Covenant Weekly Market Synopsis for February 1, 2019

February 4, 2019

Weekly Synopsis Notes

Last Week Today. The Government got back to work. Financial markets did not reward the re-opening, implying that investors (conditioned by past government closures) did not pay much mind to the initial government closure either. | Central Bankers expressed less optimism about the future as the ECB and the Fed both backed away from attempting to tighten financial conditions in their respective economies. | The European Central Bank’s President Mario Draghi announced the ECB might restart quantitative easing (QE), only one month after it officially ended in December 2018. | The Fed’s meeting last week reinforced their ‘mea culpa’ following the December-disaster, and not only are Fed rate hikes on pause for now, but Quantitative Tightening may end sooner than previously thought. | US and Chinese representatives met for two days in Washington D.C. and appeared to make progress on trade negotiations.

Whipsaw. After posting its worst December in 87 years by falling 9%, the S&P 500 rallied 7.9% in January. Even more impressive, at 2,706, the S&P 500 has rallied 15% from the Christmas Eve low of 2,351. For detailed weekly, month-to-date and year-to-date asset class performance, please click here.

The Four Horsemen of US Equities. At this point, it seems that the key variables determining the direction of domestic equities in 2019 will be 1) Fed policy and interest rates, 2) China’s economic growth, 3) Trade Policy, and 4) Earnings Revisions. Because financial markets are anticipatory systems (i.e., today’s prices discount future outcomes), what will matter most is the marginal change in each variable, relative to investor expectations. A summary of the current status and future expectations of each variable follows below.

  • Fed policy and interest rates – This past week’s news on Fed policy was more than a marginal change relative to market expectations; it was a paradigm shift. Whereas only one month ago the Fed presented an obstinate view despite financial market turmoil, including a balance sheet reduction on “autopilot” and “some further gradual increases” in rates were forthcoming, this week’s Fed revealed it would not raise rates for the foreseeable future. While the pause is welcome, the market may have gotten ahead of itself by assuming the Fed is done hiking rates this cycle. Indeed, interest rate futures are assigning an 87% probability of no hikes in 2019 and an 11% chance of a rate cut by year-end. Contrarian investors would observe that the markets, and therefore risk assets, are set-up for disappointment.
  • China’s economic growth – Economic data from China indicates the economy is slowing, but still expanding at around 5% per annum (though, admittedly, Chinese data is notoriously unreliable). No one expected China’s transition (some would call it a maturation process for the 2nd largest economy in the world) from an export-based economy to a consumer-based economy would be smooth, and the ongoing trade battle with the U.S. is exacerbating growth issues. Many economists expect the Chinese government to introduce new fiscal stimulus to reverse the slowing growth trend, but recently stimulus has had mixed results and, hence, near-term risks are skewed to the downside.

clip_image001

Source: Goldman Sachs

  • Trade Policy – This variable is best described as ‘uncertain.’ Recent press reports indicate the negotiations are yielding progress, but on what specific issues it remains unknown. In broad terms, the issues fall into two categories: the bilateral trade deficit and intellectual property disputes. The former can be cured relatively easily (e.g., China can simply purchase more soybeans from the US), but the latter issue is thornier. Most believe that either some interim agreement will be reached by the March 1st deadline or the deadline will be extended to avoid implementing the scheduled tariff increases from 10% to 25% on $250 billion of China imports and new tariffs on an additional $258 billion of imports. If the deadline comes without one of these resolutions, equity markets will be at risk.
  • Earnings Revisions – 2019 S&P 500 earnings per share estimates have been cut by 2% during the past month and by nearly 4% in the last three months, reflecting slower domestic and global growth. Consensus earnings estimates for the S&P 500 center around 6% year-over-year growth over 2018. Indications by management teams of further slowing in 2019 will result in lower equity prices.

Notes From the Road. Traversing a very chilly East Coast last week, below are key observations from a variety of meetings with hedge fund masters of the universe.

  • Based on conversations with corporate management teams, the economy looks pretty darn good. Slower growth, but growth nonetheless. They are nervous across the board about the ability to hire (labor availability) and cost to hire (wage inflation).
  • We expect a lot of mergers and acquisitions to be completed this year because of the market sell-off in 2018. Corporate management teams are happy their stock prices are off their lows, and having been reminded about how bad things can get for their respective stock price, and many feel that now is an excellent time to sell.
  • The Fed has been so admonished they will likely not do anything for at least six months. “A 2% growth economy with the Fed out of play is better than a 3% growth economy with the Fed in play”.
  • In credit markets, December did not present many opportunities to add to positions. There were not a lot of weak hands forced to sell, even though some bond prices declined significantly.
  • One of our largest portfolio concentrations is in small business lending. This gives us a good view of the real economy and things look fine right now, in spite of the government shutdown, China trade tensions, and slowing economic growth.
  • After falling an average of 12%+ in 2018, large, diversified MLPs are attractive. They’ve become fiscally conservative since oil bottomed in 2016 and during December’s turmoil were selling at cash-flow multiples similar to where they were in the first quarter of 2009 when the entire financial system was on the brink of collapse.
  • The notion that corporate debt markets lack liquidity is a myth. Yes, the Volcker Rule [a component of the broader Dodd-Frank Wall Street Reform and Consumer Protection Act] eliminated much of the proprietary trading by large banks. Nevertheless, trading volumes are at record highs as hedge funds have replaced banks as the liquidity providers. Moreover, because banks don’t own the paper, the systemic risk from corporate defaults is lower than in the past.
  • We haven’t raised a distressed debt fund since 2009, but we are now. We don’t see another 2007 in the future because that was a systemic banking problem. However, Fed-induced low rates have encouraged investors to buy risky corporate debt with thin covenants. The animal spirits that have driven corporate debt prices higher in the last few years will reverse when people begin asking themselves what have I been buying for the last five years? When that happens, corporate bond bonds will sell off and, since banks are not a meaningful player anymore, the prices won’t stop at 90 because buyers like us won’t step in with a bid until the prices reach 70 or 80-cents on the dollar. This is the opportunity we are seeking to capture with our new distressed debt fund.

Be well,

Justin