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Low Interest Rates – Good today, but bad tomorrow?

Low Interest Rates – Good today, but bad tomorrow?


Blog by Jean M Rosenbaum, CFA, Hotaling Investment Management, LLC

 

Borrowers typically find low interest rates very attractive because it reduces the amount of money they have to repay to their lender. Think about the impact of lower interest rates on your mortgage or your auto loan!

Savers on the other hand, find them less attractive as lower interest rates means lower earnings on their savings such as bank deposits, CDs or bonds. Have you seen the rates on bank “interest” checking and savings accounts?!

While a brief period can be positive for consumption, an extended period of low interest rates can cause some long term problems. The longer rates remain low, the more difficult it will be to generate income and savings needed for future consumption.  The lower rates mean lower earnings for pension funds which rely on investment gains to meet their obligations.  Insurance companies may also find it increasingly difficult to meet their obligations as the return on their investment portfolios continues to fall below previous assumptions.  When the obligations for these firms were first established years ago, the assumption was the investment portfolio would grow and in some cases, the growth is critical to their ability to meet the future obligations.  This situation could result in individuals receiving less money (or even no money) from sources they had previously believed were secure. 

Taking this a step further, many European debt instruments are yielding negative rates. Negative interest rates means that investors pay to hold debt obligations as opposed to a positive rate environment where investors get paid to take risk and hold the debt of another entity.  In the case of an investment portfolio that holds negatively yielding instruments, the investment portfolio will shrink!  These companies cannot abandon the bond markets as they are regulated by their respective governments.  The basic operating assumption of these organizations is that they can take in money and then generate a positive investment return and meet or exceed their obligations.  This assumption has now been turned upside down as investment returns are meager at best.

The low interest rates helped consumption at a time when the sales of consumer durable items (houses, cars, etc.) were at very low levels. These sectors have recovered, but the ongoing environment of ever lower rates could cause more serious long term damage.  Workers that have entered retirement may need to find a new source of income which could be very difficult.  New workers will need to save even more money than expected to counteract the inability to generate a positive return or accept greater risk and/or volatility in their investment portfolios.  With one part of the population saving more and another receiving less income, the outlook for consumption growth looks difficult.  The economy could remain in a slow growth or even deflationary environment due to the “medicine” that has been used to try to counteract the problem of low economic growth.

Kaizen

The stock market, in the face of some high levels of skepticism, continues to befuddle investors who thought they understood what was going on. Stocks, measured by the S&P 500, finished the month of May at the 2,096 level, up 1.5% for the month.  Stocks are now up 3.6% year to date.  After a rocky start to the year, when prices fell relentlessly for two months, stocks have recovered 8.4% since the end of February.

The market made an abrupt shift to value stocks with the start of 2016 and looked to be committed to that path.  Oil prices were in total free fall the first 6 weeks of the year, leading to uncommon correlations between asset classes and immense levels of fear.  Investors drank the Kool-Aid and began to unload all the favored growth stocks of the last few years, hoping to ride out the storm with dividends and low valuations.

Then, growth stocks woke up in May. Not all, to be sure, but enough to raise the level of doubt that the newly proclaimed value regime had legs.  Stocks with ties back to the energy complex have strengthened with the recovery in oil prices.  Industrials, some transportation stocks and a range of materials stocks have shown solid earnings strength and price improvement.  The financial stocks, banks in particular, after a difficult start to the year, have also been coming around.  This reflects the market’s anticipation of a more friendly yield curve, and some relief that loan losses from the oil patch are manageable.

At a time of year when things tend to simmer down, there are some sideshows looming.  Brexit may bring some added volatility when the UK’s “should I stay” referendum takes place on June 23rd.  It’s interesting that roughly half of Britain’s exports go to the EU, while only about 6% of the EU’s exports end up in the UK.  The unknowns surrounding this question are weighing on the UK financial markets and currency.  The UK, on its own, is in the top 10 US trading partners.

Brazil is host to the 2016 Summer Olympics (Rio 2016) this August.  This year’s competition will include rugby sevens and golf for the first time, at the expense of baseball and squash.  The issue is the mosquito-borne Zika virus.  It is largely symptomless and no current vaccine exists.  This has led athletes from several countries to withdraw from competition.  It’s not at all clear how this will develop, but the situation harks back to the Ebola scare during the fall of 2014.  When fear raises its ugly head, all rational thinking goes out the window.

As I have discussed in the past, we have been slogging our way through an earnings recession.  The earnings decline for 2Q 2016 will mark the fifth consecutive quarter of quarter over quarter earnings decline since Q3 2008.  The anticipation of weak earnings was likely the prime factor in the milquetoast returns to stocks in 2015 (the year of the FANG stocks).  The market was discounting a prolonged earnings recession due to the expanded fallout from the implosion in oil prices.

In my opinion the market’s current lift is both a reflection of a slowing rate of decline and an expected recovery in the second half of 2016 and into 2017.  The most significant change is the recovery in the energy space. According to FactSet Research, the energy sector actually recorded an increase in the bottom-up earnings estimate of 1.8% (to $1.10) over the first two months of the quarter.  During this time the price of crude (WTI) has increased 28% to $49.10.

According to FactSet Research, the CY2017 bottom-up earnings forecast is for $135.42.  With the S&P 500 currently in the 2,090 range, stocks are trading 15.4x next year’s earnings.  Stocks are not cheap.  At the same time, they are discounting an earnings recovery or a return to earnings growth which we have not seen for some time.

