where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.

REITs when interest rates are rising

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 (ii)

yesterday’s post: bonds

To summarize yesterday’s post, when interest rates are rising, newly-issued bonds bear higher coupons than ones issued in the recent past. Older bonds look less attractive, because they provide less return.  So they have to go down in price until they’re trading at equivalent returns to new ones.

Other than inflation-indexed bonds, Treasuries have no defense against this.

What about stocks?

Here the issue is a bit more complicated.

Let’s make the useful, and more or less correct, assumption that stocks and bonds are in equilibrium before rates start to rise.  If so, if bonds get cheaper, stocks will also have to get cheaper in order to compete for investor money against now-higher-yielding bonds.

This means rising rates puts downward pressure on stocks, too.

But stocks do have a defense.  It has to do with why rates are rising.

In most cases, rates begin to rise when either bond investors or the Fed sense incipient inflation that threatens to erode the purchasing power of money.  This is what triggers the impulse to raise rates.  Since in advanced economies, inflation is always an issue of wage inflation, its early warning signs are that the economy is reaching full employment and/or wages are beginning to rise at an accelerating rate.  In the US, that’s where we are now.

But more workers employed and wages rising at a healthy clip imply that consumer spending is likely to rise at an accelerating rate.  This implies accelerating profit growth for, in sequence, retailers, their suppliers and the providers of capital goods to both retailers and suppliers.  To the extent that a given stock market represents the local economy (which about half of the S&P 500 does), profits of publicly traded companies will start to go up at an unexpectedly sharp rate.

Rising profits create upward pressure on stock prices that serves as at least a partial counter to the downward pressure created by rising rates.

currency

A second issue that will affect stocks directly is how the combination of inflation and higher rates affects the local currency.

If the currency falls, which is the most common case, export-oriented or import-competing companies will have the best results.  Purely domestic firms, and domestic firms that use foreign inputs, will fare relatively poorly.

If the currency rises, the opposite will most likely happen.

the S&P 500 in past times of rising rates

In the US in the past, the upward pressure from rising profits and the downward pressure from rising interest rates have most often neutralized each other.  There have certainly been diverse sector and industry performances, based on currency, technology, government fiscal policy and the overall state of the world economy.  So there have typically been substantial outperformance opportunities even in a sideways market.  But the overall market tendency in the early year or so of rising rates has typically been sideways, not down.

 

Tomorrow, REITs.

 

 

new oil and gas finds in mature areas

a lesson from base metals

A decade of intensive exploration for base metals during the 1970s, on what proved to be the mistaken idea that their consumption must rise in lockstep with global GDP, resulted in a substantial glut of copper, zinc, lead…by the end of that decade.

Miners responded by redirecting their exploration and development efforts in two ways:

— they started looking for gold, for its high value in a small package, and

–they concentrated on areas near existing infrastructure.

This cut costs and almost immediately began to generate much-needed cash flow. In some cases, miners even went back to the tailings (dump heaps) of nineteenth-century mines to extract now-economical gold.  Yes, this effort created a glut of gold within a decade, but that’s another story.

the oil industry today

Something similar seems to be going on now in the oil industry in the US.  A few months ago, Apache announced a major discovery (3 billion barrels of oil, 75 trillion cubic feet of gas) in an overlooked area near the Permian Basin in Texas.  Two days ago, Caelus Energy, a privately-held firm, announced a potentially large find (2.4 billion barrels of light crude) in shallow water in Smith Bay in northern Alaska–close, at least in Alaska terms, to delivery systems from earlier finds by oil majors.

That exploration effort should have shifted in this direction isn’t surprising.  The large amounts of oil and gas being uncovered are.  Although no one would want to generalize from this small sample, the discoveries do seem to me to call for demands for greater evidence for any claim that oil and gas prices will rise a lot from current levels.

 

 

the slow-motion disappearing act of the British pound

Brexit

Just prior to the Brexit vote in June, at a point when sentiment had temporarily swung in favor of Britain remaining in the EU,  the British pound reached a high of about 1£ = $1.48.  Yesterday the post-vote slide reached a 31-year low of 1£ = $1.27, 14% lower.

What makes the $1.27 level significant isn’t just the continuing fall in national wealth induced by the Brexit vote.  It’s also that the UK has now slipped behind France for the title of second-largest economy in the EU.

The cause is the gradual working out of the detailed consequences of something that was, or should have been, well known in general terms before the Brexit vote–that however emotionally satisfying the Brexit vote might have been, there are potentially very large economic costs to the UK from leaving the EU.

They come in two forms:

–London is the financial center of the EU, and as such has tons of banking jobs which may well shift out of the country

–because it is more open to foreign companies than continental Europe, many multinationals have chosen the UK as the home base for their EU operations.  Much of that presence–and the associated jobs–may well be leaving now, as well.

US parallels

Two parallels can be drawn between the UK and the US from Brexit.

The first is that the vote in favor of Brexit–since generally regretted in the UK–was driven by an older, rural constituency that felt left out of EU-generated prosperity.  There is also an anti-immigrant element in the pro-Brexit camp, though not so overtly racist, I think, than among Trump supporters here.

The second is that in stock market terms the Brexit vote has not been as bad as one might have feared.  The currency has since fallen by about 12%.  The large-cap FTSE 100 has risen by 10% or so, however, offsetting most of that decline.  Many multinationals are actually up in US$ terms.

However, although the same forces driving voters in the UK may well be motivating those in the US, I don’t think the idea that the S&P 500 reaction to a Trump presidency in the US would be similar to the post-Brexit FTSE holds water.

That’s because the two stock markets have very different structures.  The UK is a small country with an outsized stock market, dominated (about 3/4 of the market cap) by multinationals headquartered in Britain but doing the vast majority of their business elsewhere.  For most of those, a fall in sterling has lowered administrative costs significantly but has had very little negative effect on revenues.  For multinationals with their debt in sterling, the advantage is magnified.  In additions, because multinationals give access to a stream of hard-currency revenue, they also serve as a modest form of capital flight.

Half the US stock market, in contrast, is made up of purely domestic companies, with another quarter doing business in nations whose currencies are linked to the dollar.  So the safe haven effect would be much smaller.  In addition, all of his other negatives aside, simply given Mr. Trump’s loony notions about foreign trade, the economic damage he might do is considerably greater.