Covenant Weekly Market Synopsis for October 26, 2018

October 29, 2018

Last Week Today: Saudi Arabia pledged to eliminate any oil shortage from Iranian sanctions by pushing up production from 10.7 million to 11 million barrels per day. | MBS, Saudi’s crown prince called Khashoggi’s murder “heinous”; two days later, Saudi Arabia admitted the murder was premeditated – and the worst cover-up in history continued to unravel. | The European Central Bank reiterated the end to bond purchases in December. | The Fed’s “Beige Book” showed sustained strength in labor markets and rising prices across almost all Fed districts, suggesting that absent a severe deterioration in capital markets, the Fed will raise interest rates in December.

Concluding a tumultuous week, the S&P 500 briefly dipped into correction territory, before bouncing midday Friday. For the week, the S&P 500 fell -3.9% and is –9.3% from its all-time high (-10% is considered a “correction” and -20% a “bear market”). The tech-infused Nasdaq Index was not as fortunate and is officially in a correction after falling -3.8% last week to -11.6% from its August 29th high mark. The rise in equity market volatility and building losses (the S&P 500 has shed $2.1 trillion in market capitalization this month) is intensifying criticism of the Fed’s monetary policy (from President Trump to CNBC-pundit Jim Cramer). Irrespective of the criticism, the Fed is unlikely to change course in the near-term absent a much lower level on the S&P 500 (e.g., another -10% drop) or the weakness spreads to credit markets (high yield bonds have had only a muted reaction relative to equities, thus far).

International developed market equities did not fare much better last week as the EAFE Index fell -3.5% and Emerging Markets lost another -3.3% (-17% YTD). Chinese equities bucked the global trend, rising +1.9% for the week, though ’tis a drop in the bucket compared to the -19.5% YTD decline.

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

Q3 GDP Review. The first estimate of third-quarter economic output was released on Friday. Below is a quick summary of the report:

  • Q3 real (inflation-adjusted) annualized GDP growth was 3.5% – higher than the consensus estimate of 3.3%, but well off the 4.2% pace of Q2.
  • Equipment investment rose by only 0.4%, in spite of the corporate tax cut and more generous depreciation allowances.
  • Residential investment contracted by 4.0%, the third consecutive quarterly decline.
  • Inflation (as measured by the Core Personal Consumption Expenditure deflator) rose only 1.6% annualized in the third quarter (vs. the consensus estimate of 1.8%) and is moving away from the Fed’s target of 2.0%.


Takeaway: No real surprises relative to our house view. We expect that the boost from fiscal stimulus (so evident in Q2’s economic activity) will continue to fade and GDP growth will track back towards 2% in 2019. Slowing economic growth in the absence of inflationary pressures will call into question the Fed’s forecast of four rate hikes between now and the end of 2019.

Pessimists. Worries contributing to the equity market decline:

  • Impact of the trade war (highlighted by companies like 3M during its earnings call last week)
  • The Fed’s interest rate increases
  • Italy’s standoff with the European Union over its budget
  • Brexit
  • Slowing profit growth
  • China’s economic growth

The question for investors is how much of these known concerns are already priced into the market. There are also several reasons to think we are not in the midst of a significant pullback, two of which are described below.

Optimists I. The forward Price to Earnings (P/E) multiple for the S&P 500 has tumbled to 15.6x, from 18.8x at the end of January. Globally, the MSCI All-Country World Index P/E multiple has fallen to 13.8x from 16.7x.

Optimists II. 48% of S&P 500 companies are now out of their blackout windows and can resume share buybacks. With the recent pullback, most companies will be able to buy their shares at a discount compared to the prices before the Q4 earnings blackout period began which may buoy the market.

Hedgies.  Hedge funds are typically engaged in diversifying portfolios from the inherent risks in traditional asset classes (i.e., fixed income and equities). It sounds good on paper, but it is complicated to execute in practice. With thousands of available funds, most investors gravitate to strategies that are easily explainable, such as long/short equity. In long/short equity strategy, a portfolio manager purchases a basket of stocks she believes will move higher in value and she shorts (i.e., sells) a basket of stocks she thinks will go down in value. The problem with that approach is that while the volatility may be lower than an S&P 500 investment, the average long/short equity fund maintains significant net exposure to the stock market. For example, it is common for long/short funds to have greater than 70% net long equity exposure. The bias toward net long exposure means that the average hedge fund will move in sync with the stock market, which feels good when the market is rising (as it had relentlessly before this year) but fails to offer diversification when the market is declining. Indeed, through last Thursday, the S&P 500 was down -7.06% month-to-date, and Goldman Sachs’ measure of long/short hedge fund performance was off by -7.75%.

Not all hedge fund strategies are created equal, and there are a variety of strategies that reliably diversify portfolios in the long-run. But long-biased equity long/short strategies are not one of them and typically represent a very expensive means of doubling down on equity exposure. By contrast, Covenant does not employ traditional long/short strategies in our hedge fund allocations. Instead, we focus on strategies with positive expected returns and low to no correlation to equity investments. Through last week our recommended basket was down -1.2% MTD – while performance is slightly negative in the short-run, the strategy has provided real diversification and protected capital during a very tumultuous month. The message here is that strategy selection is incredibly important when investing in alternative investment strategies.

Be well,