- Rising rates are a headwind to the stock market and a could tip this 10-year-old equity bull market into a bear market.
- Rising rates and a bond bear market could mean that the world’s largest asset class has turned from a perennial safe moneymaker into a fundamentally challenged asset.
- Since interest rates underpin real estate finance and declining rates have powered the real estate boom for the last three decades, rising interest rates could lead to challenges in real estate markets.
This letter will offer insight into this new interest rate regime, ways to protect your wealth and ways to prosper. Since October, we have been arguing that rising interest rates could unravel the stock, bond and real estate markets.
- One problematic scenario would be if inflation were to reassert itself. In April, commodity prices began to rise and several companies’ earnings calls cited rising commodity prices as a stress on margins.
The Big Picture on Interest Rates:
Since August of 1981, interest rates as measured by the 10-year US Treasury yield have been declining. They first touched bottom in July, 2012 at 1.39% and again at 1.33% in July, 2016. Since then, they have been rising.
The $15 trillion in bond buying bond by global central banks since the Financial Crisis of 2008 have created artificially low interest rates. Starting in September 2013, the Federal Reserve began reversing its Quantitative Easing “QE” programs by reducing its monthly purchases of Treasuries from $85 billion per month to $65 billion per month. This “Taper” led to sudden weakness in the stock market2
In June 2017, the Federal Reserve began “Quantitative Tightening” to unwind its unprecedented $4.5 trillion-dollar balance sheet. With the Federal Reserve reducing its regular purchases of US Treasury bonds, interest rates began rising more rapidly in late 2017 and 2018. The reversal of Fed’s extraordinary monthly purchases of US Treasuries caused the concomitant rise in 10-year Treasury yields which is shown on the chart below.
Markets are influenced by psychology. And momentum is a powerful driver of market psychology. The chart below shows the trendline break of lower interest rates and their turn upward. Further, the psychological impact of breaking the 3% level for the 10-year US Treasury is another important milestone for bonds just as breaking Dow 1000, 10,000 or 20,000 were important milestones for stock investors. Regrettably this 3% milestone is not a positive one. This shift in psychology will change investor and consumer behavior; higher interest rates are a counterweight to higher asset prices and profits.
Rising interest rates are not limited to 10-year US Treasuries. It is a yield curve wide phenomenon covering all maturities from T-bills to 30-year US Treasuries. While our analysis has been focused on the 10-year US Treasury, which yields 2.98%, the 2-year Treasury offers an attractive relative return of 2.49%–with far less duration risk than 10-year Treasuries. Unfortunately the 2-year Treasury exemplifies the range of maturities which will compete with other assets which have enjoyed significant price appreciation in recent years.
The chart below shows the yield on two-year Treasuries doubling in the last eight months, rising from 1.25% in September to its current 2.49% yield.
The fundamental reason for our caution is that higher yields offer competition to stocks, bonds and real estate.
The Stock Market Watch:
The stock market is expensive, but relative to artificially low interest rates, stock prices are reasonably priced and sustainable. If commodity prices and interest rates continue to rise or accelerate, this could profoundly impact the equity markets.
Our dour perspective on the ending of this 34-year bull market in bonds is not novel. In January 2017, Sanford C. Bernstein & Company analysts4 wrote this: “A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years …We are profoundly worried that this could be a risky allocation over the next 10.”
If the most heavily adopted “prudent” asset allocation strategy on Wall Street stops working, there could be profound investment implications. Consider that the S&P 500 is the most popular and widely owned equity investment investment in the world. What would happen if it ceased being the cornerstone of investment portfolios? Since S&P 500 index vehicles have no cash to cushion redemptions, what would happen if investors started reducing their holdings of the S&P 500?
Earnings are still Growing!
In last month’s letter, we analyzed the Fed Model concluding that while equity market valuations are reasonable, the market is still vulnerable. Consequently, we are closely monitoring the trend in both earning and interest rates. While the 10-year US Treasury pushed higher in April, so did reported and estimated earnings. See the table below: the trailing and forward earnings for the S&P 500 rose in April as the majority of S&P 500 companies reported their earnings.
The three-pane chart below shows an extended stock market riding an earnings surge related to the improving US economy and the impact of the Tax Cuts and Jobs Act of 2017.
High Margin and High Stock Prices are a Bad Combination:
The chart below shows that the S&P 500 index rose from 666 on March 9, 2009 to its recent high of 2872, on January 26th, 2018–a 331% rise. During that last 9 years the amount of money borrowed to invest in equities grew from about $250 billion to over $650 billion. Historically, record levels of margin debt are often correlated with market peaks.
Source: Advisor Perspectives5
With the trend of rising rates, stock prices are being challenged by increasingly attractive fixed income alternatives. At some point psychology will tip from stocks to bonds. Unfortunately, investors are a herd animal. Historically, near market tops, investors are fully invested in equities. When the time comes to get out, prices drop so quickly they don’t react and suffer large losses. Today, with record levels of derivatives, quantitative trading and margin debt, the next bear market will likely be faster and more costly than previous declines. While the equity market may push higher for a few more months, and possibly a two more years, reviewing your equity allocation would be prudent given the increasingly risky proposition equities offer compared to traditional alternatives like Treasury bills, notes and bonds.
