Tag Archives: bond market

Q1 2019 Markets Review: Curb Your Enthusiasm

It’s been a wild opening to 2019 for investors. It’s always hard to know why markets make big moves, but it seems the big gains of this quarter are the result of Fed Chairman Powell softening his stance on interest rate hikes. The Fed’s support has likely buoyed the stock market since the financial crisis, and that could continue. But, at some point, a spate of bankruptcies or some other failure could take the Fed’s control away. Over the short-term, anything is possible, but, at current prices, investors shouldn’t expect too much in terms of long-term stock returns.

The quarter ended with the S&P 500 Index up 13.65%. Because of the mathematics of compounding, that doesn’t completely erase the 13.55% loss in the last quarter of 2018, but it’s comes close. The index is within two percentage points of where it ended the Third Quarter of 2018, including dividends. That also means the index is expensive again, hitting nearly 30 on the Shiller PE metric (current price relative to the past decade’s worth of real average earnings). The long-term average for the metric is around 16.5, and it has spent most of the last quarter-century above 20. Companies are more profitable now than in the past. Competition is diminished, and workers have less bargaining power. Those factors may persist for a while longer, but conservative investors will have to think hard about counting on those factors enduring, say, two decades into the future.

US small-cap and mid-cap stocks did even better than their large brethren. The Russell MidCap Index returned 16.54%, while the Russell 2000 gained 14.58%. Small cap stocks look even more expensive (and poised for even lower future returns) to asset class valuation firms Like Newport Beach, Calif.-based Research Affiliates, however. Think US small-cap stocks are poised to deliver less than 2% annualized over inflation for the next decade.

Foreign stocks also did well in dollar terms, with the MSCI EAFE Index delivering a nearly 10% return and the MSCI EM Index just on its heels at 9.92%. Emerging markets struggled for most of 2018, but they seem to have shaken off their difficulties for the time being. Debt problems remain in Argentina and Turkey, and Russia has its own set of difficulties. But all seems well in the other larger emerging countries.All of this means both domestic and global balanced indices also did well. The Vanguard Balanced Index fund returned nearly 10%. That gaudy number owes to the fact that the 60% of the fund that’s in stocks tracks the MSCI USA Index, which has more small-cap and mid-cap exposure than the S&P 500. A global balanced index composed of 60% MSCI All Country World Index and 40% Bloomberg Barclays US Aggregate delivered an 8.34% return. Global indices are important to track because many, if not most, investors have portfolios benchmarked against them. A balanced portfolio seems to strike the right balance between aggressiveness and the need for safety for many investors, though it may be poised to deliver low returns in the future.

Among the S&P 500 sectors, information technology led the way with an eye-watering 19.9% return for the quarter. Real estate wasn’t far behind with a 17.5% return. The bond rally likely encouraged dividend-paying REITs. Usually utilities participate in a bond rally, and they did this time too with a 10.8% return. But that return landed them in the bottom half of sectors. Health care and financials pulled up the rear with 6.6% and 8.6% returns respectively. A flattening yield curve can have a negative effect on banks since the bank business model depends on a steep yield curve or “borrowing short” and “lending long.”

Overall, investors enjoyed excellent returns in all asset classes. This presents a problem of which asset class is “correct.” Stocks rally, after all when the economy appears strong, and bonds rally when the economy appears weak, and interest rates might be on the way down as a result. Since the financial crisis, stocks and bonds have rallied in tandem in response to low interest rates. They continued that trend in the first quarter of 2019. At some point, though nobody knows exactly when, investing won’t be so easy.

Clues from the Fed II – A Review of Jerome Powell’s Speech 11/28/2018

The following speech by Jerome Powell, Chairman of the Federal Reserve, was given on November 28, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below. If you have not read our review of Vice-Chairman Richard Clarida’s speech from yesterday you can find it HERE.


The Federal Reserve’s Framework for Monitoring Financial Stability

Chairman Jerome H. Powell

At The Economic Club of New York, New York

It is a pleasure to be back at the Economic Club of New York. I will begin by briefly reviewing the outlook for the economy, and then turn to a discussion of financial stability. My main subject today will be the profound transformation since the Global Financial Crisis in the Federal Reserve’s approach to monitoring and addressing financial stability. Today marks the publication of the Board of Governors’ first Financial Stability Report. Earlier this month, we published our first Supervision and Regulation Report. Together, these reports contain a wealth of information on our approach to financial stability and to financial regulation more broadly. By clearly and transparently explaining our policies, we aim to strengthen the foundation of democratic legitimacy that enables the Fed to serve the needs of the American public.

Outlook and Monetary Policy
Congress assigned the Federal Reserve the job of promoting maximum employment and price stability. I am pleased to say that our economy is now close to both of those objectives. The unemployment rate is 3.7 percent, a 49-year low, and many other measures of labor market strength are at or near historic bests. Inflation is near our 2 percent target. The economy is growing at an annual rate of about 3 percent, well above most estimates of its longer-run trend.

