Covenant Weekly Market Synopsis as of August 18, 2017

August 21, 2017

It was an eventful week, but not a week of good events. From political strife at home to terrorist acts abroad, the media channels had a lot to talk about. Financial markets were impacted by these events and prices changed swiftly as investors reacted to rumors, facts and updates to the same rumors and facts. When the dust settled on the week, domestic equity markets declined modestly, while international developed (except for Japan) and emerging market equity indices moved higher. European stocks took an outsized hit on Thursday and Friday following the tragic terrorist event in Spain. A somber reminder that while our country has a number of internal issues that must be dealt with, there is a global organization of radicalized Muslims that wishes to do harm to those that do not share their beliefs.

For the most part, while equity market volatility has increased over the last two weeks, the markets have largely been stuck in the mud. Most broad indices (e.g. S&P 500, Nasdaq, MSCI All Country World Index) are at similar price levels to where they were at the end of May. In other words, while equity indices have zigged and zagged, they have made little-to-no progress in 2.5 months. This is not unusual market behavior, especially for this time of the year (hence the old Wall Street adage “Sell in May and Go Away”), but the additional volatility has caught many off-guard. Again, it seems that investors have become conditioned to low volatility. Reportedly, the Dow has only dropped by > 1% in three days this year vs. 34 times in 2015, and 24 times in 2016.

Yields on US Treasuries ended the week marginally higher at the front and middle of the curve (bonds maturing in 2 years through 10 years) and marginally lower on the long-end of the curve at 30-year maturity.  Currently, the yield on the 10-year UST is 2.19% and the yield on the 30-year bond is 2.78% (low, but levels consistent with a slowly expanding economy accompanied by low inflation expectations).  Precious metals and crude declined on the week, but here again, losses were mild at less than 1%.  The US Dollar ticked higher by 0.4%, but remains down 8.6% year-to-date (a weaker USD is a positive for US exporters, especially manufacturers, who can provide more competitive international bids in a weak USD environment).  For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

 

When Doves Coo – Minutes from the July Federal Open Market Committee (“FOMC”) meeting were released last week. As usual, it makes for rather dry reading. Yet, a couple of topics are worth highlighting. First, the FOMC staff is concerned about elevated asset prices.

Vulnerabilities with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets.

Apparently, the relentless rise in asset prices has ratcheted up risk of a pullback from “notable” to “elevated” among members of the FOMC. It’s also worth noting that the accompanying historically low volatility levels of prices was not lost on the FOMC (keep in mind, this meeting took place prior to the showdown with North Korea and the events of last week).

Second, the FOMC may be once again shifting how it sets monetary policy.

Most observed that the Committee could afford to be patient under current circumstances in deciding when to increase the federal funds rate further and argued against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist and that inflation was more clearly on a path toward the Committee’s symmetric 2 percent objective over the medium term.

This is a big deal, so let’s unpack the statement. Translating into non-Fed speak (and dissecting a rather long sentence) it appears that the Fed is pivoting from setting monetary policy based on forecasts to actual observed data. This is notable because as recently as December 2016, the Fed had signaled they would set monetary policy based on the output of their forecasts (which have been flat out inaccurate). Employing a wait-and-see approach to inflation and interest rates implies a slower pace of hiking than previously believed if inflationary pressures fail to materialize.

It’s also worth noting that in the second part of that sentence, the FOMC specifically noted a “symmetric 2 percent objective” for the inflation level. This implies that the FOMC will not overreact should inflation rise toward their 2% target, a concern highlighted in last week’s synopsis in the “Inflation Stagnation” commentary.

In sum, although the FOMC is concerned about elevated asset prices, they are unlikely to raise rates simply to address perceived valuation imbalances. It is neither politically expedient nor is it consistent with their dual mandate of price stability (i.e. stable inflation) and maximum employment. On balance, the FOMC meeting minutes tip in favor of the doves. Thus, if inflationary data remains subdued we should expect a slow pace of rate increases allowing the economic expansion to continue at a measured pace.

 

Teslas and Trees – It’s difficult not to appreciate the sleek styling, impressive technology and flat out quickness of Tesla vehicles. Aside from Tesla’s endemic “cool” factor, another common reason people cite for buying is that the vehicles are 100% electric. That is, they generate no pollution, including zero carbon dioxide emissions. Carbon dioxide is one of the primary “Greenhouse Gases” and, according to abundant research, is contributing to global climate change. Hence, the common belief is that replacing one’s traditional internal combustion engine with an electric vehicle will reduce his/her carbon footprint (i.e. the amount of carbon dioxide generated by that individual). What I’ve always wondered is, when giving consideration to how the electricity that powers these vehicles is produced, are Tesla vehicles as environmentally friendly as commonly believed? The answer came in a report from Morgan Stanley that found “the carbon emissions generated by the electricity required for electric vehicles are greater than those saved by cutting out direct vehicle emissions”. In other words, electric vehicles reduce direct carbon dioxide emissions, but these are not perpetual motion machines and they require electricity to charge their batteries. The vehicle’s greenhouse emissions are essentially pushed up the productivity chain and are generated in the form of electricity power plant greenhouse emissions. So unless one is recharging their Tesla’s lithium batteries with electricity generated from wind or solar energy, enjoy the vehicle but go ahead and plant some trees to offset your carbon footprint.

Be well,

Jp.