Last Week Today. After HSBC’s anti-money laundering compliance group reported a series of suspicious financial transactions, China-based Huawei Co.’s CFO was arrested for alleged violations of US sanctions on Iran. Her arrest came only days after presidents Trump and Jinping’s described their trade talks as successful. | Over the weekend, China summoned the Canadian envoy (the country responsible for her arrest) and the U.S. ambassador (the country that ordered her arrest) to protest the situation, stating U.S. actions have violated the “legitimate rights and interests of Chinese citizens and are extremely bad in nature”. If the CFO is extradited to the U.S., it will surely complicate any further progress on the trade front and is quickly escalating into an international incident with unknown consequences. | Despite President Trump’s suggestion via Twitter that the “world does not want to see, or need, higher oil prices!” OPEC agreed to cut oil production by 1.2 million barrels per day.
Equity and Fixed Income Markets. Although it was an abbreviated trading week (US markets were closed on Wednesday in honor of the passing of President George H.W. Bush), there was no shortage of fireworks in financial markets. After gaining +1.1% on Monday, the S&P declined by -3.2% on Tuesday when investors began to doubt the veracity of President Trump’s claims about the success of his trade talks with China’s President Xi Jinping. However, after the markets closed on Tuesday, China released a statement backing Trump’s claims about the trade talks. The following day the market was closed, but when they reopened on Thursday, the S&P fell an additional -2.9% by 11:30 am ET. A WSJ article suggesting the Fed may be pausing interest rate hikes following their December meeting is at least partly credited with turning the market around, which rallied to close down only -0.15% on Thursday. Then on Friday, the S&P 500 seemed determined to return to the previous day’s intraday lows and nearly did so, closing the day down -2.3%.
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Equity markets are notoriously obstreperous, and as the chart below highlights, market pullbacks are not unusual… even in the period of relatively low volatility we’ve witnessed since the Financial Crisis. Although conditions remain favorable for more volatility ahead, it’s worth noting that “volatility” does not necessarily mean stocks decline in value, as sharp movements higher count as volatility as well. For example, the VIX index rose from approximately 15 in 1993 to a peak of 25 in 1998 and the S&P 500 annualized returns of 20% over that period (Source: BAML).
Sources: Bloomberg and Covenant Investment Research; Note: drawdown values are estimated.
Anything can happen in financial markets, and no one knows if this recent move is the beginning of a bear market or just another example of a short-term pullback in the context of a more extended bull market. However, the situation would be more concerning if the economic data were deteriorating rapidly and the Fed was messaging a hard line on monetary policy tightening. Neither of those conditions exists at this point, though we are paying close attention. Although the fundamental data implies economic growth is slowing from the sugar rush of the tax cuts, the economy is still expected to expand by 2.5% or more this quarter and track towards its post-Crisis growth rate of about 2% in 2019. We are in no way wedded to this view, and if the data changes, so will our forecast.
Fixed income markets were no less interesting than equities last week, and market pundits were tripping over themselves to report that the yield curve inverted for US Treasury bonds maturing between 2 years and those maturing in 5 years. The “kink” in the yield curve is shown in the chart below, which also highlights the significant decline in yields (the green line) from one week ago (the yellow line). While “yield curve inversions” have signaled impending recessions in the past, the most accurate forecasting metric of an imminent recession is the yield differential between the 3-month T-bill and the 10-year T-bond. Although the yield differential has declined since November, the spread remains 0.47% wide. With an increasing number of Fed officials signaling a slowdown in the rate hiking cycle, it is unlikely the Fed will continue to raise rates beyond December’s meeting if it causes an inversion in the portion of the yield curve that matters most.
Sources: Bloomberg and Covenant Investment Research
Independence Day. For the first time since possibly the early 1900s (during the first Texas oil boom), US crude oil exports exceeded imports. This phase of independence will likely be short-lived, according to analysts, but many predict sustained oil independence within the next two years. Never discount the creative ingenuity of the American Spirit, which led to the development of unconventional drilling (aka “fracking”) and a new chapter in America’s role in the global energy marketplace.
MONTHLY CRUDE OIL PRODUCTION