For seven years during the crisis and its painful aftermath, the Federal Open Market Committee (FOMC) kept our policy interest rate unprecedentedly low–in fact, near zero–to support the economy as it struggled to recover. The health of the economy gradually but steadily improved, and about three years ago the FOMC judged that the interests of households and businesses, of savers and borrowers, were no longer best served by such extraordinarily low rates. We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth. My FOMC colleagues and I, as well as many private-sector economists, are forecasting continued solid growth, low unemployment, and inflation near 2 percent.


RIA Pro commentIn these first two paragraphs Jerome Powell points out that the economy is running above its longer-term trend in large part due to the support of “near zero” interest rates (Fed monetary policy). Given recent above-trend economic growth and a sustained recovery from the financial crisis, the Fed raised rates to get to a less simulative level.

He states that “interest rates are still low by historical standards” and “remain just below” what they would consider neutral for the economy. The phrasing “remain just below” is the key line from the speech as it was only a month ago, on October 3rd, when he said they were a “long way” from neutral. In no uncertain terms, this abrupt change in posture is a clear signal to the market that the Fed may be close to ending their hiking cycle.

There are two other important points regarding the neutral rate worth discussing. First, the Federal Reserve does not know with any real precision what the “neutral” rate of interest for the economy is or should be. This is best left to un-manipulated markets and the independent buyers and sellers that drive them. Second, if indeed Powell and the Fed did know with certainty where the neutral rate should be, it likely would not be at a real rate near zero, with economic growth running above 3% and the unemployment rate at 50 year lows as is currently the case.


There is a great deal to like about this outlook. But we know that things often turn out to be quite different from even the most careful forecasts. For this reason, sound policymaking is as much about managing risks as it is about responding to the baseline forecast. Our gradual pace of raising interest rates has been an exercise in balancing risks. We know that moving too fast would risk shortening the expansion. We also know that moving too slowly–keeping interest rates too low for too long–could risk other distortions in the form of higher inflation or destabilizing financial imbalances. Our path of gradual increases has been designed to balance these two risks, both of which we must take seriously.

We also know that the economic effects of our gradual rate increases are uncertain, and may take a year or more to be fully realized. While FOMC participants’ projections are based on our best assessments of the outlook, there is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us. As always, our decisions on monetary policy will be designed to keep the economy on track in light of the changing outlook for jobs and inflation.


RIA Pro comment- Powell is parroting the substance of Clarida’s speech yesterday essentially saying that the Fed is no longer on rate-hiking auto-pilot. They will raise rates or abstain from raising rates based on what economic and financial data tell them (data dependency). As we mentioned yesterday, the increased emphasis on data dependency by definition reduces their reliance on forward guidance which will introduce more volatility to the markets. Prior reliance on forward guidance helped suppress volatility, so it follows that less reliance on it will make them less predictable and naturally raises the level of uncertainty for investors.


Under the dual mandate, jobs and inflation are the Fed’s meat and potatoes. In the rest of my comments, I will focus on financial stability–a topic that has always been on the menu, but that, since the crisis, has become a more integral part of the meal.

We omitted the rest of the speech as its focus is a historical perspective of financial stability and less relevant to current monetary policy. The entire speech can be found HERE

RIA Pro Summary

It is clear from this speech, as well as recent trial balloons put out by the Fed, that they are taking a more dovish stance. This does not mean they will halt their rate hikes, but in our opinion it is clear that once we move beyond the scheduled hike in December, all bets are off the table. Barring signs of wage growth, stronger inflation or sustained economic growth above 3%, they are unlikely to raise rates further.

The stock market rocketed higher on what is perceived as a dovish speech with the strong possibility that Fed hikes will be halted come 2019. Time will tell if the gains are sustainable and if the market is interpreting his speech correctly. It is worth mentioning however that a recession followed the last three times that the Fed Funds rate hit a cycle high. 

 

 

 

 

Clues from the Fed – A Review of Richard Clarida’s Speech 11/27/2018

The Following Speech by Richard Clarida, Vice Chairman of the Federal Reserve, was given on November 27, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. More specifically, given Clarida’s role as the Vice Chairman, he is one of the main sources of communicating whether the Fed is indeed considering reversing to a more dovish stance in the months ahead. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below.


Data Dependence and U.S. Monetary Policy

Vice Chairman Richard H. Clarida

At The Clearing House and The Bank Policy Institute Annual Conference, New York, New York

I am delighted to be speaking at this annual conference of the Clearing House and the Bank Policy Institute. Today I will discuss recent economic developments and the economic outlook before going on to outline my thinking about the connections between data dependence and monetary policy. I will close with some observations on the implications for U.S. monetary policy that flow from this perspective.

Recent Economic Developments and the Economic Outlook
U.S. economic fundamentals are robust, as indicated by strong growth in gross domestic product (GDP) and a job market that has been surprising on the upside for nearly two years. Smoothing across the first three quarters of this year, real, or inflation-adjusted, GDP growth is averaging an annual rate of 3.3 percent. Private-sector forecasts for the full year–that is, on a fourth-quarter-over-fourth-quarter basis–suggest that growth is likely to equal, or perhaps slightly exceed, 3 percent. If this occurs, GDP growth in 2018 will be the fastest recorded so far during the current expansion, which in July entered its 10th year. If, as I expect, the economic expansion continues in 2019, this will become the longest U.S. expansion in recorded history.

