Covenant Weekly Market Synopsis as of August 19, 2016

August 22, 2016

It was a fairly quiet week in the markets. The S&P 500 pushed modestly upward on Monday (+0.3%) to a new high, but finished the week up only 0.1%. Stocks on the international stage were mixed with European and Japanese equities falling just under 2%, while Emerging and Frontier Markets edged higher by about 0.1%. Interest rates bounced around during the week as dovish FOMC minutes were counterbalanced by hawkish comments from a couple of FOMC members – the Fed could use a good PR-firm to ensure they are communicating a consistent message. On that note, Fed Chairman Yellen will be speaking this Wednesday at the annual monetary policy conference in Jackson Hole, Wyoming. Though no major announcements are expected, investors will be tuning in to see if she provides any hints about the Fed’s interest rate plans for the balance of the year. WTI Crude rose 9% last week and is now up more than 20% in the last two weeks to $48.52 a barrel. The US Dollar declined by 1.3%, while the VIX Index is below 12, signaling investors are showing little concern about near-term market volatility.

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The Natural Rate of Interest – Apologies in advance for delving into an esoteric economic term like “Natural Rate of Interest”, but it is an important concept to understand, at least at a cursory level.

First, what is it?   The Natural Rate of Interest is the inflation-adjusted interest rate required in a country to maintain stable inflation and it is something that Central Bankers use as a target when implementing monetary policy.

Second, why discuss it?  As the chart below shows, following the Financial Crisis the Natural Rate of Inflation has moved sharply lower, to near zero for the United States and less than zero for the Euro area.  In other words, the Financial Crisis fundamentally altered the natural, steady state of the economic engine.

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Source:  Holston, Laubach, and Williams (2016); data are four-quarter moving averages.

Third, is this important to us?  Yes it is, because in a letter published last week San Francisco Fed President John Williams contends that in a low natural rate environment monetary policy is ineffective, leaving the Fed powerless to fight the next US recession — the European Central Bank and Bank of Japan are in even worse positions relative to their economies.   As a result, if the Natural Rates of Interest do not rise, we can expect weak expansions and deep recessions because monetary policy will not be able to stimulate the economy.  We are already witnessing the limits of monetary stimulus in the U.S., Euro zone and Japan where a tsunami of accommodative monetary policies have failed to accelerate real economic growth.

Mr. Williams suggests several strategies to increase the Natural Interest Rate in the U.S., including combining fiscal stimulus with monetary stimulus.  This approach was also suggested by then Fed Chairman Ben Bernanke following the Financial Crisis when he admonished Congress that the Fed cannot solve all of the country’s economic problems.  However, that plea fell on deaf ears, or at least ears that could not cooperate to put forth a true fiscal stimulus bill.

Will the next administration be able to change the political narrative and take action to right the economic ship in the U.S.?  Given the divisiveness both between and within the major political parties, the odds are unfortunately long.  For example, in 2010 the Obama administration attempted to implement a fiscal stimulus package, but he had his knees cut out from under him by Nancy Pelosi, his own party’s House Leader.  The resulting negotiations eviscerated the impact of what was once a near-trillion-dollar infrastructure bill.

As policy makers come to grips with the limits of monetary policy, will the market be far behind?

The Big Ten – We all know that when we go to the grocery store in this country the food options are nearly limitless. What I didn’t know, until I came across this infographic, is that 10 companies including PepsiCo, General Mills, Nestle, and Coca Cola own the vast majority of those food options. I’m not a “foodie” nor a “nutritionist”, but I do recognize that a common thread amongst these brands is that they consist of highly processed foods. I suspect that is a requirement when mass producing food products and one of the reasons that farmers’ markets and buying local have becoming increasingly popular options for shoppers seeking diversity in their foodstuffs.

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Source: Oxfam International

Economic Data Wrap-Up: Industrial Production increased by 0.7% in July, the second consecutive month of expansion. Manufacturing, which makes up nearly 80% of total production, rose a higher than expected 0.5%, a nice bounce, but a sustainable recovery in Manufacturing remains elusive. Speaking of elusive, July’s Inflation data supports our notion that the recent increase in inflation measures are not indicative of building inflationary pressures in the economy. The Core CPI rose only 0.1% in July, with Housing costs a key source of the gain.

Be well and Godspeed,

Jp.