Covenant Weekly Market Synopsis as of March 18, 2016

March 21, 2016

Global equities rallied for the fifth week in a row pushing the S&P 500 to a slightly positive value year-to-date (YTD). Large capitalization stocks have been the primary beneficiary of the rally (not dissimilar from stock market performance in 2014) and while small cap and technology names have enjoyed substantial gains recently, they are not yet in positive territory as the Russell 2000 is down 2.7% YTD and the Nasdaq is off by 3.9% YTD.

International developed (with the exception of Japan) and emerging markets equities jumped last week as well. Chinese equities are now up more than 10% this month, yet remain down 15% YTD, highlighting the level of volatility present in that market as investors weigh the effectiveness of fiscal and monetary policy actions being taken to stimulate growth. In spite of the rally in risk assets, traditional fixed income assets appreciated last week (likely in response to the Fed’s inaction) and as a result the yields on the 10 and 30-year US Treasuries declined to 1.88% and 2.68%, respectively. Hard assets also rallied (in response to a declining US dollar that fell 1.2% for the week), including Copper’s gain of 2.2% on the week (+7.5% MTD) and WTI Crude’s jump of 2.2% (+16.5% MTD / +6.2% YTD). Detailed asset class performance data is available here.

Easy Money: At last week’s Federal Open Market Committee (FOMC) meeting the Fed chose to hold the Federal Funds target rate steady at 0.25% – 0.5%, as was widely expected. Moreover, the Fed’s now infamous “dot plot” (a chart that shows the FOMC members’ expectations for future interest rate levels) indicates that Fed is likely to raise rates only twice this year (down from the 4 times signaled in December’s dot plot). Clearly, the Fed is not overly concerned about inflation at this point in time, in spite of the recent firming of Core inflation levels. The Fed’s view may be informed by a recognition that we are now lapping weak inflation data from early 2015, so the recent increase in annual Core inflation data (on a year-over-year basis) has been anticipated (see Economic Wrap-up section for more detail). This view is supported by the markets, which are now pricing in only one more interest rate hike in 2016. Notably, the markets have had a better forecasting record on future interest rate levels than the Fed’s dot plot.

While it received less coverage domestically than the FOMC decision, the Bank of England (BOE) also held interest rates at historic lows last week. Once believed to be on the verge of raising rates along with the U.S., the BOE is now more concerned about uncertainty of the June 23 referendum on the UK’s membership in the European Union. With the Bank of Japan, European Central Bank, and the People’s Bank of China in easing mode, and the Fed and BOE on hold for now, global monetary policy remains highly (and unusually) accommodative which has helped risk assets largely recover from a historically poor start to the year.

Rising Drug Costs: The January US Wholesale Inventory report may have offered a glimpse into how quickly healthcare costs are rising in the U.S. The report revealed that pharmaceutical inventories, at $53.58 billion, are now the largest constituent of Total Wholesale Inventory, having increased from 9.2% in Dec ’13 to 12.4% of total Wholesale Inventory levels. One can reasonably assume that the increase in inventory levels is one of valuation not volume. That is to say, we suspect that the price of medication has risen, rather than a spike in the amount of medication held in storage. One implication of rising healthcare costs is a reduction in discretionary purchases by consumers. We have suggested in our recent Economic Review and Outlook quarterly letters that the rise in healthcare costs is a likely a contributing factor in the disappointing growth in Retail Sales as consumers are forced to direct an increasing portion of their paychecks to healthcare.

Economic Data Summary: Retail sales data released last week disappointed market expectations twice over: 1) January Retail Sales growth was revised down from +0.2% month-over-month to -0.4%; 2) February’s estimate suggests an additional decline of -0.1% from January’s already depressed levels. The decline in Retail Sales will negatively impact Q1 GDP growth, which is now estimated to be less than +2% annualized. That being said, when viewed on a year-over-year basis, the data isn’t all that bad with Core Retail Sales rising by +3.8%.  Inflation data was mixed with February Consumer prices falling by -0.2% (in line with consensus estimates) and up only +1% year-over-year. However, Core CPI (which excludes food and energy) rose +0.3% in Feb and +2.3% year-over-year (the largest increase since the Great Recession). The increase in Core CPI was largely due to upward pressure from housing and medical care (specifically, health insurance inflation, which rose from +4.8% to +6%). However, it should be noted that we are now lapping weak inflation data from early 2015, so an increase in year-over-year Core Inflation data is not all that surprising.

Be well,