Likewise, the labor market remains healthy. Average monthly job gains continue to outpace the increase needed to provide jobs for new entrants to the labor force over the longer run, with payrolls rising by 250,000 in October. And, at 3.7 percent, the unemployment rate is the lowest it has been since 1969. In addition, after remaining stubbornly sluggish throughout much of the expansion, nominal wage growth is picking up, with various measures now running in the neighborhood of 3 percent on an annual basis. 

The inflation data in the year to date for the price index for personal consumption expenditures (PCE) have been running at or close to our 2 percent objective, including on a core basis‑‑that is, excluding volatile food and energy prices. While my base case is for this pattern to continue, it is important to monitor measures of inflation expectations to confirm that households and businesses expect price stability to be maintained. The median of expected inflation 5-to-10 years in the future from the University of Michigan Surveys of Consumers is within–but I believe at the lower end of–the range consistent with price stability. Likewise, inflation readings from the TIPS (Treasury Inflation-Protected Securities) market indicate to me that financial markets expect consumer price index (CPI) inflation of about 2 percent to be maintained. That said, historically, PCE inflation has averaged about 0.3 percent less than CPI inflation, and if this were to continue, the readings from the TIPS market would indicate that expected PCE inflation is running at somewhat less than 2 percent.


RIA Pro commentClarida believes the economy is growing at a healthy clip and wage growth is relatively strong in the 3% range. These statements by themselves argue that the Fed is woefully behind the curve in raising rates. Based on historical precedence, one would expect Fed Funds to currently reside in the 3.50-5.00% range versus the current 2.25%. One explanation for the low Fed Funds rate, as Clarida implies, is that inflation and inflation expectations remain low. In the next two paragraphs, he goes on to explain why inflation may remain low and not rise to levels that would overly concern the Fed.


What might explain why inflation is running at or close to the Federal Reserve’s long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust? According to the Bureau of Labor Statistics, productivity growth in the business sector, as measured by output per hour, is averaging 2 percent at an annualized rate this year, while aggregate hours worked in the business sector have risen at an average annual rate of 1.8 percent through the third quarter. This decomposition–in which the growth in output is broken down into measures of aggregate supply, the growth of aggregate hours and the growth of output per hour–suggests that the growth rates of productivity and hours worked in 2018 each have been exceeding their respective longer-run rates as estimated by the Congressional Budget Office. In other words, while growth in aggregate demand in 2018 has been above the expected long-run growth rate in aggregate supply, it has not been exceeding this year’s growth in actual aggregate supply.

Ultimately, hours growth will likely converge to a slower pace because of demographic factors. But how rapidly this happens will depend in part on the behavior of labor force participation. And recent years’ developments suggest there may still be some further room for participation in the job market‑‑especially in the prime-age group of 25-to-54-year-olds‑‑to rise. Labor participation by prime-age women has increased around 2 percentage points in the past three years and is now at its highest level in a decade. That said, it is still 1-1/2 percentage points below the peak level reached in 2000. Labor force participation among 25- to 54-year-old men has risen by roughly 1 percentage point in the past several years. But it is still 2 percentage points below levels seen a decade ago, and it is 3 percentage points below the levels that prevailed in the late 1990s.

As for productivity growth, there is considerable uncertainty about how much of the rebound in productivity growth that we have seen in recent quarters is cyclical and how much is structural. I believe both factors are at work. The structural, or trend, component of productivity growth is a function of capital deepening through business investment as well as a multifactor component sometimes referred to as the “Solow residual.” Initial estimates from the recent GDP release indicate that equipment and software investment in the third quarter moderated from the rapid pace recorded in the first half of the year. One data point does not make a trend, but an improvement in business investment will be important if the pickup in productivity growth that we have seen in recent quarters is to be sustained.


RIA Pro comment- The highlighted sentences in the paragraph above are important to understand. Productivity growth, demographics and levels of debt/money are the primary components of economic growth. Given, for the most part, that the amount of debt and demographic trends are a known commodity, productivity growth is the marginal determinant of growth. His statements above suggest that productivity growth has picked up recently but “one data point does not make a trend.” This means that a failure of continuing strength in capital investment by corporations will imply weaker productivity growth and therefore will signal weaker economic growth ahead.


As for the economic outlook, in the most recent Summary of Economic Projections (SEP) released in September, participants had a median projection for real GDP growth of 3.1 percent in 2018 and 2-1/2 percent in 2019. The unemployment rate was expected to decline to 3‑1/2 percent next year. And, for total PCE inflation, the median projection remains near 2 percent.

With a robust labor market and inflation at or close to our 2 percent inflation goal and based on the baseline economic outlook for 2019 I have just laid out, I believe monetary policy at this stage of the economic expansion should be aimed at sustaining growth and maximum employment at levels consistent with our inflation objective. At this stage of the interest rate cycle, I believe it will be especially important to monitor a wide range of data as we continually assess and calibrate whether the path for the policy rate is consistent with meeting our dual-mandate objectives on a sustained basis.


