Covenant Weekly Synopsis as of December 11, 2015

December 14, 2015

Equity markets suffered their worst weekly decline since the August correction as prices of key commodities (metals and fuels) fell to new cyclical lows. Developed market equities slumped between 2% and 4%, while emerging market stocks declined nearly 5% on the week. Last week’s drop pushed the S&P 500 into negative territory on a year-to-date basis. This is not a prediction, but if stocks do not recover from here 2015 will be the first year since the Financial Crisis in 2008 that the benchmark index has produced a negative total return.

What caused the sell-off last week? The cheeky response is that there were more sellers than buyers. While that is factually accurate the truth is no one knows precisely, but price action in the commodities markets is likely one of the more important explanatory factors. Energy-related commodities experienced an even worse week than equities with Brent and WTI crude prices plunging more than 10%, while front-end futures contracts for natural gas fell 9%. Notably, the price for WTI Crude ended the week at $35.62 per barrel, the lowest closing price since the commodity bottomed at $35.40 during the Financial Crisis in January 2009 (note: WTI crude is trading below $35 this morning). Another noteworthy event during the week in commodity-land was Kinder Morgan’s decision to cut its dividend by 75%, the first major MLP to do so.

The energy complex carnage impacted high yield spreads, which blew out to multi-year highs (relative to comparable maturity US treasury yields). For example, the Barclays Corporate High Yield bond index (CSI BARC INDEX) closed the week yielding 6.18% over 10-year US Treasuries. Conversely, U.S. Treasuries provided their traditional safe haven role in periods of stress as the yields compressed across the curve with the 30-year bond yield declining below 3% again closing the week at 2.87%. I would note that the decline in UST yields appeared rather modest given the overall financial market stress and may be a result of expectations that the Fed will raise interest rates during their final FOMC meeting of the year this week. Trivia: Which occurred more recently, an increase in the Federal Funds rate or the release of the first iPhone? (The answer is included at the end of this note).

Additional market detail can be found here.

Caveat Emptor. While hedge funds are often criticized for being illiquid during periods of extreme stress, Third Avenue proved last week that highly regulated, daily liquid mutual funds are capable of locking-up client capital as well. Third Avenue’s Focused Credit fund (TFCVX) halted redemptions from its high yield strategy to allow for an orderly wind down, meaning that investors who thought they held a daily liquid publicly traded instrument, in fact do not. While nearly unprecedented to put into effect, most (if not all) mutual fund prospectuses include an often overlooked provision that allows the manager to prevent investor redemptions. Traditionally mutual funds limited their trading to traditional, highly liquid equities and developed market sovereign debt instruments, which made this provision largely unnecessary. However as the profit seeking machine known as “Wall Street” seeks to expand its footprint with retail investors, product innovation has pushed mutual fund strategies into less liquid instruments such as high-yield corporate debt and as a result meeting daily liquidity demands can become problematic. TFCVX offers yet another lesson for investors to use common sense when purchasing securities, keeping in mind the liquidity of the underlying instruments held by the mutual funds they purchase.

Economic Data Release Summary. The headline November US Retail sales figure increased by a rather modest 0.2% m/m, however this was dragged down by a 0.8% decline from lower gasoline prices (a net positive for the consumer). Importantly, control group sales (which exclude gas, autos and building materials) rose by a more encouraging 0.6% m/m. The University of Michigan consumer confidence index rose to 91.8, a four-month high indicating fourth quarter consumption levels should be relatively healthy. Notably, while the current conditions index increased to 107.0 (from 104.3), the expectations index declined to 82 (from 82.9) signifying that consumers are becoming more anxious about the future (at least on the margin).

Trivia Answer: The first iPhone was released on June 29, 2007; the last time the Fed raised the Federal Funds Rate was July 11, 2006. It is hard to believe that the most recent interest rate increase occurred before the introduction of the now ubiquitous iPhone.