What Happens to the Marketplace When Mortgage Rates Rise?
How would you describe the state of the global economy?
This is one area where there is very little need to do deep analysis. Sometimes bond yields are telling you things are going really, really well. And sometimes bond yields are telling you that things are not going well at all. I admit that there is an in-between place where bond yields are not necessarily telling you anything with much clarity. This is not one of those times. Of the world’s government bond debt, 67% ($15 trillion out of $22 trillion, for those counting) is yielding less than the local inflation rate. I’m sorry to oversimplify, but there is no way to argue that there is an impressive global economy on the horizon when that is the case. These numbers are so severe and obvious that I think most other nuanced analysis is unnecessary: The bond market has answered the question for you.
What is your assessment of earnings season so far?
Better than I expected. You see a blend of companies either hitting revenue targets, or, in cases where revenue growth has not surfaced as hoped, they have creatively managed around it with M&A, cost-cutting, and strategy optimization. Companies exiting their financial services business, or announcing plans for a turnaround, or lower impact from currency moves than anticipated – these kinds of stories are bigger than the headline results. The dispersion is high as I predicted – meaning, you have a wide array of results from different companies meaning the market is not reacting monolithically. Individual company execution matters right now – a lot.
Have you changed your forecast on a June Fed meeting rate move?
My forecast was, and is, that June will come and go without Fed action on the Federal Funds interest rate. The piece I would add to my rate forecast is that whether or not their first rate increase comes in September, December, January, or March, I actually do believe a tiny, almost inconsequential increase will come, and then be followed up by … absolutely nothing … for quite some time. In other words, we may very well see one tiny increase, and then another prolonged period of nothingness from there.
What’s a barely discussed recent story?
It’s really a story that has been in motion all year, but that is the German bond yields utterly collapsing, while the Greek bond yields scream that default is imminent. Greek 30-year bonds are trading at 40% of face value. Their two-year notes offer a 30% yield right now. And as all of this is happening (the market flat-out telling you “Greece is a goner”), German bonds have a negative yield almost out to 10 years on the curve. I have never seen anything like this in my career, and neither has anyone else. Your question is surely, “What does this mean to me?” I regret that I don’t have a great answer. I most certainly wouldn’t be buying German bonds or Greek bonds right now. But economically, and crossing over the Atlantic, I suspect the entire European story has not been fully digested into what it is most for global capital markets, and that is not a task I will take lightly in the weeks and months (and likely years) ahead.
What’s your favorite line of the last week?
A dear client sent me a wonderful report from Knightsbridge Asset Management, a local money manager I have been familiar with over the years. On p. 4 of their spring quarterly commentary, they mockingly quote a manager who said, “We see significant client interest in the energy sector; we think it is a great contrarian play.” What the commentary I read was pointing out – and what I am hereby pointing out to you –is this: Significant public interest in something is antithetical to contrarianism.
How does that apply that to us?
I am deeply committed to finding growth-of-dividend value in the energy sector. When our portfolios suffered price depreciation in September and December last year related to the oil price drop, I did the right thing in not letting us panic out of high-quality oil and gas pipeline holdings, amongst other names we believe in. I also added lightly to positions as part of conventional rebalances, particularly near the January troughs. However, the massive contrarian moment of loading up on such energy names really never came. The reason? The sentiment was always, “Oh, I love energy; these names are beaten up.” A real contrarian waits for the sound of wailing – the gnashing of teeth – that capitulation moment when the last “dumb investor” says, “I can’t take it; energy is never coming back; all pipelines are going away; I am out.” Those are the moments that create contrarian buying opportunities which change portfolios. I have been prudent, modest, and mildly opportunistic. Most importantly, I have avoided panic. But no, too many people believed in the story for it to become as investably believable as I wanted it to be. Tell me this: Are you following what I am saying here?
What’s the best argument for the leveraged loan floating rate space in your bond portfolio?
The spread between high yield bonds which offer credit risk and duration risk and floating rate bank loans which offer credit risk but no duration risk is very, very thin right now. You can argue that credit, in general, is concerning and maybe even unattractive. If that argument is made I am hard-pressed to see how that wouldn’t apply to BOTH high yield and floating rate … But all things being equal, with some degree of credit risk, I think the spreads are telling you that bank loans are the better relative value, with less exposure to troubled sectors, and with a higher place on the capital structure, and most importantly, with no duration risk.
What do you see as the good, bad, and ugly on the housing market?
The market is strong right now, particularly in Southern California, and I believe the “good” (for people selling homes or people who like believing their house price is really high) is that low long mortgage rates are really low, and really providing aid to the market. Lending standards have slowly come down, and more favorable lending environment means more buyers and higher prices. The questions I would propose long-term are, “Where is our country headed in terms of household formation?”, and short- to mid-term, “What happens to the marketplace when mortgage rates move higher?” For a family with a primary residence, I reiterate my long-held and oft-expressed view that this is a non-issue; you need a place to live. For those approaching it from an investment standpoint, I have little to offer that will be constructive. The market is heated, and rates are low. That’s what I would say.
When you look at 2015’s stock appreciation, what do you see?
Broad stock market moves (take the S&P 500 for example) has almost entirely come from P/E expansion, not E expansion. In other words, earnings have not grown much – if at all. So the slight price improvement the broad market has is a by-product of higher P/E ratios (investors being willing to pay more for earnings). I think investors have said, “Sure earnings growth has slowed, but that is because of a strong dollar, so that doesn’t really count. We can pay more for earnings because – adjusted for currency – they’re growing okay.” I will explore this topic more next week – where it may be right, and where it may be off.
QUOTE OF THE WEEK
“Indeed, a major source of objection to a free economy is precisely that it gives people what they want instead of what a particular group thinks they ought to want. Underlying most arguments against the free market is a lack of belief in freedom itself.”
– Milton Friedman