RIA Pro comment- As he implies above, the Fed is becoming more “data dependent.” Clarida has made that comment explicitly in prior speeches. In other words, their path towards more rate hikes or a suspension of hikes will be more heavily influenced by incoming economic data. This likely means that markets will become more volatile around major economic data releases. Furthermore, if the Fed does become more data dependent, that also suggests a reduced reliance on “forward guidance.” We will expand more on that later, but be aware that forward guidance is the Fed’s way of telegraphing to the markets where they expect rates to be in the future. In the past this guidance has proved comforting to the markets.


Data Dependence of Monetary Policy: What It Means and Why It Is Important
Economic research suggests that monetary policy should be “data dependent.” And, indeed, central banks around the world, including the Federal Reserve, often describe their policies in this way. I would now like to discuss how I think about two distinct roles that data dependence should play in the formulation and communication of monetary policy.

It is important to state up-front that data dependence is not, in and of itself, a monetary policy strategy. A monetary policy strategy must find a way to combine incoming data and a model of the economy with a healthy dose of judgment–and humility!–to formulate, and then communicate, a path for the policy rate most consistent with our policy objectives. In the case of the Fed, those objectives are assigned to us by the Congress, and they are to achieve maximum employment and price stability. Importantly, because households and firms must make long-term saving and investment decisions and because these decisions‑‑directly or indirectly‑‑depend on the expected future path for the policy rate, the central bank should find a way to communicate and explain how incoming data are or are not changing the expected path for the policy rate consistent with best meeting its objectives. Absent such communication, inefficient divergences between public expectations and central bank intentions for the policy rate path can emerge and persist in ways that are costly to the economy when reversed.


RIA Pro comment- Clarida alludes to something we wrote about in Everyone Hears the Fed, But Few Listen. Essentially, the comment highlighted above is in reference to the fact that the Fed is still projecting another 1% increase in the Fed Funds rate, while the market is currently estimating a smaller increase of .37%. Whether the Fed backs down from their forecast or they talk the market up to their level is important to follow. The reason it is important comes back to the topic of forward guidance. The difference in rate expectations (1% versus 0.37%) is evidence of less investor certainty about what the Fed may do. That uncertainty contributes to volatility by challenging the notion, as John Maynard Keynes put it, “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.”


Within this general framework, let me now consider two distinct ways in which I think that the path for the federal funds rate should be data dependent. U.S. monetary policy has for some time and will, I believe, continue to be data dependent in the sense that incoming data reveal at the time of each Federal Open Market Committee (FOMC) meeting where the economy is at the time of each meeting relative to the goals of monetary policy. This information on where the economy is relative to the goals of monetary policy is an important input into the policy decision. If, for example, incoming data in the months ahead were to reveal that inflation and inflation expectations are running higher than projected at present and in ways that are inconsistent with our 2 percent objective, then I would be receptive to increasing the policy rate by more than I currently expect will be necessary. Data dependence in this sense is easy to understand, as it is of the type implied by a large family of policy rules in which the parameters of the economy are known.

But what if key parameters that describe the long-run destination of the economy are unknown? This is indeed the relevant case that the FOMC and other monetary policymakers face in practice. The two most important unknown parameters needed to conduct‑‑and communicate‑‑monetary policy are the rate of unemployment consistent with maximum employment, u*, and the riskless real rate of interest consistent with price stability, r*. As a result, in the real world, monetary policy should, I believe, be data dependent in a second sense: that incoming data can reveal at each FOMC meeting signals that will enable it to update its estimates of r* and u* in order to obtain its best estimate of where the economy is heading. And, indeed, as indicated by the SEP, FOMC participants have, over the past nearly seven years, revised their estimates of both u* and r* substantially lower as unemployment fell and real interest rates remained well below prior estimates of neutral without the rise in inflation or inflation expectations those earlier estimates would have predicted. And these revisions to u* and r* almost certainly did have an important influence on the path for the policy rate that was actually realized in recent years. I would expect to revise my estimates of r* and u* as appropriate if incoming data on future inflation and unemployment diverge materially and persistently from my baseline projections today.


RIA Pro comment- Clarida resorts to economic jargon in the paragraph above to affirm his belief in the Phillips Curve. He is saying that lower levels of unemployment spur wage growth, and if that is occurring, interest rates should be higher to offset the effects of higher inflation caused by wage growth. This statement tells us that the monthly labor report from the Bureau of Labor Statistics (BLS) should be followed closely for signs of further strength in employment. Within the labor report, other important statistics include hours worked, wages and the participation rate.


Consequences for Monetary Policy

What does this mean for the conduct of monetary policy? As the economy has moved to a neighborhood consistent with the Fed’s dual-mandate objectives, risks have become more symmetric and less skewed to the downside than when the current rate cycle began three years ago. Raising rates too quickly could unnecessarily shorten the economic expansion, while moving too slowly could result in rising inflation and inflation expectations down the road that could be costly to reverse, as well as potentially pose financial stability risks.

