Covenant Weekly Market Synopsis as of June 3, 2016

June 6, 2016

Global equities, for the most part, could not build on the gains from the previous week as the MSCI All Country World Index (ACWI) rose a modest 0.3% last week. Domestic large cap stocks were flat on the week (though small cap names rose more than 1%), while European and Japanese equity indices declined more than 2%. U.S. Treasuries were bid, with the yield on the 10-year falling to 1.7% and the yield on the 30-year UST declining to 2.5%, a good indication of the lack of inflation fear present in the market. Precious metals climbed last week (gold +2.6% and silver +1.1%) with some suggesting that the bid for gold is being driven not by inflationary fears, but rather by investors losing faith in the omnipotence of central bankers. WTI crude recorded its first weekly price decline in a month, with a price of $48.62 per barrel. The US Dollar eased by 1.7%, while the VIX Index (at 13.5) remains near the low for the year indicating investors are either confident or complacent.  Please click here to view detailed asset class performance.

Confidence Shmonfidence: According to data from the Conference Board, consumer confidence levels vary widely by income levels as can be seen in the chart below (source: FTN Financial).  At the nadir of the Financial Crisis the confidence levels of all three income classes reached a nearly identical low. As the Fed began applying extraordinary monetary policy measures, the confidence level of consumers in the highest income bracket (income greater than $50k, depicted by the purple line) recovered quickly relative to the lower earners.

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In fact, while the higher earners’ confidence levels recovered to pre-Financial Crisis levels, the confidence levels of the less well-off have only retraced about half of the 2008-2009 declines. The likely reason for the difference in the pace of recovery is that the Fed’s actions resulted in a stock market that mostly appreciated from mid-2009 through 2015. This benefited the highest earners because they tend to have larger investment portfolios than those in the lower income brackets. However, since the stock market leveled off high earners’ confidence has waned. Interestingly, only the middle earners confidence remains in an upward trend.

Lies, damn lies and statistics: When someone makes reference to a 500-year flood, they are referring to an event that is expected to happen on average once every 500 years. In other words, it is a statistically rare event. However, statistics are no guarantee of reality. A good example of the fallacy of relying exclusively on statistics was presented last week when Texas was smacked by multiple storms that caused flooding that reached or exceeded 500-year flood events. Last year was a tough year for flooding in Texas as well, including two 500-year flood events, meaning that Texas has just been hit in consecutive years by events that should only happen once every 500 years on average. While statistics can be helpful in some aspects of life, they should not be relied upon in isolation. Similar to the randomness of Mother Nature, the financial markets regularly experience events with greater frequency than would be predicted by statistics (see Nassim Taleb’s seminal work The Black Swan). Since no one can rely on statistics alone to forecast market prices, portfolio diversification remains the best approach to prudently grow capital in the face of 500 or 1,000-year market floods that occur far more frequently than once every 500 or 1,000 years (for example the S&P 500 declined more than 50% twice within 10 years (2000 – 2009).

Economic Data Wrap-Up: Consumer Spending jumped 1% month-over-month (m/m) in April, well above the consensus estimate of 0.7% recording the largest monthly increase since 2009. It is also worth noting that the Savings Rate reversed a long upward trend, declining from 5.9% to 5.4% as consumers opened their wallets. Core Personal Consumption Expenditures (Core PCE), the Fed’s favored measure of inflation, rose 0.2% m/m and 1.6% year-over-year, but remains 0.4% below the Fed’s 2% target rate. The ISM Manufacturing Index surprised to the upside (51.3 vs. consensus estimate of 50.3), but the increase was largely due to a surge in supplier delivery times which may have been impacted by flooding in Texas. On the brighter side, New Orders (a good leading indicator of future sales, held steady at 55.7 down only a tick from 55.8 in April. Nonfarm Payrolls were a huuuuge disappointment (as Trump might say), rising only 38k in May vs. consensus estimate of 160,000). Moreover, the payroll figures for the previous three months were revised downward. We have been of the belief that the best hiring numbers are likely behind us in this economic cycle, but admittedly we did not forecast such a dramatic decline in hiring this soon. May’s employment report may turn out to be a lagged effect of weak economic growth in the first quarter, but it will certainly figure into the Fed’s decision about whether to raise interest rates at their next meeting on June 14th. And if the employment report was not enough to give the Fed pause, the US ISM Non-Manufacturing Index, previously an area of service sector strength, slipped from 55.7 to 52.9 in May.

Be well and godspeed.

Jp