Covenant Weekly Market Synopsis as of July 15, 2016

July 18, 2016

In yet another week marred by terrorist atrocities, equity markets recorded strong gains with the S&P 500 hitting a new high. While domestic stocks set records, it was international stocks that shined brightest with Japan leading the way gaining 5% on hopetations (hope + expectations) that the BOJ will inject more stimulus into the flagging economy (the Nikkei is still down 12.5% year-to-date). As investors embraced risk, safe haven fixed income instruments in the U.S. sold off causing yields to rise by about 0.2% on the 10 and 30-year bonds. An increase of 0.2% may not seem like much, but relative to the pricing of the instruments it represents an 8% move over 5 days and that is a pretty large move for stodgy bonds. In commodity-land: precious metals declined on the week and the energy complex clawed back some of its month-to-date losses, but generally remains underwater this month (e.g. WTI Crude is down 4.9% at $45.95 per barrel). The VIX Index (a measure of expected volatility in the S&P 500) declined 4% on the week and, given the geopolitical events, it is fairly shocking that the VIX now has a 12-handle, closing the week at 12.67 (vs. a long-run average of 20).

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Gravitational Pull: The black hole of negative interest rates claimed another victim last week, this time drawing in the 10-year German Bund (Europe’s benchmark bond issuance). While other Eurozone nations had previously sold shorter maturity bonds at negative interest rates, Germany became the first kid in the bloc to issue new 10-year debt at a negative yield. On that same day, Portugal and the U.K. were also able to raise inexpensive financing, even though the strength of their economies is questionable, highlighting the deflationary pressures that monetary policies have failed to quell. In other news from Wednesday’s debt financing smorgasbord, Switzerland (the first country to issue 10-year bonds with negative rates back in April 2015) sold bonds that mature in 2058 at a yield of minus 0.023%, meaning the buyers of those bonds will “enjoy” negative interest rates for more than 40 years. What happens, in a practical sense, when you buy a negative yield bond? You receive no interest payments and, if you hold to maturity, you will be paid back a smaller principal amount than you originally lent. Incredibly, the total amount of negative yielding debt globally has risen from $11 trillion to $13 trillion just in the three weeks since the Brexit vote. Note, there was virtually no negative interest rate debt as recently as mid-2014 (source: BAML). It would seem that negative yields beget more negative yields, creating a positive feedback system that will require fiscal stimulus (not monetary stimulus alone) to break.

Speaking of which: Fiscal stimulus may be on the way, at least according to a number of well-regarded economists and political observers. Their theory is as follows: since the Financial Crisis central banks have relied on monetary policy in an effort to kindle economic growth. While the success of that strategy is debatable, central bank actions have unequivocally driven up asset prices. Rising asset prices are benefitting the wealthiest classes of citizens (since they are the ones predominantly holding investments), leading to greater income inequality. This, in turn, is fueling populist fervor globally as evidenced recently by Brexit, Trump, and the Liberals winning the election in Canada on a pledge to spend more on infrastructure. In response to their citizens’ demands, politicians will need to (gasp) work together to increase deficit spending, or risk failing in their respective reelection bids. If this comes to pass, inflation will rise (something central banks are desperate for) and traditional fixed income investments will no longer provide the tailwind to portfolios that they have for the last 30 years.

Economic Data Wrap-Up: The JOLTS (Job Opening and Labor Turnover Survey) for May missed expectations, as did much of the other May labor data. Total Job Openings fell from 5,845 in April to 5,500, while Quits (2.0%) and Layoffs (1.0%) rates remained unchanged from the previous month. This data is largely consistent with our house view that the best labor numbers are behind us – that is not to say that we expect significant declines, rather that the labor market momentum is slowing. June’s monthly Producer Price Index rose 0.5% in June (exceeding expectations of 0.3%), while core prices (which exclude food and energy) rose 0.4% (vs. expectations of 0.1%). This data suggests that Producer Prices have stabilized, and if energy prices remain relatively steady there will be modest upward pressure on wholesale prices in the second half of the year. Retail Sales rose 0.6% in June, exceeding expectations of a 0.1% increase and the retail sales control group (used to calculate GDP) increased by a better than expected 0.5%. The increase in Retail Sales should boost the real annualized Q2 GDP growth rate to around 2.5%. The Consumer Price Index (CPI), aka “headline inflation”, came in as expected at 1.0% year-on-year. Core CPI (which excludes food and energy costs), rose to 2.3% year-on-year. Although consumer inflationary pressures have risen recently, it has largely been due to rising medical care and housing costs, and rents have been showing a moderating trend of late. Bottom-line, some inflation is good and there is nothing in the data currently to suggest a period of rampant inflation is imminent.

Be well and Godspeed,