The Biggest Ramifications of Rising Interest Rates
Dear Valued Clients and Friends,
One of the fun things about this week’s commentary is that we get to revisit a lot of the driving principles of our investment philosophy (growth vs. value, dollar-cost averaging, beating inflation, etc.) all in the organic flow of the commentary itself (natural questions being answered as they came). October is nearly over. (By the time you are reading this it likely is, but as we’re writing it, we still have a day to go.) It was quite a spectacular month overall. We begin this week’s commentary with a deeper dive into foreign policy than normal, but as certain things shape up and shake out in the Middle East, we’re convinced it is going to give energy investors a leg up from a portfolio standpoint.
Oil prices are a byproduct of supply and demand –as are all commodity prices – but more exposed to geopolitical implications than anything else on earth. The Sunni/Shiite divide in the region and the role of Russia in interfering with the power matrix is going to have profound effects one way or the other. Growth vs. Value is a false and dangerous dichotomy. We want attractively priced stocks at growing dividend yields with growing earnings. Dollar-cost averaging is a risk-reduction mechanism, not necessarily an opportunistic strategy. It is pretty easy math to see that stocks, not gold, have been the world’s greatest hedge against inflation (for decades and decades). MLPs have had seven of their worst 20 weeks ever this year. One year later in all other cases? A 25%+ increase. Will this time be different? China is in a pickle, or shall we say the world is in a pickle around China. A slowing growth rate in China is bad for global growth. A devalued currency is good for China’s growth. A devalued Chinese currency is bad for global growth – and therein lies the rub. High Yield bonds continue to look attractive to us at these valuations on a tactical basis. The Fed hand-wringing going into December’s FOMC meeting has begun, and we feel fine …
Of all the reasons to believe oil prices may go up in the next year or so, what is the one people are talking about the least?
Most of the arguments that oil prices will return to a higher level (an argument we agree with) center around basic supply/demand economics: As prices have dropped, economic incentives have dropped for greater production, which means eventually lower supply, which then creates higher prices, etc. The demand has not dropped, so prices fall (and rise) inversely with supply. This is basic economics and good enough for us. However, we would very much like our clients to understand more of the geopolitical climate driving the present oil pricing economics. The Saudis economic aim was never actually an economic aim – it was a political one, in our careful and rigorous analysis. It was never driven by fear of U.S. fracking production, but rather to provide leverage points in the Middle East where an unholy axis with Russia, Iran, and Syria threatened to minimize – if not obliterate – the century-old Sunni stronghold of power and oil. Should the area east of the Arabian peninsula see a Shiite majority take hold, we expect greater instability in the region – the kind that would push oil prices dramatically higher. The decline in oil prices over the last year has decimated both sides of this divide (the Russia/Iran side on one, the Saudi/OPEC on the other), but the latter has had greater financial reserves to withstand it (for now). The recent intervention of Russia is the significant wild card that we are desperately trying to get our arms around. Is it a mere leverage point for Putin to force Saudi into production cuts (which pushes oil prices higher), or are they playing the long game to change the power struggle in the region (which also pushes oil prices higher)? We would write about foreign policy every single week if it were of greater interest to our clients, but, frankly, in this case, the economic implications are too substantial to ignore.
Do you like Value stocks or Growth stocks better in this environment?
We have a rather permanent belief that the “dichotomy” between growth and value is disingenuous. We would not buy a “growth” stock if it were insanely expensive and we would not buy a “value” stock if we did not feel promise for its growth prospects. All growth should be at a value and all value should have growth. Because we do not tend to like the very expensive kind of growth (high beta) that many investors like, we have what is traditionally known as a more value bias in our client portfolios. Short of a significant credit event happening, we think the environment looks good for this style of equity investing.
What do you think about partially investing into an investment portfolio to “average” in as opposed to going in all at once?
I think that if the market goes up after money is “partially” invested it cost the investor money to have not gone all-in, and if the market goes down after the money is “partially” invested it makes the investor money. Is that profound?
Look, when averaging into an investment position, the objective is to control the risk, not act on a market call. Timing is a fool’s errand. The decision to average in vs. go all-in has to be made as a byproduct of risk appetite, not a short-term market forecast. We do it both ways at The Bahnsen Group depending on circumstances, valuations, and most importantly, client particulars.
