Tag Archives: rising interest rates

REITs when interest rates are rising

November 16, 2016 By in bond market, real estate, stock market, Uncategorized Tags: , , , , , Leave a comment

Finally, to the question of REITs (Real Estate Investment Trusts).

A REIT is a specialized type of corporation that accepts restrictions on the kind of business it can do and limits to how concentrated its ownership structure can be.  It must also distribute virtually all its profits to shareholders.  In return it gets an exemption from corporate income tax.  It’s basically the same legal structure as mutual funds or ETFs.

Traditionally, REITs have concentrated on owning income-generating real estate.  But they are also allowed to to develop and manage new projects, provided they do so to hold as part of their portfolios instead of to resell.

Because they must distribute basically all of their profits, and to the degree that their property development efforts are small relative to their overall asset size, REITs look an awful lot like bonds.  That is to say, their main attraction is their relatively steady income.  Yes, they hold tangible assets of a type that should not be badly affected by inflation.  But current holders, I think, view them as bond substitutes.

As I suggested in Monday’s post, that’s bad in a time of rising interest rates.  Both newly-issued bonds–and eventually cash as well–become increasingly attractive as lower-risk substitutes.  This is the reason REITs have underperformed the S&P by about 5 percentage points so far this month, and by 9 points since the end of September.  I don’t think we’ve yet reached the back half of this game.

How can an investor fight the negative influence of interest rate rises in the REIT sector?   …by finding REITs that look as much as they can like stocks.  That is, by finding REITs that are able to achieve earnings–that therefore distributable income–growth.

This means finding REITs that can raise rents steadily or whose development of new properties is large relative to their current asset size.

 

stocks vs. bonds when interest rates are rising

November 14, 2016 By in bond market, government economic policy, securities markets, stock market, Uncategorized Tags: , , , , Leave a comment

A regular reader asked what I think about REITs in a comment last Friday.  I thought I’d answer him here, starting in a more general way.

One of the safer conclusions we can draw from the US election results is that interest rates are going to be rising over the next couple of years.  Most likely this will happen at a more rapid rate than under the Washington gridlock scenario a Hillary victory would probably have perpetuated.

Two reasons:

–the US appears to be at or near full employment, as evidenced by recent wage gain acceleration, so rates would be rising to fend off future inflation in any event, and

–Republicans, who have been blocking Obama’s infrastructure spending proposals (for no good economic reason), are in favor of fiscal stimulus now that they will get the credit. This will remove some of the pressure the Fed is now under to compensate for congressional failure to do its part to restore economic stability.

 

What happens to stocks and bonds as rates go up?

cash

— a point of merely academic interest right now, but something to tuck away in the back of our minds, there could come a time when the returns on cash are high enough to draw money to it that would otherwise have gone to stocks and bonds.  I don’t know what that point might be, just that it’s a long time away.  The question to answer is:  if the expected return for stocks is 8% a year and I can get, say, 4% in a savings account, am I willing to take the greater risk of owning stocks?

government bonds

–if we take the simplest case, a government bond is a high-quality promise (i) to pay a specified amount of interest for a set period of time, and (ii) to return the principal at the end of the bond’s term.

The annual return on a bond should be the return on cash + a premium to compensate for tying one’s money up for a long period of time.  At the moment, the rate for a 10-year Treasury bond is about 2.16%.  That compares with, say, 0.5% for overnight money.

Suppose the rate on overnight money rises to 2.0%.  A newly-issued 10-year would likely have to yield at a minimum, say, 3.25% to draw buyers (yes, the time premium normally fades as rates rise).  This implies that an already-existing 10-year yielding 2.16% must be worth less than par (since the going rate for a bond at par is 3.25%).

In other words, as interest rates go up, the value of an existing bond goes down.  There’s nothing the issuer can do to change that dynamic.  Since the issuer has the use of what is now cheap money, he will presumably have no desire to change it, either.

