How Will a Weakening Economy Affect Mortgage REITs?

 |  Includes: AGNC, ANH, CIM, CMO, HTS, MFA, NLY
by: Parsimony Investment Research

Chairman Bernanke’s recent FOMC comments indicate a downgrading of the economy. Unsurprising to market watchers, the Fed decided to keep rates unchanged and maintain its “extended period” language. The Fed is still clearly in a wait and see and assess mode for the time being. The economy has slowed and importantly the labor market is seeing little signs of improvement.

The Fed lowered growth expectations and raised unemployment expectations at the recent FOMC meeting (see table below). In other words, the Fed downgraded the economy and the recovery. Click to enlarge:

Click to enlarge

We remain positive on mortgage REITs as we see a weak, slow, and choppy recovery, which will keep the Fed on hold for a truly extended period. Unemployment rates of 9% have economic, political and social implications and we believe the administration and the Fed will respond to a slow economy with high unemployment with ease money.

We believe that future rate increases will be well telegraphed by Chairman Bernanke. The Fed does not want to surprise markets and is focused on engineering a smooth recovery. We believe that Bernanke instituted press conferences to further increase transparency for market participants. Many believe that as long as the extended period language remains a rate hike/ tightening is at least two or three meetings away.

While many market participants are concerned with inflation (rising food and commodity prices) the Fed does not seem to be concerned and believe the rise is transitory. We believe it is important to be pragmatic and while certain market participants want rates to rise and ultimate arbiter will be the Fed (the Fed holds the printing press).

The last paragraph of the FOMC statement reads "The Committee will monitor the economic outlook and financial developments and will act as needed to best foster maximum employment and price stability." We believe that the Fed will be more focused on employment.

REITs provide investors who are being robbed by ultra low policy rates a return on investment. From an asset alocation perspective, we recommend modest exposure to REITs (5%-8% of portfolio). Bill Gross who has been very critical of the Fed’s ultra easy policy recently recommended Annaly Capital (NYSE:NLY).

Our two main M-REIT holdings continue to be Annaly Capital (NLY) and MFA Financial (NYSE:MFA) due to the tenure of the management team, composition of portfolio and their commitment to hedge against rising rates. We believe these managers will be in the market for the long-term. We also have a small position in American Capital Agency Corp. (NASDAQ:AGNC).

We continue to believe that the best strategy for investing in this space is to own a portfolio of mortgage REITs to diversify your risk. That said, the following REITs are currently on our watchlist and we are following them very closely: Chimera Investment Corp. (NYSE:CIM), Anworth Mortgage Asset Corp. (NYSE:ANH), Hatteras Financial Corp. (NYSE:HTS), and Capstead Mortgage Corp (NYSE:CMO).

Disclosure: I am long NLY, MFA, AGNC.