Covenant Weekly Market Synopsis for October 19, 2018

October 22, 2018

Last Week Today: The U.S. budget deficit jumped from $665.8 billion in 2017 to $779.0 billion in 2018 (3.9% of GDP) as spending increased by 3.2%, but tax receipts only rose by 0.4%. | The Job Opening and Labor Turnover (JOLT) survey for August revealed a record 7.1 million job openings – there are only about 6 million people who are considered unemployed. | China’s Q3 GDP growth rate was 6.5%, the lowest in ten years, but only 0.1% below consensus estimates. | President Trump pulled out of a 144-year old postal treaty, raising China’s shipping costs into the U.S. And, Treasury Secretary Steve Mnuchin is considering changes to how the U.S. defines currency manipulation, potentially giving President Trump a chance to label China a foreign-exchange manipulator. Both actions serve to tighten the screws on China as President Trump is seeking maximum leverage to redefine trade terms between the world’s largest economies.

Financial markets are realizing the higher volatility levels that October is known for. Although Tuesday saw a global equity rally in which the S&P 500 jumped +2.2%, it was an otherwise difficult week as the S&P 500 declined the other four days to close the week flat. International equities fared slightly better, with Developed International stocks (i.e., the EAFE Index) eking out a +0.1%. Among relevant market indexes, Japan’s Nikkei Index was the top performer, gaining 1.2% – however, all major regional indexes are down -5% to -8% MTD. In fixed-income land, yields on US Treasuries rose a handful of basis points, with the yield on the 10-year bond closing the week at 3.19%. Although off its recent high of 3.23%, the yield has remained above 3% for five weeks, something that hasn’t happened since 2011.

Q3 GDP will be released this week. Current estimates show a deceleration from Q2’s 4.2% growth rate, to about 3.2% – 3.5%. This growth level would be consistent with our view that Q2 was likely the peak growth rate for the cycle and that economic growth will trend back towards its potential growth rate of 2% in the coming year

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

Corporate Earnings Update: earnings season is in full swing. Through last Friday, 17% of S&P 500 companies had reported Q3 financial results, and earnings growth is tracking +19.4% YOY. Approximately 160 companies will join the earnings catwalk this week. Strong Q3 earnings are expected and priced into markets – what’s not priced into markets is the outlook for the next year and analysts are carefully parsing management teams’ forecasts for signs of margin deterioration from labor costs and tariffs.

Fed Update: Minutes from the September Federal Open Market Committee (FOMC) meeting were released Wednesday. Overall, it was a reasonably balanced report, though traders focused on a comment reporting that a few participants had discussed moving policy into restrictive territory.

Participants offered their views about how much additional policy firming would likely be required for the Committee to sustainably achieve its objectives of maximum employment and 2 percent inflation. A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level in order to reduce the risk of a sustained overshooting of the Committee’s 2 percent inflation objective or the risk posed by significant financial imbalances.

In Fed speak, “restrictive” means that the Fed funds rate is higher than the real neutral interest rate (aka, R-star rate) that neither stimulates nor restricts the economy. The thing about the neutral interest rate is that it cannot be measured in real time, only estimated. For what it’s worth, this unobservable metric is currently estimated to be about 1%. With inflation running at approximately 2%, this implies the Fed Funds rate would become restrictive when it moves from the current level of 2.25% to 3% (or in three more 0.25% rate hikes).

Takeaway: Though monetary policy is not predetermined, it will take a significant shock for the Fed to abandon its quarterly rate hike trajectory. Given the uncertainty regarding R-star, it is entirely possible that the Fed unintentionally becomes too restrictive and joins a long line of Federal Reserve governing bodies by “murdering” the economic expansion. On the plus side, Fed Chair Powell has more financial market experience that he does formal economic training, and he is wary of relying on unobservable metrics to make monetary policy decisions. Indeed, within the FOMC Powell is advocating a new “risk-management approach” to monetary policy that acknowledges the lagged effect of changes in interest rates. Adhering to this strategy is becoming increasingly important to the Fed’s objective of engineering a soft-landing for the economy as the real Fed Funds rate gets closer to the theoretical R-star rate.

What Trade War? While tariffs are impacting farmers and businesses that trade internationally, they have had little lasting impact on the equity markets. As the chart below highlights, headlines about the trade war have a relatively short half-life when it comes to U.S. stocks with equities returning to their pre-event peak level within two business days in more than 50% of trade news events.


Oxford Economics analyzed 70 trade ware news events over the past two years and found:

  • A clear decline in the impact of negative news on global equities
  • Rapid reversals of equity losses that do arise
  • A stark contrast between the reaction of U.S. and Chinese markets (where negative news has a more lasting impact on the latter)
  • Minimal effects on bonds

Indeed, as so often happens, domestic markets have become desensitized to the rhetoric. Of course, if the rhetoric transitions into an all-out trade war, resulting in an unwind of established, cost-effective supply chains, global growth will slow, and financial markets will react the world over. Below is one firm’s estimate of the worldwide growth drag from a full-blown trade war.


Air Bags. If you do not find any of the information above helpful, perhaps this will be of greater utility for the next time you go grocery shopping. Assuming your palate is not averse to Chili Cheese Fritos, they represent the best bang for your buck regarding product vs. air. Cheetos are the worst offender, with the bags consisting of 59% air and only 41% product. It’s good to see that one of my favorites, Pringles, are only 28% air owing to their finely engineered stackable shape.


Be well,