Covenant Weekly Market Synopsis for May 10, 2019

May 13, 2019

Synopsis 2019.05.10

Last Week Today.  Trade negotiators for China and the U.S. failed to reach an agreement last week, an event well-covered by the media. However, on Sunday White House economic adviser Larry Kudlow revealed President Trump’s cognitive dissonance on tariffs when he conceded that China is not paying the duties as the President regularly asserts. Instead, American companies purchasing goods from China pay the tariffs, which is in effect a tax increase that is often passed on to the consumer. | The widely anticipated initial public offering of ride-hailing superstar Uber Technologies, Inc. was a disappointment. The IPO priced at the low end of the offering range (not a good initial sign) and then fell 7.6% on Friday, its first day of trading. Of course, one day does not determine the future of this stock, but it is a good reminder that the friendly stockbroker calling with an offer to sell you IPO shares does not make for a risk-free investment.

Although media outlets produced provocative headlines on Friday varying on the theme “Worst Week for Stocks Since December 2018”, the damage was rather light. The S&P fell 2.1%, International stocks (MSCI EAFE) declined 2.9%, and the antagonist in the trade negotiation saga, China dropped by 4.7%. It could have been a lot worse, save the on-again, off-again trade talks ended the week in the “on” position as in “we’re continuing to speak.” For all the intraday whipsaws, the S&P 500 ended the week only 3% off its all-time high. That interim low will be tested this week as encouraging words on Friday gave way to finger-pointing between China and the U.S. over the weekend. Unless investors detect some encouraging news on the trade front, this upcoming week could be a rocky one for risk assets. Speaking of which, volatility is back in vogue, as the VIX Index is averaging 16 with a peak of 23 thus far in May vs. an average of 13 and a peak of 14.4 in April.

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The Enemy of My Enemy.  President Trump is openly critical of the Fed, calling for lower interest rates and another round of Quantitative Easing. Though under attack for raising rates in December, Fed Chairman Jay Powell’s real enemy is a lack of inflation. Interestingly, President Trump’s move to reinstate tariffs on China will lead to higher prices for Chinese-produced goods. Although only expected to increase inflation by about 0.2%, Fed Chair Powell will take it in an effort to prove their last rate hike in December was not a mistake (though it almost certainly was).

“Good but not Great Growth” Thesis in Jeopardy.  Last week we held our quarterly Investment Committee meeting. We parsed the recent economic data, challenged each other’s views, and reviewed outsiders’ perspectives.  As we sifted through the economic tea leaves it became apparent that our long-held thesis of “Good But Not Great” economic growth (i.e., sustainable real GDP growth of 2% – 2.5%) is under threat from a weak global economy, overly tight domestic monetary policy, and weakness in the cyclical sectors of the economy.  Irrespective of the 3.2% Q1 GDP print, the net effect of these headwinds is slowing economic activity.

One need look no further than the Chicago Fed National Activity Index (CFNAI) for evidence of just how much economic growth has slowed since the peak in mid-2018. The CFNAI is a weighted average of 85 monthly indicators designed to measure overall economic activity and inflationary pressure, including data from four macroeconomic categories:

  • Production and income
  • Employment, unemployment, and hours worked
  • Personal consumption and housing
  • Sales, orders, and inventories

The index is engineered to have an average value of 0 (based on the trend growth rate) and a standard deviation of 1. As economic activity is cyclical, a positive reading indicates above-trend growth, while a negative reading implies economic activity is flagging. Furthermore, readings above 0.7 suggest activity is significantly higher than the sustainable potential growth rate, which leads to inflationary pressure. Readings below 0.7 indicate increasing risk of a recession and lower inflation.


Sources: Federal Reserve Bank of Chicago and Foleynomics.

While the series is volatile, even on a 3-month moving average, the upward trend that began in early 2016 has broken down. The last two recessions (2000/2001 and 2008/2009) are evident in the data as the index falls through the bottom of the chart. We don’t believe the economy is headed for that type of slowdown, but the trend is undoubtedly concerning and somewhat reminiscent of the 2015/2016 period in which economic growth slowed but did not turn negative. As a reminder, slowing growth increases the volatility of financial assets, and in 2015 the market suffered two drawdowns of more than 10%. Those market corrections didn’t end the bull market, but if growth continues to slow investors should prepare for higher volatility and lower long-term total returns based on current valuations.

Another conclusion evident in the CFNAI chart is that inflationary pressures remain low in the economy. While data last week showed Core CPI rose 2.1% on a year-over-year basis the reading was largely due to low inflation readings from one year ago that flatter the current April reading. Indeed, on a 3-month annualized basis, Core CPI is ticking along at just 1.6% (Capital Economics), which is not what the Fed is hoping for in substantiating their December rate hike.

Bottom Line: We are not giving up on the Good But Not Great Growth outlook, but we are slightly less confident in the forecast. Although headline GDP growth in Q1 was strong at 3.2%, more than half of the growth came from transient factors such as increased inventories (~70bps) and net exports (~100bps) that are extremely unlikely to be repeated in Q2. Our “no recession in 2019” outlook relies on the strength of the consumer to overcome the current weakness in other sectors of the economy. The good news is that the Consumer is in relatively good shape:

  • The labor market is plateauing, but not shrinking
  • Wage growth is accelerating
  • Debt levels are low relative to Disposable Income (excluding Student Debt, which probably won’t be paid off in any event)
  • Consumer Confidence remains elevated

As the chart below highlights, Real PCE is running at nearly 2.9% year-over-year, supported by strength in expenditures on Services which make up almost 45% of total GDP. So long as the consumer continues to consume, a recession is unlikely.



Sources:  Bureau of Economic Analysis and Foleynomics.

Be well,