Although the real federal funds rate today is just below the range of longer-run estimates presented in the September SEP, it is much closer to the vicinity of r* than it was when the FOMC started to remove accommodation in December 2015. How close is a matter of judgment, and there is a range of views on the FOMC. As I have already stressed, r* and u* are uncertain, and I believe we should continue to update our estimates of them as new data arrive. This process of learning about r* and u* as new data arrive supports the case for gradual policy normalization, as it will allow the Fed to accumulate more information from the data about the ultimate destination for the policy rate and the unemployment rate at a time when inflation is close to our 2 percent objective.


RIA Pro comment- In the final two paragraphs, Clarida is essentially relaying that the Fed Funds rate is much closer to its terminal value than when they started raising rates in 2015. While obvious, the statement seems to convey a feeling that future rate hikes will require more robust data than that seen over the last three years.


RIA Pro Summary:

In general, we are not swayed that Clarida is looking to stop Fed Funds rate hikes, but he makes it apparent that weakening economic growth and any slowdown in employment data will result in a more dovish Fed. As is now customary for Federal Reserve officials, Clarida is making a bold attempt to “have his cake and eat it too.” Broadcasting the Fed’s tendencies with regard to interest rates through forward guidance has afforded the Fed tremendous power over guiding market expectations and thereby reducing volatility. Their wish is to maintain that influence, but doing so while raising interest rates is a very different circumstance than doing so while lowering them.

As was the case when the Fed expressed 100% certainty about implementing extraordinary policies, they are now desperately trying the same approach but while keeping a foot in the exit door. More than anything else, what they want to avoid is being caught dead wrong as they were about the housing market and economy in 2007-2008.

Simply said, on the one hand, Clarida wants to convey certitude about the economic outlook and the Fed’s path, on the other hand, he is trying to reserve the right to be wrong. We would applaud an honest acknowledgment of possible alternative outcomes, but his approach in this speech was more than a little ham-handed.

Municipal CEFs – A Potential Home Run for Bond Bulls

In July of 2015 and again in late November of 2016, bond yields were surging higher which prompted us to recommend that our readers consider investing in Closed-End Funds (CEF) that hold municipal bonds (Muni CEF). In the wake of rising yields, there were some dislocations which we believed presented a great opportunity for investors who felt that increase in yields was temporary. In both instances, yields halted their increases shortly after our recommendation, and as we suspected, readers that followed our advice were rewarded with double-digit returns in a relatively short time frame.

Since mid-2016, the yield on the 10-year U.S. Treasury Note has risen nearly 2% and stands at levels last seen in 2011. For those who believe the recent rise in interest rates is at or near a peak, we believe Muni CEFs once again offer similar opportunities. The following article shares highlights from our prior articles that help explain what Muni CEFs are and what drives their return. The article concludes with a fresh analysis of six funds that we believe can produce favorable returns going forward.

Before preceding, we want to stress that this recommendation is for those that think yields are at or near their short-term peak. If yields continue to rise it is quite possible that Muni CEFs, due to their leverage, could underperform individual municipal bonds and other fixed income sectors.

What are CEF’s?

Closed-End Funds (CEF’s) are mutual funds with a fixed number of shares, unlike most other mutual funds whose share count fluctuates daily with investor interest. Also differentiating CEF’s from open-ended mutual funds is the fact that CEF shares are bought or sold on exchanges, not via direct transactions with the associated mutual fund company. It is this unique feature that results in CEF’s trading at a premium or discount to their net asset value (NAV).

The three biggest factors which determine why a CEF might trade at a premium or discount to its NAV are:

  1. Strong demand and/or low supply of the fund may result in a premium, while weak demand and/or excess supply will frequently result in a discount
  2. Quality of the fund management team
  3. The liquidity of the underlying fund holdings

The change in the premium or discount to NAV is just one factor determining total return for CEFs. The table below highlights all of the factors influencing the total return for M-CEF’s.

Total Return Factor Comment
Price of underlying municipal bond As yields decrease, prices increase helping total return. The opposite occurs when yields increase.
Dividend (coupon)/Yield Most of the CEF’s we researched have a yield ranging from 5% to 8%.
Discount divergence from NAV As the discount normalizes towards zero, the price of the M-CEF increases. If the discount widens, the price falls.
Leverage Leverage used by the M-CEFs amplify price changes (gains and losses) and dividends.
Expense ratio The fee that the fund manager extracts from the M-CEF’s return. Higher fees erode returns.

 

The following table from our 2015 article highlights key statistics from the date we recommended the funds to the date we recommended taking profits. Reviewing the sources of returns allows us to better understand how gains may be achieved this time around.

Sources of 2015 gains:

  • Coupon yield- The funds we recommended had an average yield of 6.41% which provided reliable income.
  • Price appreciation due to yield- After a six month period, the yield on the funds declined to 5.98%. As a result, the prices of the underlying bonds and therefore the net asset value of the CEF’s rose by approximately 2.50%. Because the funds are leveraged the price appreciation was closer to 3.50%.
  • Price appreciation due to discount to NAV- In July of 2015 the average discount was at or near the respective lows since 2013. Over the next six months the average discount to NAV would rise from -11.19 to -8.03, resulting in an additional 16% of price gains on the CEF’s.

