Covenant Weekly Market Synopsis for March 29, 2019

April 1, 2019

Last Week Today. President Trump suggested he will nominate Stephen Moore to the Federal Reserve. A loyalist to the President, Moore called for Fed Chair Powell’s resignation after the Fed raised rates last December. In an interview last week with the New York Times Moore called for an immediate 50bps cut in the Fed Funds rate, though he said he would also try to make amends with Chairman Powell. | Data collected during the first quarter by the privately held, independent firm China Beige Book showed an “unmistakable” credit-fueled recovery in the Chinese economy. | Bloomberg News reported US representatives are working through the draft text of the China/US trade agreement line-by-line to ensure there are no discrepancies after US officials noticed the Chinese version omitted commitments made by negotiators. Whether this is an example of Chinese subterfuge or an honest mistake, the inconsistencies may be why President Trump signaled he is not rushing to close a deal.

The S&P 500 closed out Q1 2019 with the largest first-quarter gain (+13.6%) in more than 20 years.  The impressive performance follows the growth-scare scarred fourth quarter, which was the worst quarter (-13.5%) since the Financial Crisis and included the poorest December monthly performance (-9.0%) since the Great Depression.  Nevertheless, at a CFA event on Friday Thomas Lee, of research firm Fundstrat, made the case that 2019 could look like 2009, a year in which equities jumped more than 25%. We’ll happily take a 25% gain if we can get it, but there have been eleven first quarters in which the S&P rose double digits and the average return over the final three quarters has been 5.8% (source LPL).

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

GDP Update. Q4 GDP was revised down from 2.6% to 2.2% (consensus estimates were 2.3%), reflecting weaker personal consumption expenditures, nondefense federal government spending, and nonresidential fixed investment. A growth rate of 2.2% is in line with the post-Financial Crisis trend and consistent with our “Good, but not great” theme for an expansion that, barring a recession in the next few months, will tie for the longest on record in June of this year.



As anticipated, Q1 is shaping up to be a relatively weak quarter of sub-2% growth.






Imperfect Science. According to the Merriam-Webster dictionary, science is defined as “knowledge or a system of knowledge covering general truths or the operation of general laws especially as obtained and tested through scientific method.” I highlight this definition as too frequently people treat economics as a true science with immutable laws akin to the effects of gravity as defined in physics. I was reminded of this on Friday at the 5th Annual CFA Societies of Texas Investor Summit.

Among the notable speakers were two economists David Rosenberg (Chief Economist and Strategist for Gluskin Sheff) and Joseph Kalish (Chief Global Macro Strategist for Ned Davis Research). Both Mr. Rosenberg and Mr. Kalish are highly educated and respected professionals. They have access to the same economic data, but their interpretation of the data and the implications for the economy and financial markets are dramatically different. Below is a summary of their presentations.

David Rosenberg, Gluskin Sheff

  • The yield on one-month US Treasury Bills has risen with Fed rate hikes. When the one-month yield rose above the dividend yield of the S&P 500 in Q3 2018, it was the first time in a decade and marked the top of the equity market.
  • The level of interest rates is not what matters – it’s the change. The Fed raised rates 9x, and there are lagging effects that will continue to impact the economy this year and in 2020.
  • The effects of fiscal stimulus on the economy were mitigated by the massive overhang of debt in the U.S.
  • High debt and demographics (and technology) have been pushing the neutral interest rate lower for a long time now. The neutral rate is below 2% (the Fed believes it’s 2.5% – 2.75%). The Fed has over tightened already.
  • The Schiller Cyclically Adjusted Price-to-Earnings (CAPE) ratio shows that this is the third highest priced market in history.
  • Corporate balance sheets are where the bubble is this time in thee economy. Corporate debt to GDP is higher than it has ever been. Debt to EBITDA is even higher relative to history. Triple BBB bond growth ($3T in total) has led to the junkiest investment grade market of all time – 30% of BBB corporations have a junk bond rating based on leverage ratios. A record amount of corporate debt is coming due beginning this year and over the next five years (refinancing $7T in total) – more than $1T per year. Credit spreads will move wider unless corporate America goes on a debt diet.
  • The next recession will be led by corporations, similarly to 2001.  The recession of 2001 was one of the mildest recessions in history, but equity markets got hammered.
  • Currently on month 117 of the expansion – if we get to July it will become the longest expansion in history.
  • The yield curve is his favorite recession indicator. The inversion has him on high alert, even though the economic situation is different with low rates and the large Fed balance sheet. He also looks at the unemployment rate, which has ticked up.

