Monday Market Review Sept. 23, 2019
Economic data for the week was highlighted by the Federal Reserve lowering short-term interest rates by another quarter-point, in line with financial market expectations. Otherwise, industrial production and housing sales came in stronger than expected, several regional manufacturing indexes declined but remained expansionary, while the index of leading economic indicators was little changed.
Equity markets lost ground last week moderately, both in the U.S. and abroad. Bonds fared better, with positive returns in keeping with the Fed’s lowering of interest rates. Commodities rose due to a spike in crude oil prices on the heels of an attack on Saudi oil facilities, threatening near-term supplies.
U.S. stocks ended lower last week, although with an absence of volatility in geopolitics (other than the Saudi oil attack, which was largely ignored by markets) and markedly little news on the U.S.-China trade front, which has been driving sentiment in both directions for months. By sector, defensive groups utilities and healthcare outperformed, along with energy due to higher oil prices; conversely, consumer discretionary and industrial stocks lagged for the week, with the latter presumably more affected by higher energy prices.
Foreign stocks performed generally in line with domestic equities, with the exception of emerging markets, which lagged other groups slightly. Hopes for a UK-EU Brexit deal continue to persist, although odds of a deal or ‘no deal’ outcome in coming weeks continue to appear as even odds, with the Irish backstop remaining a sticking point. The Bank of England left interest rates on hold, regardless, with offsetting risks from the economy and weaker currency factors. EM results were led by weakness in China, Turkey and South Africa. In China, several economic indicators, such as industrial production and retail sales, pointed to damage from the current trade spat, which has undermined sentiment. While oil importers generally suffered, this was offset by positivity in oil-exporting nations Russia and Mexico, which would benefit from price spikes.
U.S. bonds gained ground on the week as interest rates dipped back to lower levels across the curve, in keeping with both sentiment away from risky assets and the Fed’s quarter-percent rate cut. Investment-grade corporates fared best for the week, with long-term treasuries faring best, while high yield and senior loans lagged. A stronger dollar held foreign developed bonds back, with minimal gains, while emerging market bonds were again mixed—USD-denominated gaining nearly 2%, while local debt was flat.
Real estate bucked general equity trends, but kept pace with defensive sectors, by gaining over a percent on the week. Foreign real estate positions provided similar returns to those in the U.S., with gains in Europe offset by losses in Asia.
Commodity indexes rose broadly, due to the overwhelmingly positive influence of energy, as agriculture was little changed, industrial metals lost a bit, and precious metals gained slightly. As discussed earlier, the price of crude oil spiked early in the week, following the Saudi attack, while optimistic expectations for getting facilities back on online (by possibly month-end) resulted in a price reversal downward. On net, the price of crude oil rose by 6% to just over $58/barrel.
The FOMC decided to lower the fed funds rate range by -0.25%, as mentioned earlier in the week. The market reaction to the move was largely as expected, with the dissents by several committee members (in opposite directions) being one of the more unusual aspects of this meeting. The Powell-led press conference appeared to focus on business ‘uncertainty’ and slower global growth as the primary catalysts for the move—neither of which is based on current U.S. data. While it appeared previous Fed chairs took considerable time and effort to reach consensus prior to meetings, the Powell Fed seems less focused on such a result, allowing a wider breadth of views. The downside, of course, is that the Fed appears a bit more disjointed, with the perception of confusion as to whether the economy needs stimulus or not.
By the looks of the forward-looking economic projections, the path of future rates was little changed from current levels. Predictions for economic growth (small upgrade, but still around 2%), inflation (recovering from below to near the 2% target), and unemployment (3.5-4.0% area) were little changed in keeping with broader consensus views.
The Conference Board’s Index of Leading Economic Indicators for August was unchanged from the prior month. Underlying statistics of housing permits and credit, which performed positively, offset weakness in manufacturing and the interest rate spread. Over the past six months, the leading indicator rose at a 1.1% annualized rate, which is on par with the general growth rate over the prior six-month period. The coincident indicator rose by 0.3% from the previous month (while the six-month rate of change slowed by a few tenths of a percent), while the index of lagging indicators declined by -0.3% in August. Recent signs from these indicators have been mixed, which is no surprise to those watching the individual economic signals. At the same time, no near-term recession ‘red flags’ have been triggered, either.
Questions of the Week
How will the recent attack on Saudi oil facilities affect energy and financial markets?
Due to experiences in the past, especially in the 1970s, many investors have been conditioned to expect the worst when oil supplies are threatened. While trends in oil demand tend to be far more persistent, and are largely affected by slower-moving events such as the demographics or recessions, oil supply can be disrupted instantaneously, so acts as a faster market price catalyst.
