Covenant Weekly Market Synopsis for January 12, 2018

January 15, 2018


198%. That would be the S&P 500’s gain at the end of 2018 if the index continues to appreciate at the same rate as the first two trading weeks of this year. Of course, extrapolating results from short datasets are not statistically significant (that is, the forecasts are unreliable – but if anyone wants to make a friendly wager, I’ll take the under). Yet, this simple calculation highlights the ongoing strength of this rally that maybe (just maybe) is exhibiting some signs of euphoria. Last week the S&P 500 rose 1.6% and after two weeks has already gained 4.3% year-to-date (inclusive of dividends). Other broad equity indices in the U.S. and internationally have kept pace. It’s a bull market of global proportions for risky assets. On the other hand, fixed income investors are not celebrating thus far in 2018. As equity prices move ever higher, prices of traditional safe-haven bonds have fallen. For example, the benchmark Barclays Aggregate U.S. Bond Index has returned -0.5% year-to-date. It’s worth noting that even as the yield on the U.S. Treasury 10-year bond has creeped higher, it remains at the upper end of its 2017 trading range of (2% – 2.6%). A sustained breach above the key technical level of 2.63% will be interpreted negatively by the market, resulting in additional selling.  This scenario would put the 10-year UST on a course to test a 3% yield (a level not seen since January 2014). Wrapping up the weekly market review, precious metals were mixed on the week (gold +1.4%, silver -0.1%) and WTI Crude gained 4.8% to $64.40 per barrel.

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

Inflation’s Mystery Factor – Inflation has remained stubbornly below the Fed’s 2% target rate since the Financial Crisis.  A fact that, while not newsworthy, remains vexing nine years into an economic recovery. Some of the shortfall is readily explainable by a four-factor model that includes food/energy prices, import prices and labor-market slack. Indeed, as the chart below highlights, labor market slack (the purple-shaded area) accounted for nearly 100% of the shortfall from 2008-2012 as declining demand for goods and services forced massive layoffs in the aftermath of the Financial Crisis.


Source: FTN Financial

In more recent years, namely 2013 – 2016, food/energy, import prices and labor slack have all had a disinflationary impact on the economy to varying degrees. The fourth component to this four-factor inflation calculation is an error term in the Fed’s model – that is, the unexplained difference between the sum of the first three factors and the realized level of inflation. As can be seen in this chart, the error term is volatile both in magnitude and in direction (it’s sometimes positive and sometimes negative). According to Fed Chair Yellen, the error term captures the “one-offs” such as the widely cited decline in cell phone prices at the beginning of 2017. Yet, some members of the Federal Open Market Committee and non-FOMC economists are not convinced this is the case. Indeed, FTN Financial’s Chief Economist Chris Low points out that “Maybe we’re going about this inflation forecasting thing the wrong way. Rather than asking what will make inflation rise…maybe we need to ask what has prevented inflation from rising for the last 10 years, and whatever it is, if it is likely to go away any time soon.” Chair Yellen’s explanation of one-off’s notwithstanding, apparently a contingent of the Federal Open Market Committee members are spending a lot of resources trying to answer this very question. The results of their research have the potential to dramatically alter the course of future monetary policy.

One potential outcome would be a shift from the Fed’s current strategy of inflation-targeting to a price-level targeting approach. Under the inflation-targeting strategy, 2% inflation is treated as a level that the Fed seeks not to exceed.  While they do not overtly state as much, the 2% target has inadvertently evolved into an inflationary ceiling.   As such, the Fed’s natural reaction function to an inflation level approaching 2% is to raise interest rates to keep inflation at the 2% level. This approach is increasingly viewed as preventing the Fed from achieving its target as monetary policy is an extremely blunt tool and, more often than not, the Fed overtightens pulling inflation further below their target. Moreover, it is extraordinarily difficult to engineer a specific growth rate in any facet of the economy, let alone in an economy with the size and complexity of the U.S. With price-level targeting, however, the Fed would still target a 2% inflation level, but that target would be based on the average inflation rate over an intermediate timeframe. Under this strategy, the Fed would be more tolerant of inflation rising above 2% for a period of time if it had remained below that level in the preceding period (kind of like now).  This would slow the pace of future rate hikes and is a policy methodology championed by Minneapolis Fed President Neel Kashkari and an increasing number of FOMC members. Monetary policy academics are geeked-up about the research and investors are eager to understand a potential transition as few things have more impact on the business cycle and asset prices than Fed policy.

Non-bank Banking – Private lending, direct lending, peer-to-peer lending, shadow banking… obtaining loans from non-traditional sources (i.e. banks) goes by many names. While once dismissed as a fad, the speed and convenience of leveraging technology to obtain credit from non-bank lenders has made them increasingly the first choice for consumers and small businesses seeking a loan. From an investment perspective, the rise of private credit is creating opportunities for investors to access what is typically the most valuable piece of a bank’s business. Compared to buying stock in a bank, investing in private loans enables investors to avoid the less profitable aspects of a traditional bank including the costs of physical locations, staffing, and regulatory compliance. In a low interest rate environment, short-term (1 – 5 year) loans generating yields of 8% – 15% look attractive relative to the yield on U.S. Treasuries of similar maturities (1.8% to 2.3%) or high-yield debt coupons of approximately 5% (as measured by the yield on the iShares IBOXX HYG ETF). Moreover, relative to the longer-term return expectations for domestic equities of 5% – 7%, private lending presents an opportunity for portfolio diversification without giving up performance. Institutional investors (e.g. pensions, endowments, insurance companies and private partnerships) have certainly taken notice of the opportunity and in the first quarter of 2017 alone, committed $5.2 billion to private credit – more than 2x the commitment level to other forms of alternative credit such as distressed debt.


Source: Pensions & Investments magazine

The opportunity is also set to expand, especially as younger entrepreneurs (having grown up with technology) eschew the idea of traditional banks as highlighted in the chart below.


The space is not without risk; a couple of key factors for potential investors to consider is illiquidity and defaults. However, the return vs. risk ratio appears attractive. If you are interested in exploring the space further, we authored a white paper entitled A New Investment Frontier on the topic.

Be well,