Is gold the best hedge against inflation?
Inflation is up 123% since 1985. Gold is up 262%. The S&P 500 is up 858%.
Inflation is up 779% since 1955. Gold is up 3,278%. The S&P 500 is up 4,350%. Oh – one more thing: Those S&P numbers don’t include dividends.
Put the last year for MLPs in historical context for us.
Four of the worst five weeks in the history of MLPs took place during the financial crisis. Seven of the worst 20 weeks took place in the last year. In every case of those other 13 weeks, one year later the sector was up over 25%. Our guess is that the sector stabilizes first – perhaps a six-month process – and sees ascendant rebound in the second half of 2016. And along the way, – uninterrupted dividends and dividend growth. This is a guess, though. Our thesis centers around the fundamentals and the underlying belief in the primacy of cash flows, of the need for energy infrastructure, and so much more.
What do you see as the conundrum going on in China?
Global growth is threatened by China’s slowing growth. That is well-established. China’s growth would be enhanced by a devaluing of their overvalued currency. That is well-established. Yet, global growth is threatened if China were to devalue their currency (as seen in the market’s hissy-fit of August). Essentially, there is a pickle there that will be tricky to navigate. Japan’s aggressive depreciation of their Yen currency has hurt China. Basically, China wants to devalue as well, without signaling that they are devaluing. Good luck with that. We think they are done for now and are not likely to take any aggressive actions for the time being. We are not bullish on Japan or Europe where, for all of the talk about more aggressive action from their central bank, we just don’t know how efficacious it could be (with rates already at zero).
Why do you believe High Yield bond spreads are likely to narrow, meaning, offer good returns in the short- to intermediate-term?
Short of a real dramatic move up in defaults, we believe the space became oversold and offers attractive value. In other words, the risk became something for which we could receive a reward. Note the correlation in this chart between high yield bond spreads and the VIX (which measures equity volatility). We believe that disconnect will be met by high yield spreads falling further. And should we prove to be right, we will be pairing off that high yield position in due time – but not yet.
What was the most intriguing thing you learned this week about the Fed and their approach to raising rates?
An economist out of Northwestern, Robert Gordon, wrote a piece claiming that the Phillips Curve is alive and well in terms of the relationship between unemployment and inflation. I am totally aware that I just lost most of you, but stick with me for one second. I will lay it all out for you: I detest Phillips Curve theory, and was totally unaware that any credible economist still believed in this 1970’s debacle. (OK, I know folks still did, but I was unaware that they would admit it.) This Phillips Curve is an academic concept by which unemployment rates are believed to have an inverse relationship with inflation. The notion is that promoting inflation lowers unemployment, and vice versa. You may remember the stagflation of the 1970’s that I believe put to bed this inane economic theory. Gordon not only still posits it as economic truth, but made a case last week that the Fed still believes it, too, and with unemployment so low is likely to fear inflation sooner than people think. Here you get the rare case where I not only get to disagree with the theory, but the application, as well (and for totally different reasons).
Where do you see equity markets a year from now?
There is no plausible case to be made for what markets will be doing in six weeks, let alone six or 12 months. The variables around geopolitics, the election, the Fed, China, macroeconomics, and U.S. earnings are so dramatic that any 12-month forecast would be no more than guesswork. Remember our adage, “Our job is not to tell you what the market will do; it is to remind you that no one else knows either.”
What would you see as a general climate for equities over the next 12 months barring any major unforeseen shock to the system?
If one looks at the lay of the land and takes for granted no “tail risk” (sometimes called “black swan” events – the things that can rock the system without warning or indication), the reality is that it is hard to argue for a significant increase across the broad market. Revenues are soft but not collapsing. Margins are peaked but seem to be continuing higher. Valuations are fair but not cheap. Global growth may not be recessionary but it sure isn’t explosive. If one prefers to invest, as we do, outside of an exclusive reliance on central bank stimulus to drive prices higher, the reality is that broad index investing may give a modest positive return over the next 12 months, but we would suggest that it will be certain pockets that provide most of the return in an equity portfolio over the next phase of this market cycle. We do believe a larger move will take place at some point – perhaps to the downside if substantial monetary tightening and an earnings collapse takes place; and perhaps to the upside if some substantial pro-growth policies are enacted. (Believe me, I could make a list!) In the meantime, we expect volatility along the way without a huge directional bias, and specific pockets of value to lead the way.
