Covenant Weekly Market Synopsis for December 8, 2017

December 11, 2017

After stumbling out of the gates in December (typically a very good calendar month for stocks), equities regained their footing over the last couple of days tacking on gains of 0.4% to close out the week at highs (at least for the S&P 500 and Dow Jones Industrial Average, though the Nasdaq is not far off). International stocks were mixed on the week with Europe putting in the largest gains (+1.5%), followed by frontier markets (+0.6%) and Japan (+0.5%). There were a few losing indices on the week, but losses were generally muted as China’s main index fell 0.4% and emerging markets gave back 0.5% (but remain up 31.7% year-to-date). Yields pushed higher on the front end of the curve, while the long-end (i.e. 30-year maturity) US Treasuries barely budged, causing a flattening in the yield curve described in more detail below. It was a rough week in the commodity index as the prices of precious metals (-3%), copper (-3.7%), and crude (-1.8%) all fell. The US Dollar climbed for the second consecutive week as progress on tax reform and reasonably solid economic data should keep the Fed on track to continue raising interest rates, including a 0.25% increase when they conclude their final meeting of the year this Wednesday.

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

The Yield Curve is Flatter – so what? As interest rate differentials between 2-year and 10-year US Treasuries (“USTs”) have declined, media coverage and Google searches for the term “yield curve flattening” have increased dramatically. It seems that the ongoing flattening of the yield curve is one of the top concerns of investors who see this as a sign that the economy is beginning to sputter. To be clear, the concern is not so much that the yield curve is flattening, but that the interest rate differential will continue to decline resulting in an inverted yield curve (i.e. the yield on UST’s maturing in 2 years become higher than the yield on USTs maturing in 10 years). Inverted yield curves have a fairly reliable track record of predicting recessions.

To illustrate the point, the chart below shows the yields of 2-year USTs (orange) and 10-year USTs (blue) in addition to the differential between the two (10-year yield minus 2-year yield) in white. While the blue line has remained relatively stable in 2017, the orange line has been moving higher (especially since September). The result is that yield differential (the white line) has declined from approximately 1.3% at the start of the year to less than 0.6% today.


Sources: Bloomberg and Covenant Investment Research

So…. while the yield curve is demonstrably flattening, it is too early to call the end of the economic expansion and get overly defensive in your portfolio allocation for several reasons:

· A flattening yield curve is normal in the expansion phase of an economic cycle when the Fed is raising interest rates. The Federal Funds Rate directly impacts the front end of the curve, hence Fed rate hikes move short-dated bond maturities higher.

· The yield curve is not yet inverted. The differential between the yield on the 2-year UST and 10-year UST is still nearly 0.6%. In the last two recessions, the differential was at this same level five years before the recession in 2001 and nearly three years before the start of the 2008 recession.

· Even when the yield curve inverts, it is typically only a very early signal of slowing economic growth.

The bottom line is that it is worth keeping an eye on the slope of the yield curve, but as a standalone signal it is not currently indicating imminent trouble in the economy.

Consumption Warning – For those who have taken a basic economics course, the following formula should be at least vaguely familiar: C + I + G + (X-M) = GDP. In long-hand, Consumption + Private Fixed Investment + Government Expenditures + (the difference between exports and imports) = Gross Domestic Product. It’s a fairly straightforward calculation, but the “C” is what really matters at it makes up approximately 70% of total GDP. Hence, we pay a lot of attention to trends impacting Mr. and Mrs. Consumer as a road sign in forecasting future GDP growth. As our resident economist (and the brains behind Foleynomics) likes to say, if you get the consumer right, you’ll at least be in the right zip code for forecasting GDP growth. As I’ve written about over the last several quarters, the aggregate consumer is increasingly spending beyond his means, resulting in a lower savings rate and increased debt levels. This is an unsustainable dynamic as neither savings accounts nor the availability of credit are infinite. Eventually consumers will have to consume less, even if today their confidence is high. As the following chart shows, savings rates typically mean-revert over time resulting in lower consumer spending.


Sources: Dimitri Delis, Piper Jaffray & Co

Moreover, future consumption is being pulled forward not only by a reduction in savings, but also by increased borrowing.


Source: The Daily Shot

Ultimately consumers will feel the pinch and reduce consumption levels to rebuild savings accounts and payoff loans (rising interest rates will not help). Like the flattening yield curve, this is another very early indicator that we are in the latter stage of this business cycle. That being said, outside of an exogenous event negatively impacting the economy or a monetary policy error (i.e. tightening too fast), the “latter stage” of a business cycle can last for a couple of years. Nevertheless, it’s a good idea to keep a close eye on Mr. and Mrs. Consumer.

Be well,