Covenant Weekly Market Synopsis as of August 5, 2016

August 8, 2016

In a rather mixed week that saw crude oil briefly enter a technical bear market (decline of 20% from a recent high), global stocks were decidedly mixed. Equities began the week in the red, but started to recover after the Bank of England announced a massive stimulus program and then rallied hard on Friday following a better than expected jobs number in the U.S. The late week rally failed to pull most international indices into the black for the week (with the exception of emerging markets), however the rally enabled domestic stocks to post their fifth positive week in the last six. Overall the last six weeks have been good across the board with global equities rising 9.7% and the S&P 500 up 9.4%. The yield on US Treasuries increased by about 0.1% during the week, but it has been a volatile ride that saw the 10-year yield touch a new low in early July that quickly reversed with the yield jumping more than 0.25% through last week. Precious metals were down a few percentage points on the week, while the US dollar strengthened by 0.7% (against a basket of trading partner currencies).

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Job Fair: Nonfarm payrolls jumped by 255,000 in July (vs. expectations of 180,000), even as the headline Unemployment Rate held steady at 4.9% due to a surge of people re-entering the labor market. Importantly, jobs in the key first-time home buyer 25-34 year age cohort increased by 150,000, bringing the three month total to 420,000. While two consecutive months of strong job growth should overcome the chill from the weak payroll data from May (24,000 jobs added), employment growth of 1.9% year-over-year has outpaced real GDP growth of 1.2% – a very unusual circumstance. The variance can be explained by negative productivity growth, an unsustainable state that will be resolved by either a strong, sustained recovery in GDP growth or by businesses reducing their pace of hiring as profit margins are eroded. Based on the current data we suspect it will be the latter, but would gladly welcome the former.

Terrorism’s Bull Market: Back in 2014 Harvard Professor Niall Ferguson made the following statement “The black swan of international conflict is going to fly straight out of Obama’s foreign policy”. While Professor Ferguson’s comment may, or may not, have been a political statement, the following is not intended as political commentary (we are all subjected to plenty of that already). This is a sensitive topic, but it is important to understand the structural backdrop for global terrorism and why it will persist absent a concerted, coordinated effort by at-risk countries.

In a report titled “Bull Market for Terror”, BCA Research cites several structural factors that will contribute to an increasing frequency of what they term “low quality” terrorism. (Note: by low quality, BCA is referring to ISIS-inspired terrorist attacks on soft targets, as compared to Al Qaeda’s favored approach of highly coordinated attacks on hard targets.)

  • American Geopolitical Tapering – since President Obama took office, the U.S. has shifted its focus away from the Muslim world, creating instability in the Middle East, North Africa and South Asia. The resulting vacuum of power has created a golden opportunity for radical militants to expand their spheres of influence, take control of certain areas, and bolster their resources. This international policy focus is likely what Professor Ferguson was referencing.
  • Decline of Intelligence Agencies in key Middle-Eastern countries – The U.S. invasion of Iraq, the toppling of Libya’s Muammar Qaddafi, and the Syrian civil war have severely compromised local intelligence agencies. The weakening, if not outright collapse, of these domestically focused agencies has made it easier for Islamic terrorists to import sophisticated weaponry and expand their terrorist training programs.
  • Taking back territory form the Islamic State – the successful military efforts to recapture land from ISIS has a counterproductive aspect in that with less land to protect through conventional means, ISIS can direct more resources to terrorist activity in the region and abroad. Think of it this way, as someone who has sworn their allegiance to ISIS, a radical militant is indifferent to fighting in conventional warfare and carrying out terrorist activities. Quoting BCA: “In a way, the territory the Islamic State controlled in the Middle East has acted as a black hole, drawing young men and women willing to die away from the West and into a largely economically irrelevant piece of global real estate”. With fewer resources required to defend and hold a smaller swath of territory, those soldiers can be redeployed to carry out terrorism in the name of ISIS.

These structural factors are difficult to resolve and, in fact, assigning blame to any single political party is moot. Certainly the Obama Administration and Hillary Clinton (as then-Secretary of State) are responsible for the geopolitical tapering within the Middle East. However, it was the Republican Party under President Bush that created the power vacuum in the Middle East by invading Iraq and removing Saddam Hussein from power. Paraphrasing BCA, everyone and therefore nobody is to blame.

This is the situation in which we find ourselves. Isolationism on the geopolitical stage is a dangerous strategy. In fact, many contend that isolationist foreign policies by Britain (then the world’s superpower) in the early 1900’s set the geopolitical stage for World War I. Perhaps the next President of the sole remaining superpower will consider the failures of past policy decisions and develop a comprehensive strategy in concert with other nations to combat terrorism abroad. Failure to do so will lead to increased deaths of innocent people, reduced liberties, more restrictive immigration policies, less international commerce, and ultimately a decline in global economic growth potential.

Economic Data Wrap-Up: The June ISM Manufacturing Index fell slightly in July to 52.6 (vs. 53.2 in June). While a reading above 50 indicates the sector is expanding, poor readings in certain leading indicators such as new orders and orders backlogs point to further deceleration in the coming months. Meanwhile, the June ISM Non-Manufacturing Index (which measures activity in the services sector) was 55.5, only slightly lower than expectations of 55.9. Leading indicators in this index were positive, suggesting the services sector will remain a reasonably steady source of growth in Q3. The Personal Consumption and Expenditures (PCE) inflation gauge for June remained stable at 0.9% year-over-year, while Core PCE was 1.6%, well below the Fed’s target rate of 2.0%.

Be well and Godspeed,

Jp.