Rising Commodity Prices are a Game Changer:
Since 2008, interest rates have been largely a function of the Federal Reserve and global central bank policies. If commodity prices begin to rise, they could profoundly impact the bond markets. In the 1970s, rising oil prices and commodities led to inflation which caused to an economic malaise not felt since the Great Depression. While the present situation is far from the 1970s, we, along with market historians and cycle watchers, are watching commodities and inflation closely.
Since late February, the commodity prices have been rising while equity prices have been declining. The chart below shows the CRB Index (Commodity Research Bureau Index) plotted against the S&P 500 index.
Since June 2008, when WTI Crude peaked at $145/barrel, oil prices and commodity prices have been on a downward trajectory. Since March of 2009, stocks have been on a solid path of appreciation. These two divergent trends are shown in the chart below. A reversion to the mean for both indices would be normal cyclical behavior.
Since January 2016, oil prices have been rising since and, in April, other commodity prices (copper, aluminum, tin, steel) have also begun to rise. What could be happening is the secular shift from financial assets to commodities. This transition may be at an inflection point and both of these two trends are poignantly reflected in the chart below.
To quote investment strategist and bond guru Jeffrey Gundlach: “commodities are very, very cheap. Commodities have long cycles, as well. A fascinating chart [above] that has been circulating the investment industry. It compares the total return of the Standard & Poor’s 500 index to the total return of the Goldman Sachs Commodity Index, and it goes in tremendous cycles. In the 1970s, commodities started to outperform. They outperformed the S&P 500 by 800%, and then gave it all back. Then there was another wave up, and commodities outperformed again by 800%, actually 900%, and that continued into 2008.”
Given the prospect of rising commodity prices in this new era of rising interest rates, it seems that the case for allocating to commodities or commodity sensitive assets make senses when adjusting your portfolio of assets for this new regime of rising interest rates. We believe there is a positive asymmetric risk to reward to investing commodities and a negative asymmetric reward to reward for stocks, bonds and real estate.
Where Not to Invest?
Grantham, Mayo, & van Otterloo (GMO) is a revered Boston asset management firm with some of the brightest minds in the business overseeing billions. If their assessment of expected returns for the assets classes below is correct, there is little compelling reason to invest in these traditional assets.
Source: William Kaldus, CFA CAIA Seeking Alpha
Where to Allocate?
Commodities like oil and gold may soon outperform other traditional asset classes if the financial asset to commodity cycle engages. Additionally, Master Limited Partnerships (MLPs) are an attractive income investment which deserve a thoughtful look due to their correlation to oil prices and improving fundamentals. MLPs have underperformed stocks in recent years, especially since oil prices peaked in June 2014. Before that, MLPs had consistently outperformed the S&P 500.
Since we have been investing in MLPs, our performance relative to the S&P 500 has been excellent. We believe that MLPs will increasingly look like a safe sector to invest should the stock and bond markets struggle. The chart below shows equities (in red) have only recently outperformed the S&P 500. Now, we believe that a mean reversion is occurring and MLPs will soon begin outperforming equities. This trend could be enhanced by strength in energy and commodities.
MLPs offer both an attractive yield which is far higher than comparable yield alternatives. See the chart below comparing MLP yields to REIT, Utilities, Treasury and the S&P 500 yield.
See the chart below of Income Growth Advisors SMA MLP account strategy compared to the Alerian MLP Index and the S&P 500 since inception in 2000. While our performance has been weak since oil prices peaked in 2014, we believe MLPs are poised for a comeback. Note the swing to underperformance to the S&P 500 since 2014 compared to a 17-year plus period of 7.42% annual outperformance to the S&P 500.
While many investors have lost enthusiasm for the sector due to fears that alternative energy will displace oil and fossil fuels, we feel this concern is overstated. While we forecast an abatement in the growth in global oil production and consumption by the mid 2020s, the case for domestic gas production is in a solid growth phase, which should power infrastructure building for natural gas production and its export for the next decade.
So what kind of returns do we expect from MLPs?
We are increasing our portfolio weightings toward natural gas oriented MLPs. Here are four natural gas oriented we like. A rule of thumb for estimated returns for an MLP is adding their current yield to their growth rate.
This portfolio has an implied 25% annualized return composed of an average 7.4% yield and 17.5% distribution growth. In this portfolio, Antero and EQT are the Utica and Marcellus Gathering and Processing MLPs, that would have their natural gas processed by Cheniere, and shipped abroad on Hoegh LNG ships.
That makes good sense to us.
We welcome any and all comments.
Tyson Halsey, CFA
- With Ben Bernanke’s announcement of the end of Quantitative Easing in June 2013, the Dow dropped nearly 700 points in 3 days.
- Seeking Alpha, William Kaldus, CFA CAIA