Back to Part 6
How to think about the interest rate environment
There’s an old market saw that goes, “Don’t fight the Fed.” For the vast majority of the time, that meant one thing: don’t be bearish on bonds, and don’t be bearish on stocks. Why? The Fed is on your side. It wants asset prices higher and will pull out all of the stops to increase asset prices. The Fed has been trying to put the wealth effect genie back in the bottle.
That has changed somewhat with the new focus on tapering quantitative easing. The Fed seems determined to start backing away from asset purchases. The salient question is why? Has the economic data been so good that the Fed has to worry about inflation? Actually, no. In the last three quarters, GDP growth has averaged under 1.1%. Last week’s industrial production numbers and capacity utilization numbers were weak. Job growth has been in favor of part-time work at the expense of full-time work.
The Fed is acting somewhat inconsistently with the data. And that’s a warning flag. The Fed could be targeting leverage in the system (the timing of the increase in rates coincided with a government report warning about leverage and convexity risk—especially in mortgage REITs). The point is that when the Fed acts in a way that seems inconsistent with how it should be behaving, you should be cautious. The Fed can see all the cards. You can’t.
Implications for mortgage REITs
The REITs have been beaten bloody since May 1. The TIC report shows foreign investors continue to dump U.S. assets—particularly mortgage-backed securities (MBS). Some have held up better than others. The investors with less leverage and less long-duration MBS exposure have performed best. First, unless you think either that we’re headed into a recession or that there will be some sort of financial crisis that will drive rates downward again, you’ll want to avoid the names with large exposure to 30-year fixed-rate MBS—particularly American Capital Agency (AGNC) and Annaly (NLY). Second, if you think the economy will continue to improve, then you want credit risk, so look at the non-agency REITs. Finally, there are ways to make money in this sector in a rising rate environment. Servicers like Nationstar (NSM) and Ocwen (OCN) own mortgage servicing rights, which increase in value as rates go up.
Implications for homebuilders
The homebuilders are tough right now. The secular (long-term) story is great. Things are lining up well for them. We have underbuilt for ten years, and even with rates where they are, mortgages are still highly affordable. If we ever get inflation back to where it was even in the 1980s (let alone the ’70s), the Fed would be paying you to borrow money. This is homebuilder bullish (positive). Earnings growth could be in the 30%-to-40% range.
The bear (negative) case? Homebuilders are highly cyclical stocks. What that means for the investor is that their earnings can be volatile. So can their P/E ratios. During recessions, it’s not unusual to see homebuilders trading with P/E ratios north of 30. And during boom times, it’s not unusual to see homebuilders trading with P/E ratios below 10. Right now, the builders are trading with P/Es in the low 20s. If earnings double, don’t expect that multiple to remain at 20.