Covenant Weekly Market Synopsis for April 20, 2018

April 23, 2018

After months of escalating geopolitical tensions, last week brought good news on multiple fronts. North and South Korea are evidently negotiating an end to the Korean War – a war in which fighting ended in 1953, but did not include a formal peace treaty. It was announced that CIA Director Mike Pompeo traveled to North Korea to lay the groundwork for the upcoming Kim-Trump summit. And following last weekend’s air strikes on Syria, Russia refrained from responding militarily. Equity markets came into the week like a lion and left like a lamb, netting to modest gains of about 0.5% for broad developed market stock indices. Emerging and frontier market stocks fared worse, dropping a little more than 1%. On a year-to-date basis, most developed market stock indices have gained less than 1% (including dividends).

Interest rates moved higher last week, likely in response to a series of hawkish speeches (12 in all) by Fed officials. The yield on a 10-year US Treasury bond closed the week at 2.96%, a 0.13% rise over the prior week. It may not sound like much, but that it is a pretty big move in stodgy bond land. It’s also worth noting that while you can eek out an extra 0.5% annually (a tight spread by historical standards) investing in bonds that mature in 10-years instead of 2-year bonds, you only earn an additional 0.21% investing in 30-year bonds that mature 20 years later. Clearly, the “long-bond” crowd is not expecting that inflation will rise significantly over the intermediate term.

On Friday, the Bureau of Economic Analysis will release Q1 GDP data. The consensus estimate is for real, annualized growth of a little better than 2%. Most analysts believe that growth will pick-up to a level closer to 3% over the remainder of the year. The cause (or causes) for first quarter growth to be lower than subsequent quarters since the Financial Crisis are not well understood, but the pattern has been clear up to this point.

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Two-Handed Economists – A frustrated President Harry Truman once said “Give me a one-handed economist. All my economists say ‘on the one hand‘… ‘but on the other hand’”. The latest Global Financial Stability Report from the International Monetary Fund (IMF) would not impress Truman. Below are a few examples:

  • Emerging markets have generally improving fundamentals, but could be vulnerable to a sudden tightening of global financial conditions.
  • Banks have strengthened their balance sheets since the crisis, but parts of the system face a structural US dollar liquidity mismatch that could be a vulnerability.
  • Crypto assets have features that may improve market efficiency, but they could also pose risks if used with leverage or without appropriate safeguards.

There is a reason that economics is called the dismal science. Economies are extraordinarily complex systems subject to a myriad of variables that complicate forecasts. While the IMF hedged their bets on emerging markets, banks and crypto assets, the organization was clear in its warning about global debt levels.

Thanks to nearly ten years of accommodative monetary policies, public and private debt reached $164trillion in 2016, which equates to 225% of global GDP – 12 percentage points higher than the 2009 peak. The IMF report states that high debt levels have increased short-term risks to financial stability and medium-term risks remain elevated as higher inflation could force central banks to raise interest rates faster, tightening financial conditions and slowing growth.  The annual report also cited stretched valuations of risk assets combined with leverage and liquidity mismatches as a potential risk for the financial system.

Labor Love? – Since tax reform was implemented on January 1st, it has become increasingly clear where companies intend to direct a significant portion of their tax savings, and it’s not on R&D, capital expenditures or pay raises for employees. Instead, acquisitions and stock buybacks appear to be the favored destinations for the tax savings windfall, familiar destinations for excess cash flow to anyone keeping track since the Financial Crisis. In the first quarter of this year, US acquisitions amounted to $473 billion, an increase of 66% over last year and the highest first-quarter total on record. And while the majority of publicly traded companies are currently in a blackout period for stock buybacks (due to pending Q1 earnings releases), Goldman Sachs buyback desk has already seen a 62% year-over-year increase in repurchases. Indeed, stock buyback authorizations for S&P 500 companies totaled $205 billion thus far this year, a 48% increase over the same point in 2017. Looking at this from a slightly different perspective, the results are largely the same. The non-profit organization Just Capital has analyzed 120 large U.S. corporations and found that the majority of the tax savings are going to shareholders.

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The skinny 6% “Workers” slice of the pie in the chart above represents wage increases, one-time bonuses, expanded worker benefits, spending on training and other services. The official unemployment rate is the lowest since 2000, yet, as has been the case since the Financial Crisis, labor is still not reaping the rewards of the economic recovery as the majority of profits are being distributed to the equity holders widening the highly publicized wealth inequality gap. To be sure, wages have increased since the Financial Crisis, but real wage pressure remains absent, implying the labor market is not as tight as the official unemployment rate suggests.

Laffer Logic – Over the weekend, Barron’s published an interview with Arthur Laffer, the economist known for the Laffer Curve. The Laffer Curve theory posits that raising tax rates beyond a certain point is counter-productive for raising further tax revenue. Yet, a corollary to the the Laffer Curve has dire implications for the advancement of societies and continual improvement of our lives through innovation. Namely, taxes are a strong disincentive to behavior that benefits society such as ingenuity and, at its most base level, work.

By redistributing income [via taxation], you take from someone who has a little more, and you give to someone who has a little bit less. By taking from someone who has a little bit more, you reduce their incentive, and they produce a little bit less; by giving to someone who has a little less, they suddenly have an alternative source of income, and they, too, will produce a little bit less. The more you redistribute, the greater will be the total loss in income. The limit function here, which is really interesting, is if you were to redistribute income totally, if everyone who made above the average income, you tax them 100% of the excess, and everyone who made below the average, you subsidize them up to the average income—you follow me? Everyone would have the same income. If you actually did that… everyone will end up equal, at zero. At zero, no one will work.

Mr. Laffer is, of course, presenting the extreme example to make his case. And even he would concede that some taxation is required to maintain essential social services such as fire, police, military, etc. Incentives are a powerful motivator…as are disincentives, and that is the crux of Laffer’s logic.

Be well,

Jp.