Covenant Weekly Market Synopsis as of March 11, 2016

March 14, 2016

Mario Draghi and the ECB ventured further into unchartered monetary policy territory on Friday unleashing a new round of quantitative easing. The updated measures included pushing deposit rates deeper into negative territory (-0.4%) and increasing bond purchases by 20 billion to 80 billion euros ($89 billion) per month. There were also a couple of new twists, including the ECB’s commitment to purchase corporate bonds (as there is a shortage of sovereign debt to purchase) and paying banks to make loans.

Risk assets responded favorably to the ECB’s actions and the ensuing rally propelled global equity markets to their fourth consecutive week of gains. Developed and international market equity indices advances were more tempered than the previous week, but given that 100% of the weekly gains came on Friday, no one headed into the weekend unhappy. The yields on US Treasury bonds moved higher with the yield on the 10-year UST rising 0.1% to 1.98% (a level last visited from above when yields were contracting from 2.27% at the end of 2015 in response to the 5%+ decline in equity markets in January). The long-bond (30-year UST) also rose 0.1% to 2.75%. The price of West Texas Intermediate (WTI) Crude rose another 7.2% on the week (+14.1% MTD) and broke the surface into positive territory for the year at $38.50 per barrel.  Detailed asset class performance data is available here.

Against the backdrop of the ECB’s moves, all eyes will be on the Fed this week when they gather for their second Federal Open Market Committee (FOMC) meeting of the year. The market is not expecting the Fed to raise interest rates at this meeting (according to Bloomberg the implied probability of a rate increase is only 6%), but it would not be a surprise if the Fed signals that a rate increase is in the works for April or June.

Give me Freedom! (or slow economic growth?): The perplexing decline in annual U.S. GDP growth in the last two decades has been the subject of much speculation. In the three decades from 1970 – 2000, the U.S. Economy expanded by more than 3% per year (on average). Yet, since 2000 economic growth has averaged less than 2% per year. Many theories have been put forth to explain the slower growth trajectory, including an over-leveraged federal balance sheet and lower overall labor productivity. While these are legitimate issues, what if they are merely symptoms of a systemic problem the U.S. is contending with?

That may indeed be the case according to research put forth by the Fraser Institute (a Canada-based research firm). Each year the Fraser Institute issues the Economic Freedom of the World report, which measures the degree to which the policies and institutions of countries are supportive of economic freedom. The report centers on an Economic Freedom Index (EFI) that was originally constructed with the help of famed economist (and Nobel Laureate) Milton Friedman. The index incorporates 42 data points to objectively measure “…the degree to which the policies and institutions of countries are supportive of economic freedom”, which include “…personal choice, voluntary exchange, freedom to enter markets and compete, and security of the person and privately owned property.”  The Fraser Institute’s report is not purely academic as numerous peer-reviewed studies have shown that prosperity and other positive outcomes correlate tightly with the level of economic freedom available in a country. (Source: The Fraser Institute).

In the Fraser Institute’s most recent report (which includes data through 2013), the United States ranks 16th in Fraser’s EFI. This relatively low ranking stands in stark contrast to the U.S.’s typical top 3 ranking from 1970 to 2000 (amongst more than 100 countries and territories). Since 2000, the EFI score for the U.S. has fallen by approximately 0.9 points (i.e. economic freedom is waning). Academic research (Gwartney, Holcombe, and Lawson, 2006) indicates that a one point decline in the EFI is associated with a 1% – 1.5% decay in long-term GDP growth, which makes sense as the EFI is analogous to the level of capitalism in an economy. As highlighted in the chart below, U.S. GDP growth has fallen commensurately with the decline in its EFI score as predicted by the academic research, implying that restraints on capitalism are the driving force behind slower economic growth.

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Sources: Fraser Institute and Covenant Investment Research

There is no easy fix to this situation, as improving the level of economic freedom will require wholesale policy changes at the highest levels of government – unfortunately, agents of true change and leadership in government are rare. That being said, it is a big election year and it is worth considering economic freedom as a path to improved prosperity when casting your ballots for leadership at all levels of government later this year.

Economic Data Summary: The latest MBA Purchase Mortgage Index (which tracks the volume of mortgage applications submitted to lenders) was 225.7. This level is at the high end of its recent range, which is a good leading indicator of near-term home sales. Initial Jobless Claims for the week ending March 4, were estimated at 259K (well below the consensus estimate of 275k) demonstrating that the labor market remains on solid footing.

Be well,

Jp