Covenant Weekly Market Synopsis for August 17, 2018

August 20, 2018

Last Week Today. The crisis in Turkey combined with a local corruption scandal forced Argentina’s central bank to raise interest rates by 5% to 45% to arrest the decline in their peso. It was only last year that Argentina, a country that has defaulted on its debt six times in the previous 100 years, issued $2.75 billion of 7.75% U.S. dollar-denominated 100-year maturity bonds. A weak currency raises the chances of Argentina defaulting on its debt once again. | Turkey raised the cost of shorting the lira by 33%, and Qatar pledged a $15 billion investment in Turkey to help stabilize the currency. | The Wall Street Journal reported that a delegation from China would travel to the U.S. this week to lay the groundwork for a November meeting between President Trump and Chinese President Xi Jinping. | President Trump tweeted that public corporations should reduce financial reports to semi-annually from quarterly and asked the SEC to study the issue. While it would limit transparency, Trump is not alone in this crusade as JPMorgan CEO Jamie Dimon and Warren Buffet have made similar suggestions arguing that quarterly reporting promotes short-term thinking and limits innovation. Editorial Note: Transparency is a critical element of U.S. financial markets and is one reason U.S. stock markets are considered the bellwether of global finance – reduced transparency is hardly a good thing for investors who, via share purchases, are owners of public corporations.

Events surrounding Turkey and trade tariffs once again took center stage for investors last week and, in a near-mirror image of the previous week, equity markets got off to a shaky start but came back in the second half of the week. Domestic equity markets ended the week in positive territory, and the S&P 500 is only 0.8% below its January 26th record high. International equity markets, with the notable exception of Japan (+1.9%), were unable to get above water with the EAFE Index declining 1.4% and the Emerging Markets Index down 3.8%. Unsurprisingly, the situation in Turkey is having a more substantial impact on equity markets outside the U.S. – while the S&P 500 is up 1.4% month-to-date, the EAFE Index is down 3.9%, and the Emerging Markets Index is off by 5.9% month-to-date. Yields on traditional fixed-income investments ground modestly lower last week, resulting in a 10-year US Treasury yield of 2.86%. The commodity complex was down, led by Dr. Copper whose 4.1% decline brings year-to-date losses to -20.3% in this important leading indicator of global economic strength. Since June 1st crude oil has traded between $65 and $75 per barrel; following last week’s decline of 2.5%, crude is trading at the lower end of that range at $65.91 per barrel.

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Robots I.  Extremely tight labor markets and elevated capacity utilization rates in several industries are finally triggering management teams to invest in productivity-enhancing technology. Not only is the unemployment level below 4%, but for the first time in 50 years, there are fewer available workers than job openings (0.993 unemployed workers to job openings, to be specific).


With regards to capacity utilization, although the aggregate rate stands at 78.1% through July, several key sectors are near peak capacity: mining 92%, computers and peripherals 92.4%, crude production 90.1%, and fabricated metals 81.1%. Generally speaking, capacity utilization levels above 80% signal that producers will a) raise prices to maximize profitability on remaining capacity stoking inflation, and b) make investments to expand capacity to increase future revenue, if they believe demand will continue.

The upshot of the tight labor market and increased demand is that business investment is finally moving higher, following an extended drought. Indeed, Morgan Stanley’s measure of capital expenditures hit an all-time high earlier this year, and spending on equipment, structures, and intellectual property remained strong in the second quarter. Moreover, capital expenditure forecasts are solid according to recent surveys by the National Federation of Independent Businesses (NFIB).


A big focus of capital expenditures is on automating simple, repetitive functions (e.g., point-to-point transfers of merchandise in warehouse distribution facilities). While this may seem like it would displace workers, thus far that is not the case. Instead, automation is freeing-up workers to apply themselves in more value-added activities at companies, further enhancing productivity.

Productivity has yet to accelerate – yes, productivity rose by a 2.9% annualized rate in the second quarter, but it is only up 1.3% on a year-over-year basis – yet continued business investment should ultimately change that trend and could help extend the business cycle. Higher productivity enables the economy to run faster without associated inflation. A lack of inflationary pressure would give the Fed cover to slow the pace of rate hikes, removing one of the most significant threats to the expansionary phase of this business cycle.


Robots II.  Without a lot of fanfare, driverless cars are racking up the miles through experimental programs in select U.S. cities. Waymo, a subsidiary of Alphabet, Inc. (the company formerly known as Google), is leading the charge as its fleet of self-driving cars recently reached 8 million cumulative miles driven. While that may not sound significant (Americans drove a total of 3.2 trillion miles in 2016, according to the Federal Highway Administration), it is striking that the jump from 7 million miles to 8 million miles took only one month, when the first 1 million self-driving car miles required six years to complete.


The cost of self-driving vehicle service appears reasonable and will likely decline as competition in the space comes online. For Waymo’s test markets, the company is using an estimated charge of $1.70 per mile – approximately 30% cheaper than comparable taxi services. Industry experts foresee the rides dropping to less than $1.00 per mile, with one of the more aggressive forecasts coming in at $0.35 per mile by 2020 (Source: Bloomberg). As the father of a 13-year old girl who is quickly approaching the legal driving age, widespread adoption of self-driving technology is a welcome possibility. While there will always be reasons to worry about our children, at least concerns about her or her friends texting or being otherwise distracted while driving would be eliminated. Perhaps being trusted with a parent-funded driverless car hailing app will replace “my first car” as a teenage rite of passage.

Be well,