In this week’s edition of CIO Justin Pawl’s blog:
- Name Change – Time to rebrand the blog.
- Last Week Today – A summary of news impacting the financial markets and the economy.
- Financial Markets – An update on last week’s action.
- You’re Going to do What??? – Presidential candidate Elizabeth Warren has a plan for U.S. oil independence.
- Blame Game – The Fed ignores its own advice.
- IC Meeting Highlights – Yellow lights on our recession indicators are burning brighter.
When I began writing this blog more than six years ago, it was intended to provide a summary of key financial market and economic data points that shaped markets the previous week, and that had the potential to influence markets in the coming weeks. I thought of it as a scalable version of a Monday morning kickoff meeting intended to inform and educate my colleagues. Later we expanded the distribution to include clients and friends of Covenant. Now in its seventh year, we’ve decided to update the name based on positive feedback from clients about the brevity of the blog posts. Hence, we are renaming the blog, the “The Covenant 5-Minute Huddle.” The name reflects that the blog is designed to be read in five minutes or so, and, like a team huddle, it’s a short time together to plan for the play ahead. To keep to the 5-minute reading time, we will be publishing the Behavioral Finance posts in a separate series.
We will continue to deliver the Covenant 5-Minute Huddle with the CovenantU email each Monday. For those not familiar, in addition to this blog, CovenantU includes current videos and podcasts, giving you the flexibility to conveniently access information in the format you like when you like. If you know anyone that would benefit from the CovenantU content, which is designed to increase financial and economic literacy, please ask them to contact us, and we will add them to the distribution list. They can also add themselves to the distribution by texting “COVENANTU” to 22828. Thank you for your questions and your support.
Ready. Set. Go! Five minutes starts now. – Jp.
Last Week Today. The Brexit nightmare continued into extra innings with some procedural events taking place, lots of arguments/debates, and another extension. | Mario Draghi presided over his last meeting as President of the European Central Bank, stepping aside to make room for Christine Lagarde. Recently Managing Director of the International Monetary Fund, it’s expected that Ms. Lagarde will focus less on monetary policy and more on convincing Germany that fiscal stimulus is necessary to cure the slow growth ills of the Eurozone. | Sweden’s central bank (Riksbank) will end its 10-year experiment with negative rates, as it announced plans to raise rates in December to 0% despite slower growth and a weaker labor market. Riksbank was the first central bank to implement a negative rate policy on July 2, 2009. | U.S./China negotiators indicated progress in Phase 1 of the trade deal, which is looking like it may be ready for Presidents Xi and Trump to sign next month at the Asia-Pacific Economic Cooperation meeting in Chile. The deal won’t be perfect, and long-term issues remain, but at least both sides have agreed to measures tempering trade tensions.
Financial Markets. Global equities rallied for the third consecutive week, as the MSCI All Country World Index rose +1.3%, and is now up +2.2% in October. The S&P 500 gained +1.2% and is only a fraction of a percent from new highs, while the Dow and Nasdaq Composite indexes’ gains pushed them to within striking distance of their respective highs as well. Don’t look now, but Developed International stocks have modestly outperformed domestic equities over this timeframe, giving some credence to those who have been pounding the table that the bad news in Europe is already priced into markets. If that’s the case, things don’t necessarily need to get better overseas; they just need to stop getting worse for equities to rise further. Treasury bond prices fell (yields rose) modestly, while commodities gained on the week including precious metals (Gold +1.0%, Silver +2.8%), Copper (+1.5%), and WTI Crude, which rose +5.4% to $56.66 per barrel. For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here. This week the Federal Reserve meets and is expected to deliver another rate cut.
You’re Going To Do What??? This is not a political statement, as I don’t play politics in this blog. Just reporting the news…. Elizabeth Warren, if elected, last week reiterated her pledge to ban fracking in the U.S. on her first day in office. Analysts suggest a ban would eliminate entire oil services companies and hundreds of thousands of (high paying) jobs. Furthermore, U.S. oil production would backslide from 12 million barrels per day (mbpd) to the pre-fracking era of 5 mbpd. The U.S. would once again be reliant on imports, and analysts forecast oil would likely trade at $85 per barrel with spikes to $150 during periods of short supply.
