
  • The MNI Chicago Business Barometer recorded its lowest reading in two years, dropping from 58.7 in March to 52.6.

The Ugly

  • Auto Sales (annualized) fell from 17.5 million in March to 16.4 million in April.
  • Within the ISM Manufacturing survey, the export and import orders sub-indices fell into negative territory, highlighting the real-world impact of trade tensions.


Bottom Line: Overall economic activity is plateauing, which is not surprising following the unsustainable 3.2% growth rate in Q1. The Atlanta Fed’s GDP Now algorithm is pointing to Q2 GDP growth of 1.7%. We don’t pretend to be good enough to forecast with that level of specificity. Directionally, however, it fits our expectations that GDP growth is headed back to the post-Financial Crisis trend rate of 2% – 2.5%, which is good, but not great growth.