Covenant Weekly Market Synopsis for June 15, 2018

June 18, 2018

Last Week Today: The annual G-7 meeting concluded with fireworks as President Trump sharply criticized EU trade policies, and heard an earful himself from the other leaders criticizing U.S. tariffs. | President Trump and Supreme Leader Kim Jung-un’s historic meeting resulted in a suspension of US/South Korea joint military exercises, though sanctions on Korea will remain in place until there is further progress on a denuclearization agreement. | The US District Court approved AT&T’s acquisition of Time Warner over the antitrust-based objections of the DOJ. The next day, Comcast bid $65 billion for 21st Century Fox’s entertainment assets, topping Disney’s existing bid of $52.4 billion. Coincidence or not, the DOJ’s decision to allow the AT&T-Time Warner merger sets a precedent for how competition is viewed and is likely to lead to increased corporate M&A activity. | The Fed raised their target interest rate to 1.75% – 2.0% (a 0.25% increase). | The ECB announced it would begin tapering its QE program in September and halt the expansion of its balance sheet by the end of the year. At the same time, the ECB pledged to keep rates at current negative levels (-0.4%) until mid-2019 at a minimum. | The SEC ruled that cryptocurrencies are not financial securities (the SEC considers them a commodity), catalyzing a rise in prices for cryptos such as Bitcoin and Ethereum. However, the SEC underscored that most Initial Coin Offerings (ICO’s) are securities and subject to SEC regulation. |President Trump announced tariffs on $50B of Chinese imports, targeting China’s industrial advancement. China responded with tariffs on $34 billion of US imports, focusing on commodity producers in Trump’s support base in Middle America. The tit-for-tat tariff announcements resurfaced trade war concerns, briefly roiling financial markets on Friday before cooler heads prevailed and the markets recovered into the close.

Financial markets zigged and zagged, but ended the week pretty much where they started, at least domestically where the S&P 500 finished flat (technically, it rose 0.02%). European stocks gained 1%; however the Euro currency was smashed following the ECB’s announcement, plummeting 1.9% (vs. the US dollar) on Thursday. Emerging Market stocks continued their downward trend as a stronger dollar (up 6% in the last two months) is causing investors to reassess the ability of EM countries to service their US dollar-denominated debt. The Fed’s rate hike resulted in further yield curve flattening. The difference in yields between a 2-year Treasury and a 10-year Treasury is now less than 0.4%. Finally, it was a poor week for commodity prices (e.g., gold -1.15%, silver -1.3%, copper -4.7%, WTI crude -1.0%), which suffered as the US dollar rose 1.3% for the week.

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

This Week Today: The Organization of the Petroleum Exporting Countries (OPEC) will meet on June 22nd in what one energy-focused portfolio manager called “…the most important gathering of OPEC ministers since the November 2014 meeting in which OPEC agreed to engage U.S. shale producers in a battle for market share.” At the center of the discussion will be whether to adhere to the 2016 production cuts or to relax the standards allowing more crude oil into the market. | Economic data due for release this week includes May housing data and Markit Purchasing Manager Index updates for June (consensus estimates are for a slight decline from survey readings in May).

Interest rates bite: Credit card debt delinquencies are on the rise, and while not at disconcertingly high levels, maybe the first indicator that the Fed’s seven rate hikes are beginning to bite into the real economy. With the Fed forecasting six more hikes in the next 18 months, history suggests credit card delinquencies are likely to rise further. Note that in the chart below, the credit card debt average interest rate (the black line) is advanced 18 months, suggesting that delinquencies do not rise concurrently with higher rates, but rather with a delay.

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Source: Capital Economics

Even as credit card delinquencies are on the rise, delinquency rates on other forms of borrowing remain flat or declining.

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Sources: Capital Economics and Covenant Investment Research.

The shift higher in credit card delinquencies can be tied to the quick reaction function of credit card companies to changes in the Fed Funds rate as compared to other sources of credit. To illustrate this point, the table below compares the change in average interest rates for credit cards, mortgage rates, and auto loans since the Fed began hiking interest rates in December 2015.

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Sources: Federal Reserve Bank of St. Louis, Freddie Mac, and Covenant Investment Research.

Since the Fed initiated this rate hiking cycle, average mortgage rates have increased 70% less than the Fed Funds rate and auto loan rates 45% less. Yet, the relative percentage change in credit card rates is 31% higher than that of the Federal Funds rate.

This interest rate data combined with the delinquency statistics illustrate a fundamental principle of economics. A higher cost of credit leads to lower credit demand as consumers and corporations either proactively decide they cannot safely service more debt, or through higher delinquency rates. The interest rate/credit demand relationship is precisely why central bankers use interest rates as their primary monetary policy tool to manage economic growth. Lower credit demand results in slower credit growth, which in turn leads to slower economic growth. Conversely, higher credit demand (resulting from lower interest rates) generally stimulates economic growth.

However, higher interest rates do not immediately reduce economic activity, just as lower rates do not engender faster growth instantaneously. Economies are too complex, and monetary policy too blunt a tool to fine-tune an economy to the optimal growth rate that promotes maximum employment and price stability (i.e., the Fed’s dual mandate). Hence, despite all the available economic data, large research staffs, powerful computers, and a dizzying array of economic formulae and theories, central bankers are essentially guessing at the appropriate interest rate and the ideal unemployment rate. Indeed, at the press conference following last week’s rate decision, Fed Chairman Jerome Powell stated, “We can’t be too attached to these unobservable variables. We have to be grounded by what we see in the data.”

Powell’s comment is a rare admission by a central banker, and it highlights the fine line that central banks must walk to maintain interest rates at the appropriate level to neither overstimulate an economy nor plunge it into recession. As the Fed continues to tighten from this level, credit will become more expensive, and the economy will slow. It won’t happen overnight, but eventually, the Fed will get what it wants, which is why one of the most repeated sayings on Wall Street is “Don’t fight the Fed.” With financial market valuations stretched by most historical measures, investors should keep in mind that history is not on the Fed’s side to “stick the landing” with regards to the correct path for interest rates. Since the Federal Reserve was created, ten of the thirteen rate hiking cycles have ended in recession….Food for thought, if nothing else.

Be well,

Jp.