The other day, I was talking to a friend and she asked me "Mike, what are you worried about in this market?" In order to best understand my response, a little background: I have spent nearly three decades running money for institutions, primarily in the fixed income and preferred stock space. In these spaces you have to understand that you typically have an asymmetric risk/return profile. With the possible exception of the distressed space, you typically have massive downside and little upside. As a result, you worry. A lot.
As they say, "misery loves company", so I have decided to put forth my wall of worry and see what happens. I honestly look forward to the commentary, as I am sure there are plenty of things I should be worried about, but either haven't gotten around to it or have been living in ignorance of it (grammar worries perhaps???).
Let's begin with something that has been consuming a lot of my time lately, the term premium.
The term premium is the compensation for the risk that interest rates do not end up where an investor expects them to be or what is forecast by forward models. Perhaps it is best to let the folks at the NYFRB explain it:
Treasury yields can be decomposed into two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected
See, this is important, so it should concern you when you see the following:
Yep, negative term premium (10yr). This, to me, suggests that the market is absolutely complacent regarding the path of interest rates or they think that lower for longer means lower forever. Personally, I think both views are wrong and that there will be a time when rates move higher. Will it be any time soon? Doubtful.
Why do we care, right? Notice anything in the following chart that might imply a relationship?
Now, thinking that complacency has got us to this point, and that a change from unconcerned to concerned might swing the term premia in a different direction, can you see why I am worried. The lack of concern about the future direction of interest rates can also influence an investor's required yield.
According to a recent study by BIS:
One recent monetary policy contribution to the sharp decline in term premia is the massive central bank purchases of bonds under Quantitative Easing (QE) in the AEs. Large scale forex intervention by some EM central banks - notably China and commodity exporting countries -had a similar effect. As their forex reserves reached new highs, many central banks lengthened the maturity of their bond purchases. Note that increased QE by the ECB as the Federal Reserve had ended new purchases drove the euro term premium well below that in the dollar. There is evidence that this ECB policy shifted the portfolio preferences of international bond investors towards dollar bonds and led US companies to issue more euro-denominated bonds relative to dollar denominated bonds. These market reactions put downward pressure on the dollar term premium even in the face at imminent Fed tightening. To restate: a central bank setting its policy rate according to its own economic environment can find its long-term rate, set in global markets, moving in the opposite direction.
Aren't longer-term trends or data supposed to make you feel better? ( BIS)
Global interest rates are, according to Haldane (2015), now "lower than at any time in the past 5000 years". As the former Governor of the Banque de France noted in his recent valedictory address, "the prolonged coincidence of low interest rates and low inflation…complicate the task of monetary policy…and worsen the trade-off between price and financial stability"
5,000 years. It must be really, really different this time.
I worry about real estate and REITs too.
Imagine for a second that you believe that interest rates are going to be low forever, would you demand the same dividend yield you have been getting for years? No, absolutely not. If that is the case, does the following chart of Realty Income's (NYSE:O) dividend yield make sense?
From a macro construct, the absence of a term premia in interest rates can be applied to other "yield focused" investments. Should this hold (and I believe it does), the sub 4% yield on Realty Income (and nearly all REITs) is consistent with expectations of lower rates generally. Does this make it more palatable? No. Does it suddenly make a little more sense? I think so.
Let's look a little more broadly. Obviously, as the price of some investment rises faster than its cash flow stream (in this case dividends paid by REITs), the yield has to fall. Conversely, as the required yield on an investment falls - given interest rate expectations - then the price will rise:
Note I have provided correlations between the index and rates for various time periods. The correlation has been falling as there is, what I will call, a natural choke point. The choke point becomes some rate where investors choke on de minimus yields and resist higher prices.
Next a chart on the REIT index and 10yr term premia:
That said, I believe REITs are getting a little ahead of themselves, but I understand that there is supply and demand. The supply of yield is lower than the demand for yield and this can push yield focused investments higher than seems rational. Doesn't mean it isn't rational, just that it seems irrational (typically, from a historical perspective):
Let's look at REITs versus the Russel 1000 over various time periods:
Wilshire US Real Estate Investment Trust Total Market Index (Wilshire US REIT), % Chg YoY, Monthly.
Russell 1000® Total Market Index, % Chg YoY, Monthly
It appears irrational, but is it?
