Covenant Weekly Synopsis as of September 2, 2016

September 5, 2016

Last week included the end of August, so a quick rundown of asset class performance for the month:

Equities (including dividends): S&P 500 (+0.1%), NASDAQ (+1.2%), Global Equities (+0.4%), Europe (+0.6%), Emerging Markets (+2.5%)

Fixed Income (yield change): UST-2 Year (+0.15%), UST-10 Year (+0.13%), UST-30 Year (+0.05%). Note the yield on the short duration instruments moved higher than the yield on the longer duration instruments, which is why you may have read/heard about the yield curve flattening.

Commodities: Gold (-3.1%), Copper (-6.8%), WTI Crude (+7.5% / $44.70 per barrel)

Please click here to view detailed asset class performance.


Negative Rates in the U.S.? Fed Vice Chairman Stanley Fischer raised a lot of eyebrows last week Tuesday when he made favorable comments about negative interest rates, although he said negative interest rates “are not on the table in the US”. I’m not looking to cross swords with Mr. Fischer, but the actual data from Japan and Europe simply doesn’t support his claim: consumers are saving more (instead of increasing spending) and the currencies for each of those countries have risen (not fallen as was expected before the adoption of negative interest rate policies). Although Mr. Fischer’s comments sounded crazy, perhaps he is crazy like a fox and was intentionally preparing investors for a worst case scenario should the Fed not be able to raise interest rates sufficiently before the next recession. That seems to be the case as reflected in the notes below from a conference call last week hosted by First Tennessee Bank’s Chief Economist Chris Low).

Mr. Low thinks the recession probability is ~50% in 2017 and ~65% in 2018.  We are seeing a slowdown in consumer spending, ongoing weakness in fixed investment….pent up demand is gradually being exhausted (autos as an example).  Corporate profit growth is one of the best leading indicators [and it has been negative for five consecutive quarters].

The next recession will probably be a bad one and will likely precipitate negative rates. There will likely be a significant liquidity squeeze and credit spreads will widen a la 2007/8. We could see another 50% drop in equities in the next recession whenever it comes because investors have been conditioned to flee.

So, if the Fed Funds rate is still close to zero, we could see negative rates as a last resort. But what we have seen is that negative rates do more harm than good because instead of encouraging spending, households save more. This is one good reason that the Fed wants the fed funds rate higher. 


Food Deflation – The price of meat, eggs and dairy products has been steadily declining, though I can’t say I’ve noticed it as the prices of most everything else my family consumes seems to be going up. But it’s true and a good study of Economics 101: supply and demand, with an international twist. As the U.S. dollar has strengthened over the last year, particularly against the Chinese Renminbi, international demand for these products has fallen leaving excess supply. Farmers and grocery stores are forced to cut prices to stimulate demand and in some, extreme cases, destroy product so as to reduce the level of excess supply. For example, in some places dairy farmers have reportedly dumped millions of gallons of excess milk onto their fields.



While cheaper food is great for the consumer, it makes for a difficult situation further up the value chain with grocery stores and farmers. Grocery stores, which already operate on thin profit margins, are cutting prices and large national food retailers such as Costco, Whole Foods, and Sysco, reported a negative impact to margins in the second quarter. Farmers are largely in a worse situation and the government reportedly purchased $20mm worth of cheese from one hard-hit dairy farmer (the cheese was donated to food banks and other organizations through the USDA nutrition-assistance programs). This is an example of imported deflation – namely that slow economic growth, especially outside of the U.S., and a strong US dollar are reducing demand for certain US products leading to lower prices. (Data source: WSJ)

Economic Data Wrap-Up: Personal Income rose by 0.4% month-over-month (m/m) in July and Consumption increased by 0.3% m/m. Core Personal Consumption Expenditures (PCE), which excludes food and energy, increased by 0.1% in July, leaving the annual rate unchanged at 1.6% (the Fed’s target is 2%). The ISM Manufacturing Index report unexpectedly fell to 49.4 in August, the first reading below 50 in six months. In reality there is not much difference between a reading of 49.4 and 50.4, other than the optics of being below or above the contraction/expansion threshold reading of 50. Of greater concern is that the report was weak across the board, indicating the manufacturing sector may be stagnating again. The August labor report missed expectations on most fronts: unemployment rate, hourly earnings, workweek hours, and Nonfarm payrolls (+151k vs. expectations of +180k). The market took this as a signal that Fed will not raise rates at their next meeting in September, but the report wasn’t really that weak when looking at longer term trends.

Hope everyone has a great Labor Day,