Current Recommendation

Yields are currently on a trajectory higher for a number of reasons. First and foremost is a widely held concern amongst bond investors that strong economic growth and low unemployment will push wages higher and spur more inflation. Second, the U.S. Treasury will offer over $1 trillion of debt this year and is forecast to do the same over the next few years. The heavy supply is creating an imbalance that has pushed yields higher. As an aside, we will have more to say about who is buying U.S. Treasury debt and why it matters in an upcoming article.

The following paragraph was from 2016, the second time we recommended Muni CEFs. We believe it is just as pertinent today:

“Having begun in 1981, the current bull market in bonds is well-seasoned and no doubt much closer to the end than the beginning.  At the same time, the velocity of money is still declining in the U.S., the U.S. dollar is strengthening versus other currencies and global deflationary forces emanating from abroad remain influential.  The U.S. economy is more sensitive than ever to the level of interest rates and economic stress resulting from higher yields could easily halt economic growth and push the economy into recession. In such an instance, the Fed would likely end the normalization of rates and take actions to bring the Federal Funds rate back to zero or even lower.  Additionally, the Fed could re-introduce QE. If some form of these events unfold, Japan remains the most reliable model for the path of interest rates in the U.S.”

Higher interest rates are already depressing economic activity in interest rate sensitive sectors such as housing and autos. There is little doubt in our mind that as the benefits of fiscal stimulus erode over the coming quarters and the Fed continues to raise rates and reduce their balance sheet (QT), the economy will slow and inflationary impulses will subside. Such a result would help put a lid on rising interest rates. While timing is difficult and yields can certainly rise further, we believe that yields will peak, either now or within the next few months, and Muni CEF’s will offer similar opportunities as in the past.

We selected the following six Muni CEFs based on a number of qualifications, including but not limited to leverage, credit, expense ratio, and discount to NAV.

Summary

Given the move in interest rates in 2018, reluctance to take on investments that are negatively affected by higher rates is understandable. However, due to the nature of our highly leveraged economy, past episodes of rising interest rates have been met with faltering economic growth, deflationary impulses and ultimately lower interest rates.

Muni CEFs offer a counter-trend position to take advantage if interest rates reverse course. Further they offer a margin of safety in the form of steep discounts to their NAV.

 

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

Is It Time To Buy The Home Building Sector (XHB)

Throughout modern financial history, the ability to borrow at a 5% rate on a 30-year mortgage was considered a great deal. Over the past ten years, mortgage rates falling to between 3% and 4% have warped perceptions. Evidence of this fact can be found by the sticker shock and home buyer consternation that the currently available 5% mortgage rate is causing. The rate shock is not limited to home buyers; the home building sector has fallen over 30% since it recorded a record high in January 2018. Notably, a month before hitting that record, the popular SPDR S&P Homebuilders ETF (XHB) surpassed the previous record high established at the peak of the housing bubble in 2006.

Mortgage rates play a large role in housing affordability, which greatly affects housing sales and prices, economic growth and the profits or losses for those involved in the housing sector. We discussed and quantified housing affordability dynamics in our article, The Headwind Facing Housing. In this article, we consider whether the housing sector has fallen far enough to warrant investment consideration.

Headwinds Redux

In The Headwind Facing Housing, we produced two graphs that quantify the effect varying mortgage rates have on housing affordability. We modified those graphs, as shown below, to highlight how recent changes in 30-year mortgage rates have affected mortgage payments and housing affordability.

In the first graph, the monthly mortgage payment (excluding taxes, insurance, and other fees) for a buyer purchasing a $500,000 house has risen 12% since 2016. The second graph illustrates the purchase price a buyer can afford for a fixed $2,500 mortgage payment. Since 2016, the purchase price has dropped from $530,000 to almost $470,000. The data in both graphs are based on 30-year mortgage rates rising from 3.87% in January 2016 to 4.83% as of the most recent data from the Federal Reserve. Effectively, as the graphs show, a 1% rise in mortgage rates reduced affordability and increased monthly mortgage payments by about 10-12% in the current environment.

Higher mortgage rates dictate that buyers either take on larger mortgage payments or buy cheaper houses. The burden of higher rates does not solely fall on buyers; it also hurts sellers and those in the housing construction business.

Home Builders

Equity investors appear to be keenly aware of the toxic relationship between mortgage rates and homebuilder profits. The graph below compares the year to date price return for the S&P Homebuilders ETF (XHB) and the S&P 500.

Data Courtesy Bloomberg

Note that while XHB and the S&P 500 both fell in the first quarter, the S&P regained its footing and went on to new record highs before its recent stumble. Conversely, XHB drifted slightly lower following the first quarter decline. More recently, as interest rates rose, XHB fell precipitously. As shown, XHB is underperforming the S&P 500 by almost 25% year to date.

Looking back further, we find that since the recovery from the financial crisis beginning in March of 2009, XHB greatly outperformed the S&P 500. As shown below, in January of 2018, XHB had outperformed the S&P 500 by about 200% since March of 2009. That differential has collapsed over the last few months.

Data Courtesy Bloomberg

Statistically, XHB and the S&P have had a strong long-term correlation (2006-present) of +.71, meaning that 71% of XHB’s price can be explained by changes in the price of the S&P 500.

