Covenant Weekly Market Synopsis as of June 23, 2017

June 26, 2017

EQUITY VOL IS DEAD!!! I, of course, don’t believe this to be the case and, like most of you, recognize that this period of equity market quiescence will end.  Yet, admittedly, it sure feels like volatility is dead, especially recently. Over the last 20 years, the VIX Volatility Index has ended the day below 10 on a total of 11 days (Source: JP Morgan). There is an average of 252 trading days in a year, so over this time horizon the VIX has closed below 10 only 0.2% of the time (11 out of 5,040 days). Here’s the kicker…. 7 of those 11 days were in the past month. No wonder it feels like volatility is dead.

Speaking of which, domestic equities moved higher again last week with the S&P 500 gaining 0.2%. The Nasdaq advanced by 1.9% and is now only 0.7% below its all-time high set earlier this month. Developed international stocks were mixed, with European equities sliding by 0.3% and Japanese equities gaining 0.3%. Likewise, Emerging Markets climbed 0.7%, but Frontier Market equities declined by 0.8%. In the realm of fixed income, the U.S. Treasury curve continued to flatten as the yield on 2-year notes rose to 1.34%, while the annual coupon on 10-year and 30-year notes edged lower to 2.14% and 2.72%, respectively. Precious metals eked out a small gain on the week. The price of crude jumped around quite a bit, falling nearly 5% in the first three trading days of the week. It recovered a little ground on Thurs/Fri, but ended the week down 3.9% and is now off by -19.9% year-to-date.

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

 

Poll Position – As has been widely reported, President Trump’s Approval Ratings amongst all voters is low. For example, the latest Gallup Poll (dated 6/22/17) shows he has an approval rating of only 42% (which is actually a marked improvement from his 36% approval rating in early June). Yet, viewed through a different lens, namely that of Republican voters, his approval numbers are respectable. At this point in his administration’s lifecycle, President Trump’s approval ratings are similar to that of previous Republican administrations as illustrated in the chart below.

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*Includes Bush Jr., Bush Sr., Reagan, Nixon and Eisenhower. President Ford is excluded because he was not inaugurated.  Source: BCA Research

President Trump’s relatively strong approval ratings amongst his party imply that he remains a potential threat to House Republicans willing to challenge him and with midterm elections on the horizon, Trump retains more political influence than commonly believed. The administration may be able to play this “trump card” with Republicans up for re-election to push through a tax reform package that is not revenue neutral by threatening to support Republican challengers in the midterm elections next November (would a successful New York real estate tycoon take every advantage afforded him and play hardball to obtain his objective? – I think yes). Combined with the Republican Party’s longstanding goal (not to mention campaign promises) over the last 10 years to provide tax reform, President Trump is in a pretty good position to force Republican’s hand on approving a new tax package. It is for this reason that BCA Research forecasts stimulative tax reform will occur sometime before the late 2018. While the lack of revenue neutrality would further exacerbate the broader debt burden of the U.S. in the long run, it would have an immediately positive impact on risky assets in the short run.

 

Pick your Poison: Credit Risk vs. Interest Rate Risk – One byproduct of the coordinated effort by the world’s powerful Central Banks to reduce interest rates is the paltry return available on fixed income investments worldwide. This has forced yield-seeking investors into riskier fixed income investments (including debt issued by shaky sovereign nations) and to take on more credit risk, all of which has compressed yields in these sectors as well. For example, Greek 10-year bonds now have a lower yield (5.71%) than US High Yield debt (6%). Those seeking a “safer” investment have poured capital into domestic Investment Grade bonds, which now yield a paltry 3.67%. While this sector of the fixed income market may be safer from a credit-risk perspective, the skinny yields subject investors to increased interest rate risk. Indeed, the “breakeven yield change” (defined as the change in yield that makes the 1-year return on a bond equal to zero) is only 0.49% for Investment Grade debt. In other words, if the yield on Investment Grade bonds expanded by 0.49% over the course of one year, an investor’s total return would be zero (as the price decline in the value of the bond would offset the coupon payments). By contrast, U.S. High Yield Debt sports an average 1.72% breakeven yield change, offering a wider protective moat to rising interest rates for those willing to roll-up their sleeves and do the necessary credit analysis.

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Source: Chatham Asset Management

 

Please note, this is not a recommendation to purchase high yield debt. If you are considering the space, it may be worthwhile to lean against the trend toward passive investing and select an active manager. Aside from the usual landmines in the high yield sector, the indexes tend to be heavily skewed towards names at the higher end of the credit quality spectrum and, as a consequence, pay a lower interest rate on their debt.  Thus a passive index allocation may not offer the interest rate risk protection you thought you were buying.

 

Be well,

Jp.