Covenant Weekly Market Synopsis for September 7, 2018

September 10, 2018

Last Week Today. Jack Dorsey (CEO of Twitter) and Sheryl Sandberg (COO of Facebook) provided testimony to the Senate Intelligence Committee about foreign influence on, and alleged political biases of, their respective social media platforms. Alphabet Inc. (aka Google) declined the committee’s request to testify. Their appearance on Capitol Hill seemed to crystalize President Trump’s criticisms of the companies, spooking technology investors as the Nasdaq declined 2.5% for the week. | August’s ISM manufacturing Purchasing Managers Index (PMI) jumped 3.2 points, reaching a 14-year high of 61.3, well ahead of the 57.6 consensus estimate. | The August payrolls report was another strong one showing employers hired an additional 201,000 workers. The big news, though, was the 0.4% rise in average hourly earnings, which combined with small upward revisions to June and July pushed year-over-year earnings up to 2.92%. It appears that tightness in the labor market is finally resulting in wage inflation, as this recent data point is the highest since 2009. In response to the employment report, bonds sold off (causing yields to rise), particularly on the front-end of the curve where the 2-year note reached a ten-year high of 2.7% as the labor data supports the Fed sticking with their plan to raise interest rates two more times this year.

It was a down week for equities, commodities, and bonds. The price declines weren’t uniform, but there is a lot of red in our detailed asset class performance summary. Domestic equities (-1.0%) fell less than developed international stock indices (-2.4%), and emerging market stocks were the worst performers declining more than -3% on the week. As mentioned above, bond prices declined relatively evenly across the curve, causing a shift higher in yields with the 10-year bond ending the week at 2.94% and the 30-year bond at 3.1%. Commodities offered little in the way of shelter as precious metals fell (gold -0.4%, silver -2.5%), copper got whacked (-3.2%; -21.1% YTD), and crude slipped -3.6% to $67.75 per barrel. About the only place to hide was long volatility, as the VIX Index rose +15.7%, but remains at a relatively quiescent level of 14.9.

Central Bank Policy and Asset Bubbles. Using quarterly Federal Reserve data since 1951, the following chart highlights the historically tight relationship between US Household Net Worth and US Gross Domestic Product. What’s notable about this chart, and something that should cause investors and investment advisors to review their portfolio allocations carefully, is that for 46 years household net worth was roughly equivalent to the output of the economy. This relationship makes sense as the measure of GDP equals the sum of total consumption, government spending, business investment, and net exports.  In other words, the overall wealth of the country and that of households should be closely correlated….and they were until the last 20 years which has seen two periods of spectacular booms and busts.

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Sources: Federal Reserve, Ben Hunt, Covenant Investment Research.

What’s changed? In the last 20 years (beginning with Alan Greenspan) the Federal Reserve’s monetary policy has been focused on economic growth which has resulted in persistently low interest rates that, in turn, have promoted the use of leverage. Leverage pulls forward future demand inflating the price of assets. The more leverage employed, the more demand is drawn forward, and the higher prices rise….but there is always a day of reckoning as debt must be repaid (or defaulted on), which ultimately reduces demand and asset prices along with it. Focusing on the last 20 years, it is easy to see how the Dot-Com Bubble and the Housing Bubble were episodes in which household net worth greatly exceeded GDP for a period, before mean-reverting to a level more consistent with GDP. On each occasion when the gap between GDP and net worth closed, net worth declined to GDP, not the other way around.

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Sources: Federal Reserve and Ben Hunt.

We currently find ourselves in another period of high leverage precipitated by the Global Financial Crisis and central banks’ remedy to the ensuing recession which included a combination of low interest rates domestically, negative interest rates internationally, and large-scale asset purchases globally that inflated central bank balance sheets. For example, the Federal Reserve’s balance sheet is currently $4.2 trillion, ballooning from $0.9 trillion before the Great Financial Crisis.

Government entities are not the only ones issuing debt. U.S. corporations have taken advantage of low interest rates to issue $9.2 trillion in bonds over the last five years and have used more than one-third of the proceeds to repurchase their own stock (Source: Barron’s). Stock repurchases are a tried-and-true form of financial engineering in which fewer tradable shares give the appearance of higher earnings per share, which is often rewarded by investors.   However, the actual growth in corporate earnings has been far less than the increase in stock market value. Total US corporate profits (before taxes) increased by 2.8% from Q3 2014 through Q2 2018. Meanwhile, over that same period, the S&P 500 rose 45% (not including dividends), or 16.3x the rise in profits. But wait a minute… that’s not a fair comparison Justin. You need to consider the effects of the new tax plan. OK, fair enough. Net of taxes, corporate profits rose 12.2% since 2014, meaning that the S&P 500 market capitalization increased 3.7x more than profits. Since financial markets are forward discounting systems, the stock market (as a whole) is optimistically priced for rising future profits to support current valuations.

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The point is that leverage has once again permeated the economy pulling forward future demand. We are wealthier at the moment, but in a somewhat fragile state, like the Dot-Com and Housing Bubbles where household net worth was unsustainably high relative to GDP.

I’m not suggesting we are on the cusp of another crisis, though that outcome can never be completely ruled out. What I am suggesting is less controversial – significant demand has been pulled forward through leverage, which, in turn, has inflated asset prices. The effects are evident in the meteoric rise in the price of the S&P 500 vs. slower corporate profit growth and in household net worth dramatically outstripping GDP. It’s also worth considering that in contrast to the last nine years, where the Fed was an ally to investors, that is no longer the case.  The Federal Reserve is now reversing the course it has followed since the Great Financial Crisis, raising interest rates and reducing the size of its balance sheet.

The investment environment is changing, and traditional asset classes are no longer cheap.  Because the price you pay for something directly influences the expected financial return on the investment, forward returns are unlikely to match the experience of the last nine years. Investors should consider the potential paths the economy and market may take and how diversifying portfolios with strategies that invest in traditional asset classes in non-traditional ways can improve portfolio returns. And, importantly, how “alternative” investments can provide dry powder in the event we are in the midst of the third asset price bubble in the last 20 years as Mr. Hunt of suggests in his charts above.

Be well,

Jp.