Covenant Weekly Market Synopsis for March 2, 2018

March 5, 2018

Equities suffered a one-two punch from the Fed and the President last week, leading to a 2% decline in the S&P 500. New Fed Chair Jerome Powell landed the first blow on the stock market during his testimony to Congress, when he testified that inflation over the long run should include times when it is below 2% and above 2% (more on this below). Fearing higher inflation, investors reacted negatively by selling stocks and the S&P 500 declined 1.6% from its intraday highs on Tuesday. The second blow landed on Thursday when President Trump announced import tariffs steel (25%) and aluminum (10%), protecting the 200,000 steel and aluminum manufacturing jobs in the U.S., but exposing the 6.5 million estimated jobs in industries that purchase steel/aluminum (e.g., auto and construction industries). The S&P declined 1.3% in response. Global equities declined as well last week: Japan’s Nikkei Index -4.4%, international developed markets (EAFE Index) -2.0%, Europe (BE500 Index) -3.5% and, emerging markets (MXEF Index) -2.8%.

Although equities took it on the chin, U.S. Treasury prices were relatively stable. The short-end of the Treasury curve barely budged (2-year yield at 2.24%), while the longer-end of the curve declined by 0.02% (30-year yield 3.14%). Evidently, the market believes the Fed will be able to effectively navigate potential inflationary pressures from economic growth or an escalating international skirmish on trade. Precious metals fell modestly (gold -0.4%, silver -0.1%) and, after rising the previous two weeks, WTI Crude declined -3.6% to $61.25 per barrel.

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


In ecology, regime shifts are large, persistent changes in the structure and function of a system (Biggs, R. et al. (2009)). Regime shifts typically occur when an internal process or an external shock triggers a different system behavior. The changes tend to be non-linear and can substantially affect the flow of ecosystem services, such as the natural pollination of crops and other plants. Regime shifts occur in financial and social ecosystems as well and these significant changes from the “status quo” have the potential to influence economic conditions and financial markets. While often thought of as instantaneous change, regime shifts need not be so. Indeed, change typically begins on the margin, but it is the persistence of that change that alters prevailing trends.  Only in hindsight is the point of regime change apparent. Below are five observations of current departures from the status quo representing potential regime shifts.  The persistence of each of the changes will ultimately determine its impact on the economy, financial markets and how to position an investment portfolio for success.

Regime Shift Candidate I: The QE Era Is Over – In September 2017, the Fed announced they would begin to shrink the Federal Reserve’s balance sheet, ending ten years of emergency-level monetary stimulus. The Fed’s plan called for reducing their reinvestment of interest and principal payments on Treasuries and mortgage-backed securities by $10 billion per month. Every three months the amount that is held back from reinvestment will increase by $10 billion until the amount held back from reinvestment on a monthly basis maxes out at $50. The balance sheet roll-off began in October 2017 at $10B per month and is currently scheduled to be approximately $20B per month. So how is balance sheet reduction program performing? According to data from the St. Louis Fed, total assets held by the Federal Reserve have declined by approximately $62 billion over the last five months. Given they are 2/3 of the way through the second quarter of the roll-off plan, roughly $70 billion should have been withdrawn by this point ($10 million per month x 3 months + $20 million per month x 2 months). The Fed is a little off their projected pace, but not terribly so. This is especially true, as the roll-off is subject to the timing of interest payments and bonds maturing which do not necessarily coincide with the specified monthly reduction levels.


Source: Board of Governors of the Federal Reserve System and Covenant Investment Research

Importantly, the other two significant sources of Quantitative Easing (the ECB and the BOJ) have signaled monetary policy changes as well. The European Central Bank cut its Quantitative Easing program by 50% at the beginning of the year. By July of this year, the combination of balance sheet reductions by the Fed and reduced bond purchases from the ECB is forecast to result in a net withdrawal of global liquidity for the first time since QE began nearly ten years ago. Last, but not least, the Bank of Japan announced this past Friday that it would likely start exiting its massive monetary stimulus plan in early 2019, thus completing the trifecta of Quantitative Tightening.