Conclusion: Based on Gluskin Sheff’s economic indicators, Rosenberg believes we are 91% through the economic expansion, and we will be in recession by the end of 2019. Rosenberg recommends investing in cash, long duration government bonds, and dividend aristocrat stocks. He also suggests avoiding emerging markets, equities, and broad S&P 500 exposure.

Joseph Kalish, Ned Davis Research

Thus far in this cycle, the cumulative GDP increase has been average relative to other recoveries, but the time to achieve this level has been twice as long. To Kalish, the slow rate of recovery implies that excesses have not built in the economy.  Also, Kalish doesn’t believe the yield curve is the end-all recession indicator, as it’s an ineffective signal in international markets.

Kalish’s approach to economics deconstructs the economic cycle into sub-cycles because the US economy is large and complex.  Of their ten indicators, the only one flashing a recessionary signal is the Confidence Board’s CEO Index. However, this survey was taken in Q4 when Trump was talking about firing Fed Chair Powell, the Fed was hiking rates (with no end in sight), and trade rhetoric was high.

  • Financial Conditions – The real (inflation-adjusted) Fed funds rate has always been higher at the end of economic cycles. The historical average real rate has been 3%, but today it is 0%.
  • Credit Cycle – Credit conditions remain supportive of economic growth. He shows only 5% total credit growth (YOY) on average during this recovery, which is very low. The lack of credit creation thus far this cycle will extend the economic cycle.
  • Profits Cycle – Profits typically peak well in advance of recessions. Data released on Thursday showed corporate profits just made another new high of 11.9%.
  • Labor Cycle – Jobs and income sustain the consumer, and he sees no evidence of problems here.
  • Demographics Cycle – Pretty early cycle with regards to the number of available middle age and young-adult workers.
  • Auto Cycle – Late cycle and in a downtrend. He offered reasons why slowing vehicle sales may not reflect the broader manufacturing sector, including Millennials living in cities, ridesharing, etc.
  • Housing Cycle – Sees housing as contributing to growth in 2019 vs. a drag like it was in 2018.
  • Capital Expenditures Cycle – usually peaks at the end of the cycle. He believes we are late cycle in this sub-cycle, but that capex could pick up as management teams become less concerned about trade and economic outlook.
  • Fiscal and Trade Cycles – Tax reform will continue to have a positive impact through 2022
  • Trade & Current Account Cycle – Improvement in oil exports has offset deterioration in non-energy trade.

Conclusion: The US economy is closer to mid-cycle than late cycle and recommends corporate bonds and equities, particularly emerging market equities.

Two economists with access to the same data drawing two very different conclusions about the economy and how to invest going forward. The variance in these views highlights the challenge of making accurate economic forecasts. Even though the US economy is an open system (i.e., influenced by other economies), the global economy is a closed system, meaning that it is not subject to external forces that can alter outcomes. In the scientific world, closed systems are relatively easy to analyze, and outcomes can be calculated precisely.

Economics is different, even when considered on a global basis because although it is closed in the physical sense, human behavior represents an external force that influences outcomes and human behavior cannot be calculated precisely. Trillions of individual decisions over the course of a business cycle influence economic outcomes from Congress passing laws that impact corporations, to management teams determining how many employees they need, to consumers choosing to rent vs. buy homes. There is no model or set of models capable of perfectly assimilating this data nor predicting the cumulative effects. Hence, most economists acknowledge (even if they won’t admit it publicly) that their study is an imperfect science where general forecasts are far more accurate than precise ones.

This reality is important to remember, as the Fed is a giant economic think-tank. Although the Fed’s access to data is unparalleled and their collective intellectual firepower is unsurpassed, they are prone to misinterpreting data (like all economists). Hence, the more flexible they are willing to be (putting aside their egos if they make a bad call), the longer economic expansions can run. Thus far Powell’s Fed appears to be flexible, and flexibility in the face of changing data will be critical as the Fed attempts to navigate the economy through a slow growth global environment with a balance sheet of unprecedented size.

Be well,