Covenant Weekly Market Synopsis for August 31, 2018

September 4, 2018

Last Week Today: Trade negotiations once again took center stage and progress was mixed.  The agreement between Mexico and the U.S., along with concessions to the U.S. from Canada and the European Union (EU) boosted markets early in the week.  However, trade optimism faded when President Trump delivered a one-two punch of announcing the EU’s proposal didn’t go far enough and that he intends to levy tariffs on an additional $200 billion of Chinese imports. In other news, Argentina’s central bank raised its key interest rate by 15% to 60% (no, not a typo and, yes, that is the highest central bank rate in the world currently) in an effort to arrest the peso’s decline, which has fallen more than 50% against the dollar this year.

Domestic equities finished the week in the black, marking the fifth consecutive month of gains for the major indices. Technology (represented by the Nasdaq Index) has been the best performer, gaining 18.3% YTD vs. 9.9% for the S&P 500. Small cap stocks are also performing well with the Russell 2000 Index +14.3% YTD. Growth stocks continue to outperform Value stocks, adding 5.5% in August – this brings YTD performance for the Russell 1000 Growth Index to 16.4% vs. 3.7% for its Value-focused cousin. By several measures, this is the worst period of underperformance for Value since the late 1990’s when sock puppets, mouse clicks, and Internet companies with huge valuations (but no profits) were the only game in equities. That period also saw legendary Value-oriented investors like Julian Robertson retire in frustration, just before Value stocks came into favor again.

Gains outside the U.S. have been tougher to come by this year. Developed international market stocks, such as those included in the EAFE Index, have lost 1.9% YTD, and emerging markets are downright ugly. China’s -15.5% YTD performance is particularly weak, though the broader emerging markets MXEF Index has declined 7%. Fiscal stimulus, accommodative monetary policy, and an economy largely insulated from the impacts of international trade are a successful formula for economic growth and stock market performance in the U.S. relative to the rest of the world.

For detail on weekly, month-to-date and year-to-date asset class performance, please click here.


GICS Changes to Alter Investment Landscape: The stock market taxonomy, known as the Global Industry Classification System (GICS), is about to get a major overhaul that will forever change sector-based investment strategies. On September 30th, S&P Dow Jones Indices will reconstitute its indexes, eliminating the Telecommunications Services sector and replacing it with a new sector called Communication Services (MSCI, the other dominant provider of market indices, will put the same changes into effect on December 3rd).  As part of the index shake-up, household name stocks like Facebook, Alphabet (aka Google), and Netflix will be reclassified, changing both the relative weighting of sectors within the S&P 500 and the concentration of specific companies in sectors.

  • Communication Services – A newly created sector that will be dominated by Alphabet and Facebook, which together will comprise nearly 50% of the market capitalization. This sector will also include AT&T, Verizon, and CenturyLink, the last three members of the soon-to-be-extinct Telecommunication Services sector. Rounding out the sector are media companies such as Netflix, Walt Disney, and Comcast (which will migrate from the Consumer Discretionary sector).
  • Consumer Discretionary – Losing the media companies, along with the addition of eBay and a few others, will increase the Consumer Discretionary sector’s focus on retail. The changes also mean that Amazon’s influence on the sector will increase, as Amazon’s market capitalization will jump from 27.7% to 35% of the sector.
  • Information Technology – With the departure of social media companies (such as Facebook and Alphabet), the Information Technology sector will be dominated by hardware, software and semiconductor companies. The business models for these companies are more capital intensive and cyclical in nature, hence the sector will be more susceptible to the economic cycle a la the Industrial sector.


In all, the reclassification will impact 1,100 companies globally and countless sector-focused ETFs and mutual funds. Investors should be aware of these changes and the impact it will have on their portfolio. The giant fund providers such as Vanguard, Fidelity, and BlackRock are already implementing changes. For example, if you bought an Information Technology ETF because you love Facebook or Alphabet, you’ll need to sell that position and purchase a Communication Services sector fund. It’s also worth noting that historical sector correlations will change with the new classification system and perceived portfolio diversification along with it.


Economic Data Update: Consumer Confidence (as measured by the Conference Board) hit an 18-year high in August. This measure of consumer confidence has only surpassed its current level one time previously, from 1997 – 2000. Like today, during the 1990’s equity markets and labor markets were both strong.


Source: Marketfield Asset Management

In another similarity to the late 1990’s, the spread between Present Situation confidence (the blue line in the chart above) and Expectations (the green line) is widening. We discussed this phenomenon in our Mid-Year Economic Review and Outlook. Although it is a lousy timing tool, this divergence combined with the elevated level of Consumer Confidence signal we are in the later stages of this economic cycle. However, it must be stressed it does not imply an imminent end to this stage of the cycle.

On that note, real annualized GDP growth for Q2 was revised up by 0.1% to 4.2%. In the revised data, a downward revision in Consumption (3.8% vs. 4.0%) was offset by a sizeable revision in intellectual property growth (11.0% vs. 8.2%). Pre-tax corporate profits rose by 7.7% year-over-year, while profits after tax rose 16.1% highlighting the effects of the tax cuts. On the negative side of the ledger, durable goods orders and the housing market continue to exhibit weakness.

Inflation (as measured by Core Personal Consumption Expenditures (PCE)) was 2.0% in the second quarter, in line with expectations, but higher than the wage growth rate, thus reducing real income growth. Anecdotally, several companies are reporting higher costs which are now being passed onto consumers, suggesting inflationary pressures are real and will keep the Fed on track with its near term rate forecast (meaning two more rate hikes this year).

In sum, the domestic economic backdrop is solid, but there are no indications the economy has found a sustainable higher gear. Although the Fed’s dot-plot suggests five rate hikes between now and the end of 2019, the Fed funds futures market is only pricing in three hikes. In other words, bond investors (who are very sensitive to inflation – stemming from growth or supply constraints) believe the economy will cool off enough for the Fed to slow their pace of rate hikes. We may see another quarter or two of above-trend growth, but beyond that, we expect the economy will glide back to a trend growth rate of between 2% – 3% per year….and there’s nothing wrong with that at this stage of the cycle.

Be well,