Covenant Weekly Synopsis as of September 4, 2015

September 8, 2015

September got off to a rough start for risk assets, with developed and emerging markets alike declining 1% to 2% in the first four days of trading. For the first time in a long time, most major equity markets are negative year-to-date, with only Europe and Japan clinging to small positive values. Facing little pricing pressures and disinflationary trends, hard assets also declined last week, with WTI Crude falling more than 6% to $46.05 per barrel. The long overdue market volatility that appeared in August is unlikely to fade quickly, and the VIX Index closed the week at a relatively elevated level of 27.8.

Separating signal from noise – An article in the WSJ last week reported that pension funds have been reducing their investment return assumptions from levels of 8% to 8.5% per year to an average level of 7.68% (which still seems high in today’s environment).  By comparison, a recent survey of Fortune 1000 companies conducted by Towers Watson puts the average return assumption at 7.1% (down from 9.2% in 2000).  According to Barron’s Magazine, a group of pension specialists believes a more achievable annual return level is 6.4%.   The variance in return expectations amongst the different parties is to be expected – it is rare that any two people or groups will share the exact view on the future, be it which team will win the Super Bowl this year or the price of oil two years from now.  The variance in projections is noise, but the widespread reduction of return expectations is a legitimate signal about the future….. Institutional and retail investors alike should recognize that financial markets will be less forgiving going forward.  Appropriately, I expect conversations about effectively managing downside risk (i.e. protecting what you have) in a portfolio will become more prevalent than they have been since the bottom of the Financial Crisis more than six years ago.

The non-war currency war – A section in last week’s synopsis (“A Rose By Another Name”) suggested that even though central banks are engaged in a widely acknowledged currency war, central bankers would never publicly utter the words “currency war”. So it was an interesting admission this past Saturday when finance ministers and central banks from the G-20 met and pledged to “refrain from competitive devaluations”.   That is probably as close as a group of central bankers, when sitting in the same room, will ever come to conceding the obvious currency war they are all party to.  China’s recent devaluation of the yuan was a centerpiece of the meeting, but the U.S., ECB, U.K., and Japan have all played active roles in devaluing their currencies since the Financial Crisis.  As the U.S. and U.K. prepare to shift monetary policy from toward raising interest rates, they are uniquely keen for other countries to play nice so as not to exacerbate the relative strength of their currencies (rising interest rates typically cause a currency to appreciate).  However, amongst central bankers a pledge is merely a collection of words that may or may not serve as guidelines for how they will act.  It is common knowledge that each central bank will behave in a manner that is best for their sovereign economy.  As such, expect unconventional monetary policy to remain a key feature of central banks for the foreseeable future as different economies grapple with the slower growth prospects of the post-Financial Crisis world.

Economic Data Wrap-up: The ISM manufacturing index declined to 51.1 (two-year low) in August from 52.7 in July due to headwinds from a strong US dollar and weak global demand. However, the non-manufacturing sector (which is a larger part of the U.S. economy) remains on solid footing as indicated by the latest ISM non-manufacturing index which is near a 10-year high. The August payroll report was mixed: the number of new jobs added was slightly below expectations, but the official unemployment rate dropped to 5.1% (a 7-year low and a level the Fed considers “Full Employment”).  Of course, the labor market is not as strong as the official unemployment rate would indicate as the unemployment rate is skewed by the low labor participation rate of 62.6% (vs. 66% prior to the Financial Crisis).