A Long Way From Neutral
For the first time since 2011, the 30-year mortgage rate has topped 5%. What’s the difference between a 4% and a 5% mortgage rate? $213,862 (on a $1M loan over 30 years, see below). That’s how much more the exact same house will cost you today due to higher interest rates. You need to come up with an additional $600 per month, or $7,128 annually. In a high tax state such as California, one must make an additional $12,000 annually (approximately) to net $7,128. So it’s a thousand bucks a month that will no longer goto travel, dining out, sporting events, concerts, Amazon, etc.
As the stock market was approaching a record high, I mentioned that investors were underestimating the threat of rising interest rates and trade tensions (‘More Buyers than Sellers’ 8/12/2018). Last week the Federal Reserve Bank Chairman Jerome Powell stated the following:
“We may go past neutral. But we’re a long way from neutral at this point, probably,”
Powell is referencing hiking interest rates. The Fed wants to normalize interest rates so we’re prepared for the next recession. The irony is that as they tighten money, the chances of our economy slumping increases. Everything that is financed is now more expensive (houses, automobiles, education, business expansion, credit card debt). Economics 101…if you raise prices…you reduce demand. As rates move higher, fewer homes will be sold. Fewer homes will be financed, furnished, painted, remodeled, insured, etc. It’s not debatable that this will slow the economy. The only question is will the Fed slow (or stop) their rate hikes before money gets too tight and we fall into recession. I doubt it. However, I don’t believe we’re on the precipice of a recession just yet. The U.S. jobs market remains strong (Reuters) . Historically, we see layoffs preceding a recession.
Since reaching a new record high 2 weeks ago the stock market is down 6% (S&P 500). Not surprising that the most expensive (and popular) stocks are down the most since reaching their recent highs:
Apple -5%
Amazon -13%
Google -13%
Facebook -33%
Netflix -20%
Spotify -20%
Tesla -33%
(source: Mornigstar.com)
The tech sector is up 80% over the past 3 years versus the overall market which has climbed 38%. I don’t believe this level of outperformance is sustainable. Today, most tech giants are dealing with increased government scrutiny that will lead to more regulation and fines (see GDPR) . We’ve been seeking value away from the tech sector over the past year. We’ve increased our exposure to utilities, telecom and consumer staples. These sectors have lagged the market significantly over the past few years. But boring can be beautiful, especially if you’re paid cash in the form of hefty dividends.
“Bull markets don’t die from old age. They typically get shot in the head by the central bank (Federal Reserve)…”
The chart below compares the US stock market with the global stock market (minus the US). The orange line represents the S&P 500, the green line represents the global stock market ex-US. You can see how they diverge in the middle of the chart. On May 31st the president initiated trade tariffs on steel and aluminum from Europe, Canada and Mexico, igniting a trade war. He has since ratcheted up trade tensions with China. But as contrarians, we believe he’s providing long term (patient) investors with a potential opportunity.
Chinese tech stocks have endured a serious beatdown:
Alibaba (‘the Amazon of China’), down 48% from its high
Baidu (‘the Google of China’), down 45% from its high
Netease (‘the Activision of China’), down 44% from its high
SINA (‘the Facebook of China’), down 52% from its high
There are plenty of issues with China: trade tensions with the U.S., serious allegations of espionage, massive debt levels, etc. And many of their tech leaders are dealing with similar heightened government scrutiny. But much of the bad news may be priced in. One of our long term sustainable themes remains ‘The Westernization of Asia.’ Demographics is destiny. China’s aspirational consumer has the potential to do for the global economy what Baby Boomers did for ours.
“EM (emerging markets) also is looking attractive for value investors as they now trade at a 30% discount on a forward PE (price to earnings) basis to their developed market peers…”
Rates are rising. Easy money is waning. We’ve anticipated this. We’ve reduced our exposure to long term bonds. We continue to seek value in unloved parts of the market. This appears to be a healthy rotation away from expensive stocks (tech), to cheaper stocks (telecom, staples, utilities). This was long overdue in my opinion.
As the market falls, we remain diversified and of course, on the lookout for opportunities.
I look forward to discussing further with you.
Thank you,
randy
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