Covenant Weekly Market Synopsis for June 14, 2019

June 17, 2019

Last Week Today. Mexico’s government agreed to move forward with adopting the USMCA trade agreement (aka, NAFTA 2.0) following President Trump’s announcement he would not levy illegal immigration-related tariffs on Mexico. | Two oil tankers were attacked in the Gulf of Oman, shortly after passing through the maritime bottleneck known as the Strait of Hormuz. Iran was quickly implicated but denied involvement. Given the importance of that region to global oil transportation, the +2.2% rise in oil prices was somewhat muted considered prices had fallen -4.0% the day before on oversupply concerns. Six ships have been attacked in the volatile area in the last two months. | The 10-year German Bund (the benchmark for European bonds, and the poster-child for negative yields) hit a record low yield of -0.25%. Today, nearly $12 trillion worth of bonds are trading with negative yields as Global central bankers search for solutions to persistently low inflation. Speaking of which, U.S. Core CPI slowed from 2.0% to 1.8% in May. | In Hong Kong, an estimated two million protesters (or about 1 in 4 citizens) literally took their lives into their own hands and successfully prevented the government from passing a law allowing citizens to be extradited to China, where the legal system is less forgiving. There’s power in numbers.

Global equities see-sawed their way forward tacking on about +0.3% last week to build on June’s strong start (MSCI ACWI +4.0% MTD). Emerging and Frontier market stocks led the way with gains of +1.0%, while U.S. stocks added +0.5% (S&P 500 +5.0% MTD). Yields on bonds continued to grind lower, with the yield on the 10-year U.S. Treasury bond twice touching 2.05% intraday (the lowest level since September 2017). Equity and bond prices are telling a different story. While bond prices are signaling a significant slowdown in global growth, stock indices in Australia, Argentina, Brazil, Greece, and Russia are near all-time highs. These aren’t the strongest of economies, so it begs the question of whether equity investors or bond investors are correctly forecasting global economic strength.

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

Consumption Function. On a very positive note for the economic outlook, real (inflation-adjusted) personal consumption, which accounts for nearly 70% of the economy, bounced back in April and May. Following a Q1 annualized growth rate of only 1.3%, data released last week showed consumption is growing at an annualized pace of 3.9%. Our no recession in 2019 thesis and a continuation of the “Good But Not Great” GDP-growth-trend hinges on the strength of the consumer, who appears to be in fine financial shape (low unemployment, rising wage, low debt service ratios, etc.). Thus far, Mr. and Mrs. Consumer are not disappointing.

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Sources: U.S. Census Bureau and FTN Financial.

Following the retail sales report, the Atlanta Fed raised its Q2 GDP forecast to 2.1% (from 1.5%), in line with the post-Financial Crisis trend growth rate.

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Paging Mr. Powell. The Federal Open Market Committee (FOMC) meets Tuesday and Wednesday this week. After the meeting, the FOMC and will provide updates on their outlook for interest rates and the economy. Investors are loading up on bets the Fed will cut rates by July and then two more times later this year. Fed Futures indicate a greater than 85% probability of a Fed rate cut at their next meeting in July, and a non-trivial 25%+ chance of a rate cut this week.

It’s unlikely the FOMC will cut interest rates this week unless they want to surprise the market. Before Fed Chairman Alan Greenspan’s push for greater transparency 25 years ago, the Fed operated in relative secrecy and did not announce changes to interest rates.  Back then, investors relied on Wall Street’s “Fed watchers” to interpret the Federal Reserve’s monetary policy by observing the Fed’s Open Market Operations (i.e., the buying and selling of U.S. Treasuries to maintain a specific Federal Funds Target interest rate). The modern Fed professes transparency and forward guidance, so a surprise is improbable. A more likely scenario is Chair Powell acknowledging a slower growth rate than in 2018, reiterating that the Fed is watching the trade situation closely, and repeating the refrain that the Fed stands ready to act if necessary (i.e., the “Fed Put” option is alive and well). Given the magnitude of bets that a Fed rate cut is imminent, that type of message may be viewed as disappointing by the market.

How the Mind Works Against Successful Investing: Biases Framework

To say the human brain is complex is like saying it’s “a little” warm outside during a South Texas summer. How people make decisions, which is but one multifaceted activity performed by the brain, remains to be fully understood, but extensive research has provided some insights.

One conclusion from the research shows the frailty of human decision making. Specifically, when people face complex problems, they have difficulty formulating a rational approach to solving the problem. Instead of describing the problem, assembling the necessary data, and spending time to synthesize the information, humans generally try to simplify. People lock into a subset of the available data, typically discarding the most complicated information (which may ultimately be relevant) and settle for a solution that is “good enough.” Subjective judgments about which specific information people select as important to their decision are inherently biased by existing beliefs, past experiences, and/or emotions. These biases, in turn, often lead to a sub-optimal decision and outcome.

As it applies to finance, in theory, members of an economy make decisions based on logic that lead to “wealth maximization.” In reality, however, psychology and emotion dominate the decision-making process, leading to unpredictable or irrational behaviors. Researchers have identified more than 50 specific biases that affect individual investor decisions. These biases can generally be categorized as follows[1]:

  • Emotional Biases – irrational decisions based on instinct or impulse, rather than conscious calculations. It’s generally accepted that this category of biases is more challenging to correct than cognitive biases as they are more difficult to detect. Whereas decisions from Cognitive Biases can be demonstrated as illogical (e.g., a conclusion can be shown to be mathematically inaccurate), Emotional Biases emerge from peoples’ personal experiences and are based on how they feel rather than how they think.
  • Cognitive Biases – systematic errors in thinking that cause us to act irrationally repeatedly. These biases can be thought of as the “hardwiring” of the human brain and are likely a legacy from our hunter-gatherer ancestors when speed of decision-making was more important than accuracy for survival.[2] Cognitive Biases often occur because of heuristics, mental shortcuts we have developed to make decisions when time is limited. Sometimes heuristics can be useful for making quick decisions, but the downside of heuristics leads to two categories of biases that can negatively impact investment decisions:  (1) Belief Perseverance – sticking with the status quo, even as newly available information conflicts with that decision; and (2) Information Processing – assimilating data illogically.

With this as a framework, next week we’ll begin our exploration into specific ways the mind works against successful investing. Depending on the complexity of the biases and length of the review, we will generally cover one to three biases each week. In all, we will explore approximately 20 behavioral biases in the coming months. When we finish, you should have a solid understanding of why decision making is challenging, be able to identify potential biases and adjust for them in your daily life to create better outcomes.

Be well,

Justin


[1] Credit to Michael M. Pompian, who created this taxonomy in his book Behavioral Finance and Wealth Management, a key resource for our exploration into the topic of Behavioral Finance.

[2] As an aside, the book Thinking Fast and Slow by Nobel laureate Daniel Kahneman is a fantastic exploration of biases that result from the human brain’s two modes of thought. System 1 is fast, instinctive, and emotional. System 2 is slower but more deliberative and logical.