Over the prior weekend, it was confirmed that Yemini rebels (possibly backed or encouraged by Iran) used drones to attack two key Saudi oil extraction and refining facilities, which took nearly 6 million barrels offline—or about 5% of the world’s production volume. This is just one of several infrastructure attacks on Saudi soil this year, but by far the most damaging. The largest one-day oil price spike in 20 years ensued (over 15% at one point to back over $60/barrel). Later, prices tempered, following ramp-ups from other oil producers and the U.S. administration that crude could be released from the Strategic Petroleum Reserve as needed to shore up supply/demand in the interim. Again, as in decades prior, the U.S. government has been put in a tricky position regarding possible retaliations, and if so, towards whom and for how long.
The ultimate question always comes down to ensuring that there is enough oil getting to where it needs to go. There has always been a historical ‘risk premium’ baked into the price of crude oil, due to the geopolitical hotspots where it’s found—such as the Middle East, parts of Latin America, etc. The amount of this premium varies, but we were told years ago by an industry expert, and later government official, that it could be anywhere from $5-20/barrel at any given time. Of course, premiums only matter when they matter.
There are several differences here that separate this from reactions in prior eras. As a whole, despite the growth of emerging markets, populations use less oil per capita than they used to, due to modernized manufacturing and industrial efficiencies. The emergence of green technologies has also taken a further bite into petroleum consumption to some degree. As a result of the shale revolution, the U.S. has overtaken Saudi Arabia as the world’s ‘swing producer,’ meaning that disruptions in more volatile geographies should be less disruptive than they have been in the past. In fact, U.S. sanctions placed on Iran and Venezuela, as well as geopolitical unrest in areas such as Nigeria, have threatened far more in global inventories.
Financial markets also seem to have reflected the tempered concern. The risks, of course, are an escalation, and further attacks, which could begin to add up in terms of supply disruptions. The worst case would be a significant rise in petroleum prices, which has been a wildcard often associated with tipping economies into recession—if they’ve been on the precipice already. The positive side, of course, is higher revenues for energy-oriented assets, such as commodities and energy sector revenues, which have lagged the broader market due to oil prices being stuck in a lower trading range this year. Perhaps surprisingly, a small pickup in prices and drilling activity could also help U.S. GDP growth slightly.
What happened in short-term financing markets last week that caused rates to spike temporarily?
While falling under the radar for the most part, perhaps the most dynamic lubricants of the financial system are markets for short-term funding. These include the Fed-regulated market for ‘excess reserves,’ where banking institutions with excess cash held above their required reserve ratios can lend it to banks needing to fill their reserve bucket—governed by the FOMC-based fed funds rate used as a key tool in monetary policy. (Excess reserves are not a small part of the financial economy, totaling $1.4 trillion as of August.) Other short-term funding markets include the repurchase (or ‘repo’) market, in which firms can borrow cash for very short-term periods (a day in some cases, or longer), in return for posting a certain type of collateral (usually U.S. treasuries). Money market mutual funds are large participants in this market, which is the reason money market yields tend to be fairly close to the fed funds rate. This market is large and typically extremely liquid, considering the high quality of collateral and short maturities, but historically, the Fed has been close at hand to inject liquidity when needed to keep the ‘plumbing’ running smoothly.
Last week, however, those rates spiked when not enough funds were available to satisfy demand. In keeping with demand for an asset and limited supply, the cost (interest rate) of the good (money) rose sharply for a brief time until the Fed stepped into provide liquidity.
This has generally occurred during periods of extreme demand for cash, such as the financial crisis, which is why it was seen as a problem at first glance. However, it appears a confluence of factors created a perfect storm for such an event, which may have been brewing for some time. One of these is the Fed’s paying of interest on excess reserves (‘IOER,’ a new policy after the financial crisis) which kept more funds in the Federal Reserve system. It also adjusted the size of the repo market, depending on where lending banks can earn a slightly higher rate, even by a few basis points. Other factors may include the slow drain of liquidity by the Fed as quantitative easing was unwound, and a sharp increase in treasury issuance—which creates a mismatch between long-term maturities and short-term funding needs. More immediately, significant treasury bill settlements, adjustment of bank balance sheets for quarter-end, and quarterly corporate tax payments potentially added fuel to the fire, causing a cash crunch.
Many bond market professionals don’t see this is a watershed crisis event of any kind. The Fed didn’t address this in depth during last week’s press conference, but they may need to adjust the operations of this market a bit, such as providing more funding buffers to preserve repo market stability, in addition to lowering the IOER as they did last week from 2.1% to 1.8%, to incent banks to move more funds out into lending markets. Or, systematic changes may be required longer-term to prevent such ‘clogs,’ such as a standing overnight repo facility, like a credit line, which it has considered instigating in recent years.
Ryan Long, CFA, Director of Investments, Focus Point Solutions
Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, First Trust, Goldman Sachs, Invesco, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, T. Rowe Price, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.