Covenant Weekly Market Synopsis for September 28, 2018

October 1, 2018

Last Week Today: China pushed back from the negotiating table, snubbing additional trade talks with the U.S. (at least for now). | Key OPEC members Russia and Saudi Arabia dismissed U.S. requests for output increases to combat rising oil prices. | The Fed raised interest rates for the eighth time this cycle, to 2.25% and for the first time in more than ten years, the Fed Funds rate is now higher than the Core CPI inflation rate. | On Thursday, the S.E.C. filed a lawsuit against Tesla and Elon Musk over his Tweet claiming “funding secured” to privatize Tesla. The suit was settled two days later with Musk agreeing to pay a $20 million fine and relinquishing his role as Chairman of the company for three years; importantly for Tesla’s investors, Musk will retain the CEO role. | Late last night, NAFTA was replaced by the U.S.-Mexico-Canada Agreement (USMCA) as the three countries, which exchange more than $1 trillion annually in goods and services, came to a trade agreement.

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

Fed Policy Update: The Fed’s updated interest rate forecast (aka, the “Dot Plot”) was released on Wednesday.  The updated Dot Plot extends the interest rate forecast period out to 2021 and the median expectation for the committee is to raise rates five more times: once more in 2018, three times in 2019, and once in 2020. The Fed currently believes the terminal rate (i.e., the highest Fed Funds rate of this cycle) will be 3.50%.  The unchanged terminal rate in this forecast was interpreted as dovish by a market concerned the Fed might suggest another hike or two in 2021. Instead, the Fed expects to cut rates by 0.5% sometime beyond 2021, as their long-term view is that 3% is the correct Fed Funds interest rate for the economy and inflation to stabilize at a sustainable pace. Chairman Powell has stressed that the Fed’s policy is data dependent, so like any forecast, this is subject to change.

Passive Influence – As has been well documented, the steady rise in domestic equity market prices since the Great Financial Crisis has proven to be a challenging market environment for active equity managers. One reason is that stocks have been highly correlated for much of this period, leaving little room to add value through security selection. In other words, because stocks have moved together in a rather undifferentiated pattern, individual stock selection has been less effective, sowing the seeds for passive investment strategies to gain in popularity. Indeed, the proportion of assets under management in passive strategies has doubled from about 20% of total assets in 2009 to 42% today (Source: BofA Merrill Lynch). Vanguard, the vaunted low-cost passive investment strategy provider, is a clear beneficiary of the “passive movement” as the percentage of S&P 500 market capitalization held by Vanguard funds has more than doubled over this timeframe.


At a more granular level, Vanguard has emerged as a significant investor in nearly every company in the S&P 500 Index. To wit, Vanguard funds owned 5% or more of the outstanding shares in only 23% of S&P 500 stocks in 2010, but today that number is just shy of 100%!!!


Passive investing’s considerable market share contributes to a positive feedback loop in which additional flows into index funds creates demand for the same positions already held in those funds, pushing those stock prices higher. However, that same positive feedback loop exists in weaker markets in which investors pull money from passive index funds. S&P 500 stocks with sizeable passive ownership evidence this capital flow phenomenon. According to research from BofA Merrill Lynch, these stocks exhibit volatility that is approximately 20% higher relative to those with lower passive ownership (as measured by 3-month annualized daily volatility).

The message here is that the extra 20% volatility that adds to a portfolio’s returns on the way up is reflexive, and will work against investors in a choppy, or declining market (in fact, from a mathematical perspective, downside volatility has a disproportionately negative impact on a portfolio’s value due to negative compounding). From a portfolio management perspective, if one is uncomfortable with this state of affairs, the best solution is not necessarily to abandon passive investing, but to allocate a portion of their equity exposure to active managers with high tracking error. These types of strategies – which include portfolios that are differentiated from the S&P 500, either through the names they hold, the weights of the names (relative to the index), or a combination of the two – can complement core passive equity holdings through the back end of the business cycle.

Consumer Sentiment Up, Up, and Away – Bloomberg’s Consumer Sentiment Index is comprised of weekly survey data that extends back to 1985, and measures consumer current perceptions on three variables: the state of the economy, personal finances, and whether it’s a good time to buy needed goods or services.  Last week, this index reached its highest level since 2000, bolstered by accelerating wages and the strongest personal income growth in at least three years.  Consumer sentiment is relevant, because a healthy consumer is essential to GDP growth since consumption accounts for approximately 70% of the domestic economy.

In an interesting side note, the divergence between the comfort levels of self-identified Republicans and Democrats is striking. Whereas Democratic consumer sentiment (represented by the blue line) is virtually unchanged since President Trump’s election, Republican sentiment (the red line) has nearly doubled.


Regardless of the political divide, in the aggregate, consumer sentiment is signaling continued economic growth ahead and last week the Fed upgraded their forecast for 2018 GDP from 2.8% to 3.1%. Its worth noting that the Fed does not believe this level of growth is sustainable (nor do we, unless productivity rises), forecasting annual inflation-adjusted growth to slow over the next two years to an average 2.5% in 2019 and 2% in 2020. Although it includes slower growth, the forecast is not too shabby for an economy that, by that time, will have been expanding for more than a decade.

Be well,