Covenant Weekly Market Synopsis for January 5, 2018

January 8, 2018

BANG!  Equities came off the starting line in 2018 like Usain Bolt in a 100-meter dash (or Carl Lewis, for those of us who remember his storied career in the 1980’s).  The Nasdaq sprinted ahead by 3.4% last week, smashing through 7,000 for the first time, while the Dow Jones Industrial average also breached the big round number of 25,000 (climbing 2.3% to 25,296).  In addition to those all-time highs, the S&P 500 gained 2.6% to close at 2,743. Reflecting the optimistic market view, international developed market stock indices gained 2% or better for the week, while the MSCI Emerging Markets Index rose 3.0%. The U.S. Treasury Curve shifted higher as 2, 10 and 30-year bond yields all rose by about 0.07%. The yield on the UST 10-year, at 2.48%, is near the top of the 2.0% – 2.6% trading range it inhabited for all of 2017. Many argue that rates will move meaningfully higher due to strong economic growth and a more hawkish Fed. We agree with the sentiment, but with international bond rates at meaningfully lower levels (e.g. the 10-year German Bund is currently yielding 0.41%), investor demand for relatively juicy yields on U.S. Treasuries should temper domestic yield levels. WTI Crude rose 2.9% on the week to $61.55 per barrel, a boon for energy stocks which rose 3.7% (as indicated by the iShares Energy ETF).

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

Loosey Goosey – As most know, the Federal Reserve uses the Federal Funds Target Rate as a tool to try to manage the growth rate of the economy and fulfill their dual mandate of maximizing employment and stabilizing prices. While there are a variety of factors the Fed considers when setting monetary policy, a simplified example demonstrates how the Fed uses interest rates to manage economic growth and smooth the impact of natural business cycles. When growth in the economy is slowing or negative (e.g. during a recession), the Fed will typically cut interest rates in an effort to spur economic growth. On the other hand, when economic growth is strong enough to create the potential for high levels of inflation (i.e. a lack of price stability), the Fed will raise interest rates to make credit more expensive and slow the pace of growth in the economy. The Fed began its current rate hiking cycle in December 2016 as low unemployment levels generated concern that inflationary pressures would start building in the economy (the Fed also wanted to move rates off of the 0% level where they had been since the Financial Crisis).  Since that initial hike, the Fed has raised interest rates three additional times for a total increase of 1.0%. Interestingly, economic Financial Conditions have gotten looser, not tighter, as the Fed has pushed the Fed Funds Target rate higher. (Note: in the chart below the Bloomberg Financial Conditions Index is the white line – higher levels equate to looser financial conditions; the Federal Funds Target Rate is shown as the orange line).

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Sources: Bloomberg Finance, LP and Covenant Investment Research.

Even in the absence of pressing inflationary pressures, the Fed is also concerned with the health of the financial system. And ultra-loose financial conditions can lead to asset bubbles that, when popped, can destabilize the system. This “macroprudential” perspective should keep the Fed on pace to raise interest rates 3-4 times in 2018, even if inflation remains relatively muted.

Tranquil Waters – In many, many ways 2017 was a remarkable year in financial markets.  From record setting highs in the Dow Jones Industrial Average, S&P 500 and Nasdaq, to record setting lows in volatility as measured by the VIX Index, it was smooth sailing.  Indeed, of the 60 times in history that the VIX Index has closed below 10, 50 of them occurred in 2017.  Underscoring the low volatility, the S&P 500 has gone more than a year (385 days to be specific) without declining 5% or more from its 52-week high.  Not only is that the longest streak on record, but on only three occasions in history (1965, 1994, 1996) has the market gone 370 days without such a drop.  Yet, perhaps the most impressive feature of 2017 is that the S&P 500 completed its first ever perfect year of monthly gains.  At 14 months and counting, the S&P 500 is currently enjoying its longest streak of uninterrupted gains in history. How long can this continue?  Well, we know it won’t go on forever, but after the first week of trading in 2018 it sure seems like the record breaking streak will extend to 15 months by the end of January.  Enjoy the run, embrace the run, but don’t take the run for granted.  Trees don’t grow to the sky and, pardon my English, markets don’t not decline forever.

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Be well,

Jp.