Blame Game. I’m going out on a limb to state that if the economy succumbs to a recession in 2020, look to the usual suspect for culpability, the Federal Reserve. The limb I’m on is skinny because the Big Brains at the Fed have far more intellectual firepower than I. However, the Big Brains have a weakness, and that weakness is their reliance on financial models that have not worked for decades. Through the continued yield-curve inversion, the market has been shouting that interest rates are too high. Chairman Powell himself has argued that more aggressive monetary policy action is necessary to avoid returning to zero interest rates. Yet, the Fed has not followed its own advice. What makes their lack of action more damning is that the usual Fed boogeyman, inflation, is nowhere to be seen. The Fed could have cut rates faster earlier this year, or instead of moving in 25bps increments, they could have cut by 50bps at one of their meetings, which, for a change, would have caught markets off guard (in a good way).
Ironically, aggressive monetary policy action earlier this year may have resulted in fewer cuts than are necessary now to unkink the yield curve. In the chart below, the yellow line is the yield curve as of April 30th, and the green line is the yield curve as of last Friday, October 25th. The points on the far left represent yields of bonds maturing within six months. As the chart shows, in April, when the Fed Funds rate was 2.25%, one rate cut would have cured the yield curve inversion. That is, the yields on the front-end of the curve (bonds maturing in 1-6 months) would have been pushed below that of bonds maturing in two years and longer. Instead, the Fed waited and the yield curve became more inverted. Now, after two rate cuts so far this year, though overall interest rates are lower, the Fed must cuts rates further to un-invert the curve.
Source: Bloomberg, L.P.
Keep in mind that with the neutral interest rate level estimated at 0.75% to 1% (the level at which interest rates are neither stimulative nor restrictive), and the current Fed Funds rate at 1.75%, the Fed’s rate cuts are not increasingly accommodative, they are merely less restrictive.
IC Meeting Highlights. Last week Covenant’s Investment Committee held its quarterly confab, and it was a doozy. In our 2019 Mid-Year Economic Review and Outlook, we concluded with “In sum, overall levels of activity support continued “Good but not great” growth of around 2%, but there are worrisome trends implying downside risks to this forecast have increased.”
Our assessment of Q3 data, unfortunately, confirmed that those worrisome trends highlighted in the Mid-Year Outlook remain intact. Leading indicators are deteriorating, and our outlook for the economy has been downgraded. The lightning rod of our concerns is planted firmly at the feet of the all-mighty consumer. Consumption includes Services purchases, Nondurable goods purchases, and Durable goods purchases, and collectively these “Big 3” comprise approximately 70% of U.S. GDP. As highlighted in the blue-shaded portion of the chart below, a healthy consumer is essential for the economy to expand. In the second quarter, when the economy expanded at a real (inflation-adjusted) annualized rate of 2.0%, the Big 3 contributed growth totaling about 3.5% (with other sectors detracting -1.5%). In Q3, all of the Big 3 areas of consumption are slowing, and collectively tracking to expand at a real, annualized rate of only 1.8%.
Why have consumers pulled in their spending horns? There are several possible explanations, most centering on uncertainty, such as uncertainty about the political situation (upcoming Presidential election and impeachment) and uncertainty about trade with China. Another possible explanation, and the one that concerns us the most, is that while the labor market is tight, the total amount of income earned by consumers is trending downward. But aren’t people getting raises? Yes, wages are rising; however, in the aggregate, total hours worked is falling. This scenario can occur because of layoffs, or the more likely cause is that managers are cutting back on workers’ hours to reduce costs while retaining talent in a tight labor market. See the chart below, which highlights the divergence between the average number of jobs added over the last six months (150,000), and the equivalent amount of jobs added based on hours worked (71,000).
Source: Foleynomics and Covenant Investment Research
Bottom Line: The consumer has been the primary source of growth in the economy as manufacturing is in contraction, government stimulus is waning, business investment has been low, and housing is in the doldrums. A recession is not “baked in the cake,” but our forecasting indicators are flashing an increasingly bright shade of yellow, and we need to hold these levels to avoid recession in 2020.