Covenant Weekly Market Synopsis as of August 26, 2016

August 29, 2016

On the surface it was a relatively calm weak for equity markets, albeit with a negative bias, as most bourses recorded modest declines. Friday provided some fleeting excitement for equity bulls as markets reacted positively to Fed Chairman Janet Yellen’s speech at the Jackson Hole monetary policy symposium. However, immediately following her speech Vice Chairman Stanley Fischer struck a more hawkish tone in a CNBC interview, which reversed the positive momentum as the S&P 500 fell more than 20 points.

 

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Sources: Bloomberg and Covenant Investment Research

One takeaway from Friday’s market action is that investors’ interest in equities remains highly correlated to the continuing availability of loose monetary policy. But how have the prospects for tighter monetary policy impacted US Treasuries? The answer is that the front end of the yield curve (USTs maturing in 1 to 10 years) have shifted up, while the backend of the curve (USTs maturing in 30 years) has remained static. The chart below illustrates this point by comparing the current yield curve (green) to the yield curve as of June 30th (yellow).

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Sources: Bloomberg and Covenant Investment Research

While the Fed can influence the front end of the yield curve, it is very difficult for them to influence the backend of the curve. And this “flattening of the yield curve” (i.e. short-term rates higher, long term rates stable) implies that longer-term investors are not concerned about higher inflation levels that would accompany breakout economic growth, at least not yet.

Speaking of economic growth, Q2 GDP was revised downward slightly from a real annualized rate of 1.2% to 1.1% last week. As such, the US Economy expanded at an average real annualized rate of less than 1% over the first half of the year and only 1.2% on a year-over-year basis. As can be seen in the chart below, elevated consumption levels saved the economy from recording negative growth in the second quarter.

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Our chief economist (Sean Foley) does not see a repeat of those heady consumption levels occurring in Q3: 2Q real consumer spending rose at a 4.4% annualized rate sequentially, but was up just 2.7% YOY in 2Q.  In other words, there is nothing in the data that suggests consumer spending in 3Q will repeat anything like the 4.4% 2Q growth rate.  July’s retail sales were up 2.3% YOY, consistent with the steady but not great YOY trend.  Further, consumers in 2Q drew down savings and went on a credit card binge.  Could that happen again in 3Q? Sure, but is it likely?  Not in my view.

While we expect there will be an improvement in the overall GDP growth rate in Q3, we do not see the economy sustaining a growth rate much better than 2% – 2.5% for the foreseeable future. This is the crux of our “good, but not great” economic theme. A growth rate of 2%+ for world’s largest economy is not bad. In fact, it is the envy of our developed market counterparts such as Japan and the Euro zone. And while it is a lower growth rate than what most of us are accustomed to, we should get used to it.

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Be well and Godspeed,

Jp.