But as most folks know, REITVision is not all I have, I have more to worry about than just REITs.
Muppets. I tend to worry a lot about muppets.
The ECB's surprise announcement in March to extend its asset-purchase program to investment grade non-bank corporate bonds triggered a rapid, and indiscriminate, tightening of credit spreads and a jump in primary-market issuance. And that was all before the central bank purchased a single corporate bond.
Given its public entrance in the market as a large, price-insensitive buy-and-hold investor, it's no surprise, therefore, that the Corporate Sector Purchase Programme (CSPP) has, in recent months, unleashed fears of a widespread corporate-bond liquidity crunch. Story here.
The BOE cut rates by a quarter point, as expected. But as part of its policy easing, it also announced an expansion of quantitative easing, and like the European Central Bank, it included corporate bonds in its plans.
That brings a big new buyer to an already hot corporate debt market, and its program and the programs of other central banks put downward pressure on global interest rates, even as the Federal Reserve hopes to tighten sometime later this year.
But the bank surprised the market by boosting its government bond-buying program by 60 billion pounds and adding the purchase of 10 billion pounds in U.K. corporate bonds.
More BOE muppetery (idk, is that a word?):
"The fact that sterling investment grade has recovered much faster [from the Brexit vote hit], and indeed, is now substantially tighter than in the run-up to the referendum could well reflect that the market is anticipating BoE intervention in the investment-grade space," says Hanz Lorenzen at Citi
And the Kermit of muppets:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
If they decide to unwind some of their holdings, what happens?
A look at the Fed's balance sheet holdings:
A couple quotes from pretty smart folks (yes, it may seem like projecting from an echo chamber, and perhaps it is, but…):
"I don't like bonds; I don't like most stocks; I don't like private equity," Gross, who runs the $1.5 billion Janus Global Unconstrained Bond Fund, wrote in his monthly investment outlook Wednesday. "Real assets such as land, gold and tangible plant and equipment at a discount are favored asset categories."
DoubleLine CEO Jeffrey Gundlach says his firm went "maximum negative" on Treasuries in early July, Reuters reports. Stock investors have entered a "world of uber complacency" against backdrop of low GDP growth Many asset classes look frothy: firm continues to hold gold, gold miners. "The artist Christopher Wool has a word painting, 'Sell the house, sell the car, sell the kids.' That's exactly how I feel - sell everything. Nothing here looks good" (just an FYI from Mike - the words are from the incredible movie Apocalypse Now).
Hedge complacency? Check
I tend to worry about leverage and financial flexibility.
What does borrowing money for share repurchases (leveraged recap) result in? Well, something like this:
Who needs financial flexibility anyhow, right? Especially when the increased leverage is reflected in risk premiums as follows:
Despite a larger interest rate risk component:
What's the risk in a little duration you ask? Markit provides the answer:
Another way to quantify duration risk is to look at the change in underlying yield which would wipe out the index's yearly income, gauged by forward yield. At the start of the last decade it would have taken more than 100bps of yield rises to wipe out the expected yearly income in both asset classes. That number has since fallen to 30bps in US treasuries and a meagre 13bps in eurozone sovereigns.
Keep in mind that investors have been piling into bond ETFs.
Looking at HY and IG a little differently (high yield spreads as a multiple of investment grade spreads), we see risk is being priced better (big surprise):
Good thing the muppets aren't worried about prices and/or risk, right?
Golly, with all the CB's engaged in some form of QE, inflation must be on the rise, right?
Expectations for inflation five years out are below 1.8%. Growth? Hardly.
So to recap the worries De Jour:
- Rates are low due to a term premia dictated by a managed market where future short rates are viewed as lower forever,
- REIT dividend yields - as well as dividend yields across the board - are being partially dictated by the term premia as well as supply and demand,
- REIT dividend yields, and the demand for those yields, has propelled REITs further than the market would imply,
- Central bank muppets continue to lead the market down a dangerous path, which works until they begin to monetize,
- Volatility and hedge indicators show that the market is somewhat complacent,
- Increased leverage has been accompanied by tighter spreads and relative spreads, and
- Inflation expectations continue to be low (and are forecast to be low), removing that factor in the term premia.
And this an abbreviated list.
What, me worry?
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.