As is the case, things will develop that destabilize the markets, temporarily.  The stock market corrects on average once a year.  It corrected in September ’15 and February ’16.  I think the evidence supports small steps toward an improving market and looking for higher returns for stocks in the second half of the year.  Please touch base if you would like to review. 

Bruce Hotaling, CFA, Managing Partner

Take a Step Back

For the month of April, stock prices measured by the S&P 500 nudged incrementally higher, up 0.27%, and are now in 1.74% above where they finished 2015. These modest numbers mask a lot of price movement, speculative news flow and investor angst during the first third of the year.

Recently, the market has been shape shifting. For example, after a long period when growth stocks outperformed value stocks, the tide has turned.  The S&P 500 growth ETF (IVW) is -0.74% for the year, while the S&P 500 value ETF (IVE) is 4.23%.  The spread in favor of value is even greater for the mid cap and the small cap segments.  And dividends are the thing, today, as the DJ Dividend ETF (DVY) is up an eye opening 10% year to date.  This is a sudden and complete reversal of the trend in 2015 when the growth IVW returned 5.37% while the value IVE returned a -3.29%.

There are multiple reasons for the u-turn in the return characteristics of the market. Core CPI is in the 2% range, and holding.  With the US 10-year Treasury currently in the 1.8% range, the real yield is negative, pushing investors to own higher yielding assets, including dividend paying stocks.  Dividends are generally taxed at a much lower rate than traditional fixed income, increasing the appeal.

Another reason is investors are generally bearish, marginally outnumbering bullish investors, as measured by the American Association of Individual Investors. This bearishness in conjunction with a declining Consumer Sentiment Index does not historically represent a lot of upside for stock prices.  The numbers are leading investors’ intent on staying in the market to lower their perceived risk, by owning dividends and stocks with lower valuation metrics.

Seasonality often comes up this time of year – the May through September window is historically not the most profitable.  In my opinion, the old wives tale to sell in May is not actionable.  While returns are generally lower, they are also generally positive.  In addition, it’s difficult to justify realizing capital gains (paying taxes on profits) to buffer some near term volatility, when in fact these are stocks with attractive long term growth potential. 

Q1 earnings reports are coming in and by and large the results have been slightly better than expected. One exception has been large cap technology stocks (Apple, Microsoft, Alphabet) have surprised with reports below expectations.  In my view, Q1 is the turning point, and I expect the trend in earnings to recover, aided by the stabilization in the US$, which had been a headwind, and from a recovery in oil prices by the end of 2016.

Some patience is key to successful investing. There have been roughly six pull-backs in stock prices since 2010.  These have trampled the unhealed nerves of investors still recovering from the financial crisis.  The Flash Crash in July ’10, Europe in October 2011, the Taper Tantrum in June 2013, Ebola in October 2014, China in August 2015 and Oil in February 2016.  Unnerving points in time such as these reveal the importance of a solid strategy and continued monitoring of factors effecting the markets. 

In that light, we have been shifting our portfolios into stocks with more value characteristics.  According to Empirical Research, growth and value stocks are traditionally non-correlating.  In today’s market, the focus is more on stability, and thus, the dividend as a key factor.  The value tilt we are enacting is in an attempt to capture the heart of the market.  According to Empirical Research, the value shift is one half complete based on historical trends.  We are not jumping in with both feet, as I believe the tilt will revert later in the year.

In response to the demand for yield, we have launched two new models (Dividend 5 and 10). The intent is for them to complement a traditional growth portfolio, and act as somewhat of a replacement to traditional fixed income.  We will be happy to discuss how these “sleeves” might complement your investment portfolio going forward.

Finally, with tax season behind us, we can all take a step back and assess. The shifting characteristics of the investment landscape will remain a challenge.  Further, with the market regime shifting, we have taken more capital gains than is typically the case.  I am happy to review these and other topics with you if we have not already done so.

 

Bruce Hotaling, CFA

Managing Partner

US Banks – Why the Malaise?

US Banks – Why the malaise?

Bank BuildingBy Jean Rosenbaum, CFA and Portfolio Manager, Hotaling Investment Management, LLC 

Banks are a key component in the economic jig saw puzzle. They make up between 6-8% of the S&P 500 and roughly half of the financial sector of the index. Banks as a whole have modestly underperformed the S&P 500 for the last two years. The industry continues to struggle with the “pricing” environment. The low interest rate environment, coupled with ample liquidity, has led to ever lower rates banks can charge for loans and earn on their securities. While loans continue to grow, the revenue line for banks has been almost stagnant as the price they can charge continues to decline.

Banks have been able to grow earnings in this weak top line environment through an improvement in credit quality. Following the financial crisis, banks significantly increased their loan loss reserves. In the subsequent years, as defaults (or net charge offs) came in lower than initially anticipated, banks have been able to reduce their reserves providing a tailwind for earnings. Loan loss reserves are now approaching previous lows, so this improvement appears to be ending, or at least slowing.

The next driver of earnings for the industry may be operating expense control. Many banks have been experiencing cost growth ahead of revenue growth due in part to additional regulatory expenses. The banks have also been reluctant to limit their branch networks. However, with earnings drivers limited, it appears that some management teams have begun to take action. Going forward, physical infrastructure (a bank on every street corner) is likely to be replaced by more digital infrastructure at an accelerating pace.

Many bank management teams have been hoping for a Fed rate increase and a steeper yield curve, but the ability to wait may be coming to an end. The recently announced hiring and wage growth data was nothing short of robust. This may give the Federal Reserve the impetus to raise rates later this year, and potentially offer some relief to the banking sector.