Covenant Weekly Market Synopsis 1.20.17

January 20, 2017

In contrast to a huge week in politics that ended with the peaceful transition of power to the new administration, markets were fairly quiet and that is a good thing. Most developed market indices ended marginally lower, while the yield on the long end of the Treasury Curve rose by a handful of basis points. Crude oil prices were volatile, but ended the week up 0.4% at $53.22 per barrel. Precious metals continued to move higher; gold (+5.5%) and silver (+7.3%) are the best performing assets early in 2017.

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

Correlation Crash: Since the Financial Crisis active investment managers have been severely challenged to beat their respective benchmarks, particularly in the last few years. For the most part, this period has been dominated by a unidirectional market characterized by low volatility and low dispersion. Volatility and dispersion are key ingredients for success in actively managed strategies, be they long-only or relative value hedge fund strategies.

  • Volatility is the magnitude of a financial security’s price movements (up or down)
  • Dispersion is the degree to which financial securities move relative to each other and is the flipside of correlation (i.e. low correlation usually equates to high dispersion, and vice-versa).

An ideal market for active managers is one characterized by moderate volatility and high dispersion as this environment increases the number of mispriced securities and leads to an increased number of potentially profitable trades. As the following chart highlights, measures of correlation have recently fallen off a cliff leading to increased dispersion.

Sources: Bloomberg, Morgan Stanley Research

The chart is a composite measure of regional correlations (e.g. US vs. EAFE stocks), cross-asset correlations (e.g. stocks vs. bonds) and individual stock and currency correlations. The historical decline in correlations is an unequivocally positive development for active managers because markets and securities are finally moving independently. Against a backdrop of stretched valuations and indications we are at the latter stages of the current business cycle, active managers with the flexibility to invest long and short across various asset classes should have a particularly ripe opportunity set ahead.

Inflation and Employment: With the headline unemployment rate hovering below 5% and job gains averaging around 189,000 per month, the topic of wage-push inflation has become increasingly popular.

“Wage-push inflation” is a general increase in the cost of goods and services resulting from an increase in wages. Rising wage trends can occur for a number of reasons, but they are generally associated with a tight labor market in which employers must compete for scarce labor. With a low unemployment rate and the recent 2.5% earnings increase (year-over-year) for hourly workers, the wage-push debate has grown louder. However, the relationship between the labor market and inflation is much weaker than most believe. In a speech to the Stanford Institute for Economic Policy Research last week, Fed Chair Yellen illustrated this point.

Source: Board of Governors of the Federal Reserve System

The Unemployment Gap (dotted black line) is a measure of labor market tightness which compares the current unemployment rate to the theoretical rate at which further labor gains should increase inflationary pressures. Core PCE (Personal Consumption Expenditures, shown as the red solid line) is the Fed’s preferred measure of inflation. The yellow shaded areas in the chart highlight those periods of time in which the Unemployment Gap was negative. The takeaway from the chart is that even though the Unemployment Gap has been negative on several occasions, inflation rose little, if at all. This is yet another reason we believe inflationary pressures will remain subdued in the economy, even if there is a short move higher in the readings over the next few months as annual comparisons incorporate weak data from early last year.

Weekly Economic Data Summary: The Consumer Price Index showed a 2.1% rise in annual inflation for December (vs. 1.7% in November), led by a 1.5% increase in energy prices. Core CPI, which excludes food and energy prices, came in at 2.2% year-over-year, right in the middle of the 1.5% to 2.5% range it has maintained since 2011. Housing starts increased by an above-expectations level of 11.3%. This is a volatile series, and while the longer-term trend is supportive for housing, it does not indicate that the sector is about to breakout to the upside.

Be well,