 

More tomorrow.

the Fed in 1994

January 27, 2016 By in Federal Reserve, Uncategorized Tags: , , , , 1 Comment

Maybe there’s nothing in past Fed rate raising actions that’s strictly comparable to the situation today.  However, the period that’s most often cited as a possible model is the one from May 1994 through February 1995.  During that time the Fed raised rates by a total of +2.25% in four moves–May, August and November 1994 and February 1995.

the Fed in 1994-95

The Fed moves themselves, and the stock market responses, played out as follows:

–the Fed Funds rate remains constant at 3.75% throughout 1993, a period when the S&P 500 rises by 9%

——–from the market high on January 28, 1994 through May 13th     S&P falls by -10%

—May 17, 1994, Fed raises the Fed Funds rate by 0.50% to 4.25%

——–S&P 500 rises by 4% from May 17 through August 16

—August 16, 1994, Fed raises the Fed Funds rate, again by 0.50%, to 4.75%

——–S&P 500 is flat from August 16 through November 15

—November 15, 1994, Fed raises Fed Funds rate by 0.75% to 5.50%

——–S&P 500 rises by 4% from November 15 through February 1, 1995

–February 1, 1995, Fed raises the Fed Funds rate by 0.50% to 6.0%–and stops

——–S&P 500 rises by 29% through yearend 1995.

the pattern

aggressive rate increases every three months, totaling 225 basis points

the S&P 500 falls in ahead of the onset of rate moves, wobbles briefly as rates are raised, goes sideways/up until the next rate increase–and advances strongly once the Fed stops

relevance for today?

Entering 1994, real GDP in the US was growing at about a 5% annual rate (or about two percentage points above the maximum sustainable growth rate)–and accelerating.  So the Fed acted very quickly to slow the economy down.

We’ve got a very different problem today.  Growth is barely at trend.  Expansionary monetary policy has been exhausted, and has overstayed its welcome simply getting us to this point.  Washington has consistently failed to use fiscal policy to support GDP growth, and shows no signs of wanting to live up to its responsibilities.

The purpose of Fed Funds rate increases this time is to minimize economic distortions that happen when too much money is sloshing around in the system (think:  oil and gas junk bonds with no restrictive covenants), rather than to slow down runaway growth.

In 1994, the S&P sagged significantly in advance of the Fed’s initial move.  The index also stumbled slightly around the time of later rate increases.  But, apart from day-to-day wiggles, the index went sideways to up during the rate rising period.

Did the Fed design its rate behavior with an eye to keeping the stock market stable back then?  That’s not clear.  However, that certainly was what resulted from Fed action.  And avoiding stock market declines was clearly Allen Greenspan’s modus operandi in the Fed’s subsequent rate policy.

Today’s Fed has been quite explicit in its intention to avoid market turbulence that might occur were rates to rise too fast.  1994 shows us, I think, that it can accomplish that objective.  The Fed already seems to be signalling that its original plan to raise rates by 100 basis points this year is being revised downward.

That period also suggests that the major stock market adjustment comes very early in the process.  Arguably, that’s what the declines of August-September and November-January are all about.

 

 

 

 

 

 

 

the Fed’s rate rise dilemma

October 15, 2015 By in Current Market Thoughts, economics, emerging markets, Federal Reserve Tags: , , , , , , Leave a comment

It’s looking more and more to me as if the Fed is being paralyzed into inaction by worries about two possible negative effects of beginning to raise rates now.  The dilemma is that the current zero interest rate policy is playing a large role in making each situation worse.

 

The IMF is arguing that economies in the emerging world are too fragile at present to withstand even a small rate rise in the US.  The agency points out that many emerging economies are very dependent on dollar-denominated natural resources, and therefore are being hurt badly by the current slump in demand for minerals.  In addition, many have borrowed heavily in US dollars to finance industrial (read: natural resources) capacity expansion.  Even a small rise in US interest rates, the IMF says, could spark a sharp upward spike in the value of the dollar against other currencies.  This would further dampen demand for natural resources.  At the same time it would make the local currency cost of dollar-denominated loans skyrocket, possibly into impossible-to-repay territory.  In other words, the Fed could trigger an emerging market crisis similar to the one in smaller Asian countries in the late 1990s.

Of course, what made natural resources firms so foolish as to create wild overcapacity?   …one big reason has been the availability of cheap (by historical standards) dollar-denominated loans.   What has prompted (and continues to prompt) US investors (among many others) to take the risk of lending crazy-large amounts of money for projects in places they know nothing about and for projects they didn’t understand   …years and years of low interest rates on Treasury securities and other safe alternative caused by the Fed’s intensive-care low rates.

 

The Fed has carefully studied the failure of Japan in the early 1990s to reignite economic growth after its economic meltdown in late 1989.  The key factor there, in the Fed’s view (mine, too, for what that’s worth) was that the country tried to remove policy stimulus too soon.  The Fed knows that it has already used up all its economy-healing power, so the country would be reliant on Washington for fiscal stimulus to rescue us in the event it makes a similar mistake.  But we all know that Congress has a poor track record for corrective action in crisis and is particularly dysfunctional now.  So the price to the economy of acting too soon could be very high.

