Covenant Weekly Market Synopsis as of August 12, 2016

August 15, 2016

Unlike action in the Olympiad last week, international outperformed Team USA by 1% or more (in equity land). Domestic stocks did close the week in the black, but only by the slimmest of margins. US Treasury yields grinded lower, with the 10-year yield declining from 1.59% to 1.51% for the week, but well within the 1.4% – 1.6% range it has been trading the last two months. Precious metals were relatively flat on the week, while WTI Crude rose 7% to $44.72 per barrel, mostly on the hopes that Saudi Arabia will play ball with OPEC and agree to reduce production if oil prices remain weak. We’ve seen this movie on multiple occasions since the price of oil began its decline, but perhaps with a planned IPO of state-owned Saudi Aramco in 2017 or 2018 the Saudis will be incentivized to create an environment of higher sustained oil prices to maximize valuation. Yet, a meaningful reduction in the oil supply will require cooperation between Iran, Iraq and Russia – an unlikely, though not impossible, outcome.

Finally, the US dollar declined by 0.5%, while the Volatility Index (i.e. VIX) remains below 12 signaling extreme complacency amongst investors. Please click here to view detailed asset class performance.

Pickle – Back in 2012, financial newsletter writer Harry Dent gave a speech titled “A Decade of Volatility: Demographics, Debt and Deflation”. At the time the Federal Reserve was in the midst of its Quantitative Easing program, on the cusp of announcing QE 3, and many economists and investors were concerned that ultra-accommodative monetary policies would lead to rampant inflation. Harry had a different view though, suggesting that declining consumption levels resulting from the aging Baby Boomer generation would effectively neutralize the Fed’s efforts to stimulate inflation in the economy. Thus far Mr. Dent has been correct and this has not been his only successful prediction on this topic. In the late 80’s he predicted the Japanese economy, then a global force, would enter a slowdown that would last more than a decade which proved prescient. Recently, noted economist David Rosenberg revisited the issues of demographics, debt and deflation:

  • Demographics and the big “7-0”: Over the next ten years there will be 1.5 million people from the Baby Boomer generation turning 70 annually. Because many of these people have failed to save enough for retirement they will continue to work. However, they will be focused on saving for a time when they can’t work, rather than making large purchases that would otherwise provide a tailwind to consumption levels and GDP growth. Moreover, because of their investment horizon, Baby Boomers are more likely to invest in fixed income securities than risky equities, which along with foreigners seeking better yields than are available locally, will contribute to lower interest rates.
  • Debt: Debt-to-GDP ratios for governments, businesses and households are higher now than where they were prior to the Financial Crisis. Governments cannot afford for interest rates to rise quickly as it would impair their ability to service the debt. The Fed is essentially walking a fine line in which they are hoping for normal levels of inflation (which effectively allows the government to repay debt with cheaper dollars), without materially higher interest rates.
  • Deflation: Unfortunately, low interest rates penalize savers as their nest eggs grow very slowly, forcing them to save more and consume less placing downward pressure on GDP growth.

Quoting Mr. Rosenberg, “See what a pickle we are in?”. The demographic tide is working against the U.S. and, in fact, most developed country economies. The economic effects of demographic trends are compounded by the high levels of debt that led to the Financial Crisis, but have yet to be resolved. Fundamentally, global growth is likely to remain subpar and inflationary pressures should remain at bay until central banks and governments find common ground to apply real change to their existing policies.

Economic Data Wrap-Up: The Job Opening and Labor Turnover (JOLT) survey for June supports our thesis that the labor market is maturing. Note that the JOLT survey data is lagged compared to the more current data such as Non-Farm Payrolls, however, the additional time to collect the data makes for more accurate reporting. Job Openings increased by 110,000 but following a deep decline in May, Job Openings are nearly unchanged from February. New Hires also rebounded in June, but following three months of declines are at the same level as the start of the year.  In combination, these two metrics paint a picture of stable, though not growing, labor demand. Retail Sales were revised upward in June, but July sales were flat compared to the previous month and well below expectations of a 0.4% increase. Automobile sales were a strong contributor in July, as ex-Autos retail sales declined 0.3%. While there is no doubt that Retail Sales recovered in the second quarter, we are unlikely to see the same rate of growth in Q3. Producer Price Indices (PPI) for July were also below expectations, signaling that inflationary pressures remain at bay in the supply chain.