Interestingly, XHB has a +.21 correlation with ten-year U.S. Treasury yields over the same period. The positive relationship is not what one should expect as it implies that yields and XHB have risen and fallen together. Keep in mind, the relationship is not strong but the positive relationship is notable.

Recently, however, as bond yields broke out of ten-year ranges, reached five-year highs and brushed up against key long-term technical levels, XHB investors became concerned. Since September 2018, the correlation between XHB and ten-year Treasury yields has been -.58 and greatly reflects the lagged effects of rising interest rates on housing activity. We suspect this statistically relevant negative correlation will persist and perhaps strengthen as long as rates keep rising.

Investment Implications

The rest of this article, including our investment conclusions, is only available for subscribers of RIA Pro. To try out this new service with a 14 day free trial period visit us at RIA Pro.

 

 

 

Is It Time To Buy The Homebuilders (XHB) – RIA Pro

Please note this article will be distributed on our free site tomorrow but the Investment Implications section is only available for RIA Pro subscribers.

Throughout modern financial history, the ability to borrow at a 5% rate on a 30-year mortgage was considered a great deal. Over the past ten years, mortgage rates falling to between 3% and 4% have warped perceptions. Evidence of this fact can be found by the sticker shock and home buyer consternation that the currently available 5% mortgage rate is causing. The rate shock is not limited to home buyers; the home building sector has fallen over 30% since it recorded a record high in January 2018. Notably, a month before hitting that record, the popular SPDR S&P Homebuilders ETF (XHB) surpassed the previous record high established at the peak of the housing bubble in 2006.

Mortgage rates play a large role in housing affordability, which greatly affects housing sales and prices, economic growth and the profits or losses for those involved in the housing sector. We discussed and quantified housing affordability dynamics in our article, The Headwind Facing Housing. In this article, we consider whether the housing sector has fallen far enough to warrant investment consideration.

Headwinds Redux

In The Headwind Facing Housing, we produced two graphs that quantify the effect varying mortgage rates have on housing affordability. We modified those graphs, as shown below, to highlight how recent changes in 30-year mortgage rates have affected mortgage payments and housing affordability.

In the first graph, the monthly mortgage payment (excluding taxes, insurance, and other fees) for a buyer purchasing a $500,000 house has risen 12% since 2016. The second graph illustrates the purchase price a buyer can afford for a fixed $2,500 mortgage payment. Since 2016, the purchase price has dropped from $530,000 to almost $470,000. The data in both graphs are based on 30-year mortgage rates rising from 3.87% in January 2016 to 4.83% as of the most recent data from the Federal Reserve. Effectively, as the graphs show, a 1% rise in mortgage rates reduced affordability and increased monthly mortgage payments by about 10-12% in the current environment.

Higher mortgage rates dictate that buyers either take on larger mortgage payments or buy cheaper houses. The burden of higher rates does not solely fall on buyers; it also hurts sellers and those in the housing construction business.

Home Builders

Equity investors appear to be keenly aware of the toxic relationship between mortgage rates and homebuilder profits. The graph below compares the year to date price return for the S&P Homebuilders ETF (XHB) and the S&P 500.

Data Courtesy Bloomberg

Note that while XHB and the S&P 500 both fell in the first quarter, the S&P regained its footing and went on to new record highs before its recent stumble. Conversely, XHB drifted slightly lower following the first quarter decline. More recently, as interest rates rose, XHB fell precipitously. As shown, XHB is underperforming the S&P 500 by almost 25% year to date.

Looking back further, we find that since the recovery from the financial crisis beginning in March of 2009, XHB greatly outperformed the S&P 500. As shown below, in January of 2018, XHB had outperformed the S&P 500 by about 200% since March of 2009. That differential has collapsed over the last few months.

Data Courtesy Bloomberg

Statistically, XHB and the S&P have had a strong long-term correlation (2006-present) of +.71, meaning that 71% of XHB’s price can be explained by changes in the price of the S&P 500.

Interestingly, XHB has a +.21 correlation with ten-year U.S. Treasury yields over the same period. The positive relationship is not what one should expect as it implies that yields and XHB have risen and fallen together. Keep in mind, the relationship is not strong but the positive relationship is notable.

Recently, however, as bond yields broke out of ten-year ranges, reached five-year highs and brushed up against key long-term technical levels, XHB investors became concerned. Since September 2018, the correlation between XHB and ten-year Treasury yields has been -.58 and greatly reflects the lagged effects of rising interest rates on housing activity. We suspect this statistically relevant negative correlation will persist and perhaps strengthen as long as rates keep rising.

Investment Implications

Despite its label of “Homebuilder ETF,” XHB holds many companies that are not homebuilders. For instance, Whirlpool, Williams Sonoma and the Home Depot represent three of the ETF’s top six holdings. These non-home builders, many of which are categorized as cyclicals, have helped buffet the recent decline. On average, the top five homebuilders in the ETF are down 34% year to date or about 7% more than the ETF.

While it is tempting to buy XHB given its sharp decline, the risks are onerous. The biggest risk is that yields keep rising. This will continue to be a headwind for home builders as housing affordability declines and mortgage payments rise. It will also further pressure the stock market and the economy in general which bodes poorly for the cyclical stocks in the ETF.