How is it, though, that Congress has been able to ignore its economic responsibilities for so long?  …it’s at least partly due to the fact that the Fed continues to cover for lack of legislative action by running a super-easy monetary policy.  The Fed is an enabler.

 

my thoughts

Neither threat to policy normalization–the potential effect on emerging markets and the lack of an economic backup–is going to go away.  Arguably, the situation will deteriorate the longer the Fed waits.  I think the Fed should start the normalization process now.

bracing for higher interest rates

August 5, 2015 By in bond market, Constructing a Portfolio, Current Market Thoughts, Portfolio management, securities markets, stock market, Strategy Tags: , , , , , , , Leave a comment

Long-time readers may remember that in an embarrassingly premature fashion, I began writing about the upward path away from non-crisis interest rates toward normal several years ago.  It looks like liftoff day has finally come, however.

The consensus expectation, informed by judicious leaks by the Fed, is now that the Fed Funds rate will rise by .25% next month, and by another .25% before yearend–meaning short rates will exit 2015 at .50%.  A highly stylized view of the Fed’s intentions is that it will continue to raise rates at the same 1/4% clip at every second Fed meeting next year–meaning another 1.0% increase during 2016.  The goal of rate normalization is an endpoint for Fed Funds of around 3% (but probably lower).

This is a potentially important change of direction for two reasons:  rates have been at emergency lows for an extraordinarily long time, and the thirty-five year war against inflation has been long since won.  The secular trend of ever lower nominal interest rates–for many financial market participants, the only trend they have ever seen in their working lives–is over.  Barring another world financial disaster, nominal rates may be higher in the future, but there’s no chance they’ll ever be lower.  So the thought habits of a lifetime are about to be shaken up.

What does this mean for stocks?

Past tightening cycles have been bad for bonds, but stocks have been flat to up.  The generally accepted explanation for the latter phenomenon is that the negative effect of higher rates is offset by robust profit growth.  Said another way, positive earnings surprises (more than) offset the negative effect of price earnings multiple contraction.

Personally, I think this explanation is the right one.

Critics of the applicability of the idea to the present situation point out that this time rates will be rising long after the business cycle has turned.  Therefore, they argue, the chances of a surprisingly large corporate profit surge are slim.  In consequence, the “normal” protection for stocks against Fed tightening is absent.

Four thoughts:

–the reason rates are still at 0% is that the “normal” cyclical profit surge hasn’t happened yet.  Maybe surge isn’t the right word for today’s situation, but world economies certainly aren’t firing on all cylinders yet.

–profit rises and Fed tightening aren’t independent events.  The Fed has made it clear that it intends to tighten only to the extent that economic strength allows.  The agency has often referred to the repeated disastrous mistakes Japan has made over the past quarter-century by tightening too soon.  If profit growth doesn’t permit, tightening will go more slowly than many expect.

–for the S&P 500, half the index’s profits come from abroad.  The EU (25% of profits) will likely be stronger next year than this; China may be, too.

–where else will money go?  Certainly not into bonds.  Cash is the only safe haven.  It’s possible there will be a large outflow of money from stocks into cash.  I don’t think so.  That’s partly (mostly?) because I like stocks.  More substantively, institutional investors may shade their portfolios a bit toward cash, but their large size means they can’t maneuver quickly, so the risk to them of betting against stocks in a major way and being wrong is enormous.  In addition, my sense is that a defining feature of the bull market that began in 2009 is the lack of retail participation.  If so, retail has already bet heavily–and incorrectly–against stocks.

A final point:

–yielding 0%, cash isn’t an attractive alternative to me at.  However, given that the period of zero interest rates is coming to an end, I’ve got to ask myself at what level would it be?

If we assume that inflation will be steady at 2%, I would find 3% cash and a 4%+ long bond very attractive.  That may be evidence that we’ll never get there.

Still, what I’m trying to get at is that there will come a point in the tightening cycle where even an equity fan like me will have to reallocate toward fixed income.  We’re nowhere near that now, in my opinion.  But I think this, not the start of tightening, will be the real showstopper for stocks.  This is not an idea to act on, but it is one I think we should keep in the back of our minds.