Where would those “pockets of value” lie?
When energy prices move higher, much of the energy sector is deeply undervalued. Select names swimming in the free-cash-flow generation are of tremendous value right now, but it is time to be bottom-up, not top-down. (Focus on the company, not the sector.) These names, filtered by their freecash-flow generation, dividend payout ratio, attractive yield, propensity to grow yield, and management philosophy towards shareholder value – these are the names we believe offer “pockets of value.”
What is your criticism of those who are looking at economic data to forecast what the Federal Reserve will do about rates?
There is no reason not to look at all economic data to inform your perspective on what the Fed should do, and to generally analyze the litmus of options available in terms of what they will do. But when pundit after pundit suggests that certain anecdotes of economic strength tell you why they will raise, or pockets of weakness tell you why they will not, it seems painfully obvious that the forest is being missed for the trees. The Fed had ample economic data to support a rate increase several years ago, and did not do so. Their driving force is clearly, for right or for wrong, not merely data dependency, but how they believe others will react to their actions. We happen to believe that is distortive to markets. Other credible economists believe it is important for them to do so. But the problem when you formulate a forecast on the data itself is that you miss out on the key ingredient – and perhaps the unknowable one – how the Fed themselves believe various economic actors will respond to said data, and to said rate action around the data. A tangled web we weave, when first we practice to interfere in markets. (Sorry if you were hoping for a better rhyme.)
If and when interest rates move up, where do you think the biggest ramifications will be seen?
Positively, we think it would be in Financials and Materials and Energy stocks. Negatively, we think it would be Utilities and REITs. In the bond market, the most negative impact would be in long maturity Treasury bonds and various Inflation-protected bonds. The positive impact would be strongest in High Yield corporate bonds and Floating Rate. Our objective is to, as much as possible, be reasonably neutral about this, and not make a timing call.
If the stock market dropped 20% – a bear market – what sectors would you expect to do best and worst?
Because the vast majority of 20% drops (bear markets) are a by-product of a recession, we would think the most economically sensitive sectors would suffer the most (financials, materials, industrials) and the least economically sensitive would do the “least worst” (utilities, health care, consumer staples, telecom).
Did the Fed project on Wednesday that they will, or will not, raise rates in December?
Neither. Or both. Or I don’t know. Listen, it is a very unhealthy exercise to play this “will they or won’t they” game. Their messaging at the October meeting had some indication of hawkishness, but at the end of the day actions speak louder than words, and we believe it is a 50-70% chance that they will not raise rates in December (so unlike in September, we are open to the possibility that they might). The markets dropped 100 points and then went up 200 points, which basically is a non-event, and it was a non-event because it really, really was a non-event.
Quote of the Week
“Bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.”
~ George Soros
(It pains me to quote him, but when the quote is spot on …)
* * *
Thank you all who sent kind regards a couple weeks ago about the speech I gave on behalf of my late father. It went very well and I thank you for your notes and sentiments. Dad was further honored on last Saturday when his beloved Trojans played their best game of the year. My kids were, of course, very excited for Halloween, and I am, of course, excited for November (my favorite month of the year). October wasn’t too bad itself from a markets-standpoint; I will have the exact ranking next month but I am sure it was one of the best months in markets in quite a long time.
We hope you all will reach out with questions you may have, and more than anything else we hope this period will reinforce a few things about the relationship we want to have with you:
- We will diligently communicate our point of view whether things are going well, or poorly.
- We want to demonstrate significant value for you around our vast array of planning and advisory services – and will meet with all of you and walk through what this means even if it means us walking to the four corners of the earth.
- There are always going to be market volatility, emotions that are provoked by such volatility, and a need for a trustworthy, diligent, proactive, caring team to guide you through that volatility and accompanying emotions.
It is to all these ends that we work. Enjoy your week.
Originally posted on High Tower Advisors.
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