Covenant Weekly Synopsis as of October 23, 2015

October 26, 2015

Following a fourth consecutive week of equity market gains, October is shaping up to be a very strong month with developed and emerging markets up 8% or more thus far (additional market detail can be found here). Once again, much of the impulse for equity markets to move higher was delivered by central banker largesse. First, European Central Bank head Mario Draghi strongly hinted at additional quantitative easing for the Eurozone later this year. Then, on Friday the People’s Bank of China reduced bank reserve requirements and implemented another round of interest rate cuts (the sixth cut since last November).

Against this backdrop, Chairman Yellen and the rest of the Federal Open Market Committee are meeting this week to discuss domestic monetary policy. No one expects the Fed to hike rates this time around, or even in December when they meet for the final time in 2015. The Fed has a real problem on their hands because in the midst of sputtering economic growth, complicated by easy monetary policies elsewhere, raising interest rates will drive up the value of the US Dollar and put further pressure on an already struggling domestic manufacturing sector. I bet former Fed Chairman Ben Bernanke is very glad to be focusing his efforts on promoting his memoir The Courage to Act – an ironic title given the Fed’s current conundrum.

Housing Market – During a recent meeting with a mortgage derivatives hedge fund manager, we discussed if banks were loosening their mortgage lending standards. The answer was “yes, but not dramatically”:

  • Debt / Income ratios have drifted up to 37%, after bottoming-out at 33% in 2010
  • Average FICO scores of borrowers topped out in the 740’s and are now down to 727;
  • Loan-to-values for mortgages are up to 83% from the high 70% level.

Also, first time buyers beginning to come back to the market as Millennials are getting married, having children (and moving out of their parents’ homes).  Looser lending standards, even modest ones, will help keep the housing market’s growth on track and support the slow, but positive, economic expansion in the U.S.

Self-Reflection – “The key is not to believe our own B.S. too much” quipped the quant describing how he and his team went through a painstaking analysis of their portfolio optimization algorithms. As a systematic, short-term trader, trading costs are one of the largest drags on overall performance so they decided to attack the problem by reducing the total number of trades in the portfolio optimization process. They theorized that by determining the probability that the market would move to their current positioning at any point in time, rather than constantly trading toward the “optimal portfolio” they could cut costs and improve performance. He admitted this was a difficult intellectual concept to pursue because they knew that reducing the trading frequency would negatively impact their back tested results. However, after thoroughly researching and testing the new optimization algorithms, they took an informed “leap of faith” and implemented the change. The results were a resounding success. In live trading they have reduced trading volume by about 1/3 without any degradation to the strategy and added back more than 5% annually to performance through savings on trading costs. In the hyper-competitive hedge fund industry this manager is a rare one, having navigated markets (and ever changing investor demand) for more than 15 years. His willingness to challenge what he holds sacred is a big reason for his firm’s longevity and a valuable lesson to everyone.

Economic Wrap-Up – Retail sales in September grew a disappointing 0.1% month-over-month(m/m) and previous estimates for August and July were also revised downward.  In the month of September, annualized headline CPI Inflation dropped to 0.0%, due to a 9% decline in the price of gasoline. Core CPI edged higher though to 1.9%, just below the Fed’s target inflation rate. Preliminary Purchasing Managers Indices (PMI’s) released last week indicate developed economies (US 54, Japan 52+, and Euro-zone 52) continue to expand, albeit it at a modest pace consistent with the rate of growth seen over the last few years.

Be good,

Jp