Regime Shift Candidate II: Higher Interest Rates – At the same time the Fed is reducing the size of its balance sheet, it is also tightening another monetary policy valve by raising interest rates (for the first time in nearly ten years). DoubleLine’s Jeff Gundlach has referred to the combination of reversing Quantitative Easing and higher rates as a “Double-Barreled” approach to a more restrictive monetary regime. The current Fed forecast is to raise rates thrice in 2018, but odds are increasing that they may hike rates four times as a result of the recent tax reform policy and potential infrastructure spending plan. Below is the Federal Reserve’s latest interest rate forecast, which still indicates three rate hikes in 2018, two rate hikes in 2019 and two rate hikes in 2020, before settling into a median estimate of 2.75% (or 0.4% below the forecast peak level of 3.125% in 2020).


Source: Federal Reserve and Covenant Investment Research

Regime Shift Candidate III: New Federal Reserve Chair – For the first time in nearly 30 years, the Federal Reserve Chair will not be an academically trained economist. Paul Volcker (1979 – 1987) was the last non-Ph.D. Fed Chair, after which a parade of Ph.D. economists followed: Alan Greenspan, Ben Bernanke, and Janet Yellen. A Ph.D. is not a requirement for the role, and Jerome Powell is no slouch. He earned a JD from Georgetown University and held several investment banking roles before joining the Federal Reserve Board of Governors in 2012. It’s also no secret that Powell’s education regarding monetary policy has come mainly from on-the-job training by the Fed staff. That’s not a deficiency, but it suggests that he will be more open to staff ideas concerning monetary policy. On that point, before Powell was appointed to the Chairman role, the FOMC staff was already advancing ideas about monetary policy changes that modify the view of what constitutes “stable prices.” I’ve written about this before here if you need a refresher, but if the Fed moves from the current inflation-targeting strategy to a price-level targeting approach, the Fed would be more tolerant of inflation rising above 2% for a period leading to potentially higher levels of inflation. As noted above, Powell is now publicly hinting at this shift.

Regime Shift Candidate IV: Populism vs. Globalization – For the last several decades the world has become increasingly integrated. Disparate economies grew intertwined through trade agreements and by corporations making significant capital investments outside their home country. The Internet has contributed mightily to globalization as has immigration, connecting and assimilating people from the far corners of the globe. Since the Financial Crisis, however, a populist backlash has gained strength. This populist movement seeks to address a perception that a privileged elite is exploiting the common people. It is, in essence, a rebellion against the “elites” and the system they control. Often this leads to increased nationalism and protectionism by populist leaders. Indeed, Bridgewater’s Populism Index (constructed by tabulating votes for populist candidates) is at its highest level since the 1930’s.


Source: Bridgewater Associates

Per Ray Dalio, founder of Bridgewater Associates (the world’s largest hedge fund with $160 billion in assets) and an outstanding thought leader, “…populism’s role in shaping economic conditions will probably be more powerful than classic monetary and fiscal policies.” If populism continues to flourish, it will lead to less cooperation between countries and the potential for an increase in the number of armed conflicts. It will also reverse, or at least slow, the global commerce trend, therein negatively impacting global economic growth. One need look no further than Britain’s decision to leave the European Union or President Trump’s decision last week to impose tariffs on aluminum and steel imports as examples of political populism.

Regime Shift Candidate V: Volatility – Is the recent rise in volatility a coincidence or the result of the regime shift candidates described above? While there is no way to explicitly tie one or more of these ongoing changes to the rise in volatility this year, after an extended period of below-average volatility (as measured by the VIX Index), volatility is demonstrably higher than it was in 2017. It is logical to assume that amid the other potential regime shifts described above, we have entered an era that will be marked by volatility that is closer to the long-term average of 20 on the VIX, than the 2017 average level of 11.


Source: Bloomberg, L.P.


Be well,