Higher mortgage rates will also make it less tempting for consumers to perform cash-out mortgage refinancings or take out home equity loans. Both have translated into a sizable source of revenue for Home Depot, Lowes and other companies in the ETF that profit from home remodeling and furnishing. Those sources of funding for consumer purchases is quickly drying up. Per the Mortgage Bankers Association (MBA): “MBA’s Weekly Applications Survey refinance index averaged 1,013 in June, the lowest monthly average since December 2000. The weekly index value dropped below 1,000 in three of the past six weeks, a level that it has not gone below since December 2000 as well.

Even if yields peak at current levels and begin to trend lower, we are concerned that the reason for such a reversal in yields would be economic weakness. Heavy stimulus in the form of tax cuts and fiscal spending have boosted GDP by 0.8% so far this year. As the benefits of the stimulus fade, as is widely expected, economic growth should slow and have adverse effects on consumers. The recent takeover of the House of Representatives by the Democrats make new stimulus much less likely to counteract economic weakness.

Despite being in the midst of the second longest economic expansion in modern U.S. economic history, the Congressional Budget Office (CBO) is not currently forecasting a recession for the next ten years as shown above. We, on the other hand, realize that such a forecast is idiotic and, even more concerning, believe the probability of a recession within the next year is significant. A recession would likely result in lower mortgage rates, but the benefits to homebuilders and buyers will likely be offset by job losses, weaker consumer activity and declining consumer sentiment(home buyers).

Despite the recent decline versus the S&P 500 and other sectors, we currently recommend selling or reducing exposure to the homebuilders and the XHB ETF. We believe it is best to wait until the interest rate and economic environment becomes more clear. In our opinion, it’s too early to catch the proverbial falling knife.

To stay abreast of the situation, we recommend following the weekly MBA purchase and refinance surveys as well as 30-year mortgage rates furnished by the St. Louis Federal Reserve (LINK). Other housing data, such as housing starts and new homes sales are helpful, but the data lags significantly, so caution is advised when using that data to infer something about the demand for housing.

 

 

 

Q1 2018 Review: The Virtues of Cash

A Bloomberg review of the quarter asked “Is Nowhere Safe?” The headline had a point. Both stocks and bonds declines for the First Quarter of 2018 with higher interest rates weighing on both asset classes.

The S&P 500 Index dropped 0.76% after surging around 10% from the 2017 close in January. February and March brought turbulence that eliminated early gains. Still, damage was minimal, and investors still have the opportunity to reevaluate their asset allocations without having to do so under the stress of losses.

Developed country stocks also dropped with the MSCI EAFE Index losing 1.53% for the quarter in dollar terms. Emerging markets stocks were the bright spot with the MSCI EM Index gaining 1.42% for the quarter.

Among the global sectors, information technology led the way. The sector posted a nearly 4% gain. Telecom Services and consumer staples were the losers, each posting losses of around 5%. Consumer staples usually hold up in market downturns, and it’s surprising to see them down so much. Their decline may reflect their overvaluation, as investors have piled into dividend-paying stocks that have traditionally been less volatile.

Low beta or low volatility ETFs that often hold these stocks have also captured large amounts of cash as investors have sought yield from stocks and have sought to gain stock exposure in what has traditionally been the least painful way. Investors may have pushed the prices of these stocks up so high that they are leading the downturn.

Bonds also dropped in the first quarter. The Bloomberg Barclays US Aggregate Index closed down 1.64%. The yield on the 10-Year US Treasury went from less than 2.45% to more than 2.7%, and spent considerable time in the 2.8%-2.9% range. The yield on the 2-year US Treasury went from 1.9% to more than 2.2%. So rates are rising at the same time the yield curve or difference in yield between the 2-year and 10-Year Tresuries is flattening. Rates increase typically result from bullishness on the economy, while a flat curve indicates bearishness.

Corporate bonds also declined. The iShares Investment Grade Corporate Bond ETF (LQD) lost 2.90%, as investors sought higher yields for accepting credit risk. The yield spread on A-rated corporate bonds increased from less than 75 basis points to more than 95 basis points during the quarter.

High yield spreads also increased, but less dramatically, from less than 3.6 percentage points to more than 3.7 percentage points.

However, one of the largest floating rate bond fund, the $11 billion Fidelity Floating Rate High Income Fund (FFRHX), posted a 1.17% gain. Floating rate loans or bank loans are first lien loans of corporations whose credit is generally rated below investment grade. Investors in them are first in line in case of trouble, and they offer coupons that float with Libor (London Interbank Offer Rate), so they provide a measure of inflation protection. They often do well in rising rate environment, but excessively rising rates can spell trouble for them, as the companies behind them have limits on what they can pay.

The bond market is also sending some mixed signals. Rates are rising, and investors anticipate hikes by the Federal Reserve, but the yield curve is also flattening. And a flat or inverted curve has a good record of forecasting recession.

Impending recession or not, volatility has returned after a long absence in 2017 when every month saw a gain in stocks (the first time in history that happened). Perhaps a time of reevaluation has arrived for investors, as they rediscover the virtues of holding some cash in an environment where almost everything else is down.