The Fed, Bonds, REITs and Utility Stocks

The Fed is hosting its 2016 annual academic conference in Jackson Hole, Wyoming this weekend.  Fed Chair, Janet Yellen is scheduled to speak. While no interest rate decision will be announced, markets nonetheless are fixated on developments. With little real economic data or interest to move stock and bond prices, traders eagerly await some insight into future rate policy, in hopes of gaining some direction for markets.

We see the impact of Jackson Hole on bond and utility stock prices, and prices for REITs.  Each of these instruments trade as fixed income securities and are, therefore, rightly influenced by trends in interest rates. But, it's actually long term interest rates that impact these instruments over time, not the short end of the curve that the Fed sets.

Utility stocks have performed extraordinarily well over the past six months, as we first pointed out in this blog in April 2016, Investing in Utility Stocks.  Utility stocks as measured by the return on the ETF, XLU, were up 18.8% through August 10 of this year (see Returns on Selected Assets Year to Date).  It's also worth reading our 2016 market predications posted on December 30, 2015 and What's Working in this Market Correction from January 7, 2016.

Over the past few weeks, though, bonds, REITs and utility stocks have given back some of their gains as investors eye a potential rate hike by the Fed.  Let's take a look at how bonds are priced and why I treat utility stocks as the equivalent. Utility stocks generally trade with a high level of dividend yield. Because utility revenues are quite stable, the dividend is therefore predictable and protected, as much as possible, from swings in the economy.  Therefore, as with bonds that pay a fixed level of interest, the value of the utility stock is tied to the discounted future value of the dividend stream. If the dividend is stable, the stock value will rise as the discount rate falls and decline as the discount rate rises.

Markets, of course, are forward looking, which explains why utility stocks are weakening, while no interest hike has actually been scheduled. The Fed also does not directly impact longer term interest rates that are the basis by which utility dividend and bond interest would be discounted. Nonetheless, the markets are fragile and investors anxious.  

If we look at the last Fed hike on December 15, 2015, however, we see a very different picture emerge. The US 10-year rose by 2 basis points to 2.30% in the day following the announcement, eventually rising to a high of 2.32% on December 29.  But the yield began immediate falling thereafter, to 2.00% on January 28, and 1.63% by February 11, 2016. The 10-year yield now sits at 1.55%. The XLU utility ETF, by the way closed on the day of the December Fed hike at 42.33, climbing to 53 on July 6, 2016 (a gain of 25%).

This points to the most interesting aspect of how bonds and utility stocks trade, not on forecasted Federal Funds rates, or perhaps even the US 10-year, but on the forecast of inflation in the economy, as inflation erodes the value of fixed income securities. The point of all this is that if a Fed hike acts to curb growth (and therefore inflation) a rise in the Fed Funds rate could actually act to lower the US-10 year and raise, not lower, the price of bonds and utility stocks. This is precisely what happened following the Fed's December rate hike. There's no reason to believe that this would play out any differently in the months following the next rate increase.

Dark Clouds on the Horizon

It's that time of year again when financial markets are dominated by trading for year-end tax purposes, to clean up portfolios and to window dress statements for investors. Volatility is expected. This December certainly hasn't disappointed, with triple digit swings in the DJIA in each of its eight trading days.

But beyond the customary year-end positioning, there's a sense of real trouble brewing in markets for 2016. Here's what concerns us about the economy and financial markets for the New Year:

Plunging Commodity Prices - By mid-year 2015, the Bloomberg Commodities Index fell to a 16 year low, falling to levels below that of the 2009 Great Recession. The Index has since continued its downward spiral through year-end in sectors ranging from oil to natural gas to precious and industrial metals. The plunge in commodities has taken with it resource laden emerging market currencies whose economies and production capabilities had boomed in prior years. The culprit, many suspect is China, having pulled back from its massive infrastructure build of years prior, its financing of still empty cities and its failed attempts to spur internal consumption. Of a scale never quite seen before, in December of 2014 Forbes reported that China had used more concrete in the prior three years than the US used in the entire 20th Century. With the spigot dialing down, demand for raw materials worldwide is plummeting. But our concern is that falling commodities prices bring with them more that just price deflation, but also income, employment and consumption implications, as producers realize substantially less income for the same resources and production expense. A recent New York Times article chronicled the impact of declining commodities here at home upon America's Heartland.

The Collapse of Emerging Markets - Emerging markets currencies have been falling throughout 2015, following devaluations in China and Vietnam and trading weakness in Russia, Turkey, Malaysia and Brazil. The plunge in EM is driven by commodities prices, but also by the high levels of US dollar denominated borrowings in these countries, and borrowers now faced with paying back their loans against a strongly appreciated dollar. But others have questioned whether the ephemeral commodities demand from China is only half the problem. The corollary concern is that ultra-loose monetary policy drove capital to flow into these markets, with that capital now being repatriated as GDP and return prospects for EM countries flounder. Foremost among troubled EM countries is Brazil, once a stalwart of the Emerging Market BRICs, now in a full-scale economic depression. Goldman Sachs believes that a developing crisis in EM is the third wave of the Great Recession; the first being the US housing crisis, the second the European Sovereign Debt Crisis (i.e., Greece, Portugal, Spain, etc.)

Distress in the High Yield Bond Market - Credit spreads in the high yield bond market have been blowing out all year, with CCC rated junk bond prices down 20% from mid-2014.  And bond maven, Jeff Gundlach, head of DoubleLine Capital believes the carnage is about to get a whole lot worse as the markets prepare for liftoff by the Fed.

Weakness in Retail - A slew of third-quarter earnings reports of retail giants Macy's, Nordstrom's and Tiffany's and smaller hot retailers like LuLuLemon, have sent share prices of these companies down 10-20% in a single day following their release of dismal same store sales, top line revenues and earnings. While some of this retail demand may have been made up by online shopping, it's unnerving in what it says about the state of bricks and mortar retail and the US consumer.

Shrinking Corporate Profits - Corporate earnings for 2015 Q4 are estimated to decline -4.3%. If so, it will mark the first three consecutive quarters of year over year earnings declines since 2009 Q3.  A total of 83 companies have issued negative guidance for 2015 Q4. With the S&P 500 currently trading at 17x forward earnings, shares prices could decline amidst falling earnings while still leaving us at historically high valuations. And if both earnings and multiples contract, look out below.

Fed Policy - the 800-pound gorilla of market worries is the Fed, as it prepares to raise interest rates for the first time in ten years. While some believe the impact has been built into the markets, given its long-telegraphed move, concern is growing that implementation may be far more difficult and disruptive to markets that anyone believed.

While there are other concerns looming that bullish investors tend to dismiss, arguing "the market likes to climb a wall of worry", adages aside, investors are wise to take note of what increasingly appears to be a gathering storm.