Market Turbulence, Rising Interest Rates and Investment Strategy

Happy Labor Day! It’s hard to believe the summer is coming to an end. We hope you enjoyed yours as much as we did ours.

Other than some exciting liquidations of some of our purchases, the secondary REIT market has not produced very attractive prices to buy more this summer, so that side of our business has been relatively quiet. By contrast, the stock market has been turbulent and has consumed much of the research time. The good news to a down season is always potential buying opportunities, and we continue to look into those. However, it can be concerning to see current investments losing ground, so we will focus this newsletter on the over all market volatility as it relates to our investment strategy.

Looking Back at Periods of Rising Interest Rates

One of the biggest issues affecting the stock market over the past couple of months has been the spike in interest rates.   When interest rates go up sharply, dividend-paying investments (our current preferred strategy), tend to suffer. The 10-year US Treasury bond for example, has moved from around 1.75% to around 2.8% in just the last 60 days or so.  Below is a historical chart of the 10-year treasury yields going back to 1960:

 

You can see that the recent spike in the interest rates (on the far right of the chart) is pretty significant.  But if you were to draw a line connecting the peaks of the chart you would also see that the recent spike in rates has just brought the rates back up to the top of the trend line.

What does this mean for our investments?  We touched on this a little in our last update as it related to the traded REIT’s specifically.   We sited a study (from Cohen & Steers) which showed that REITs have performed well in previous periods when we had rising interest rates…here is an excerpt:

“In reviewing the 6 periods of rising rates with the first one beginning in 1979, they found that there were a total of 135 months when the 10-year US Treasury yields were rising and 95 months when the Federal Funds Rate (one of the rates directly controlled by the Fed) was rising.  During the 135 months when the 10-year Treasury yields were rising, RIETs were up 56.5%, Stocks were up 38.3% and bonds were up 4.2%.  And during the 95 months while the Federal Funds Rate was rising, REITs were up 31.2%, stocks were up 11.7% and bonds were up 3.3%.“

When looking at this study, you must also consider that they were looking at the numbers over the entire timeframe of when the 10-year Treasury yields were rising.  So in the study they had 135 months of rising rates over 6 different periods of time, meaning that the average period of rising interest rates was about 22 months.  In our current period of rising rates we are only about 4 months into the uptrend.

Current Rate Spike and Future Question Marks

Since the study shows REITs doing OK during periods of rising interest rates, then why have REITs and other dividend paying investments done poorly over the past few months?  We think the answer is just the fact that rates have gone up so quickly that investors are worried about how high they will ultimately go.  When you see the 10 year yield go from 1.75% to 2.8% in a couple of months, you worry that it might be at 4% in a couple more months and then who knows from there.  In other words, the higher rates go, the less attractive your dividend paying investment looks relative to other interest paying investments (like bonds & CDs).  So right now, what investors in dividend investments want to see is either some stability in rates or decreasing rates.

Predicting future interest rates is a difficult task with lots of factors to consider.  Much like predicting where the stock market will be at a future date, it is virtually impossible to get it exactly right.  Fortunately we don’t need to get it exactly right, we just want to feel confident that rates will not be dramatically higher in the near future.  The study we have discussed above and others like it show, that dividend paying investments can handle periods of increasing rates.  But we also know that dividend paying investments and really stocks in general, do not do well when interest rates are rising quickly.   We believe that the recent period of quickly rising rates will end soon.

PIMCO is the largest manager of bonds in the mutual fund universe and we follow their weekly newsletters.  In their most recent newsletter, they say that their belief is that the 10-year treasury yield should be around 2.2% based on supply, demand and the many other factors that they consider.   It is currently around 2.8%, so they deduce it will likely go down over the coming months.  One of the longer-term factors that they site is the aging of our work force.  PIMCO’s research shows that the growth of the working age population will be 1% lower than it has been over the past 40 years (due to the aging of the baby boomers).  The net result of that means a 1% slower growth potential of the GDP (Gross Domestic Product) in the US.  And slower growth means low interest rates.

Economic Growth, The Fed, and Interest Rates

On the subject of slow growth, I think we also need to keep in mind what Congress is doing now and what they can do going forward.  We all know that Congress has authorized government “over-spending” for decades, which has resulted in a huge national debt.  This has sparked lots of debate over how to reduce the debt or at least slow it down.  That is not a recipe for a fast growing economy.  Certainly, the economy can grow without the government over spending, but over the past 30+ years, the spending has boosted our economy.

Going forward, there will continue to be lots of pressure for the government to reduce the amount that they spend, which should mean that we grow slower than we have over the past roughly 30 years.   In this time period, GDP growth in the US has generally been in the 3% to 5% range, with a few short periods where it went above and below that range.  Going forward, we expect that GDP growth in the US will be generally in the 1% to 3% range, due primarily to the anticipated slower government spending and the aging of our workforce.   While this is not good news, it is more reason to believe that dividend paying stocks may fair okay as the Fed is likely to keep rates low for a long period of time, in order to help boost GDP growth.

Summary

We hope this has clarified what some of the recent volatility has been about.  In addition, while there will be periods when prices go down on our stock purchases, one of the reasons we are in this strategy is because we are collecting nice dividends despite the turbulence of the stock price itself.

With the summer months behind us, we will be gearing up for fall reviews, so please be in touch if you don’t hear from us first. Also, we would love to hear your feedback and suggestions for future newsletters. Please feel free to let us know any topics in particular about which you would like to hear us spout off, as well as any other thoughts you have to help us serve you better.