Issue 05 - June 2013
We hope you are enjoying your summer! Ours has been going along quite well with the exception of the inevitable pullback the market has finally decided to put us all through. While this was not unexpected, it was/is impossible to predict when and how hard stocks will be hit. Here we will address some of the factors precipitating the recent ugly days and our interpretation of them.
On Wednesday (June 19th), the Federal Reserve Bank or “the Fed” held their board of governors meeting and announced that there would be no change to their monetary policies. However in a press conference following the meeting, the Fed chairman, Ben Bernanke, said that if economic data continues to improve then the Fed might gradually scale back their bond purchases later this year.
As a quick review, the Fed’s “bond buying” program refers to their current Quantitative Easing program, whereby the Fed creates money to purchase bonds (mostly treasury bonds and mortgage bonds). The idea is that when the Fed buys these bonds from the bond market they are both putting downward pressure on interest rates and making more money available to be invested elsewhere. In their current program, the Fed is buying $85 billion in bonds each month, meaning that $85 billion of investor assets that would have gone to buying those bonds are now available to be used elsewhere. Most likely a lot of this money ends up going into stocks and other investment assets, though no one can say for sure where it all ends up.
On the surface, it would seem that nothing in the Fed’s policy changed. Their bond- buying program was set up as a temporary program, which would continue until unemployment got down to around 6.5% (it is now 7.6%) or until inflation hit about 2% (Core CPI was 0.2% last month). In other words, the bond-buying program was set up to help improve economic conditions and once the data shows improvement then the Fed will end the program. On Wednesday, Bernanke essentially restated that objective and said that conditions are improving somewhat and if they continue to get better, then the bond program could start scaling back late in the year. This would seem to be either no news or good news, since he said things are improving.
Uncertainty And the Market
So why did the stock market react so poorly over the past couple of days? In a word, uncertainty – one thing the stock market always hates is uncertainty. The market has enjoyed the Fed’s bond program and Bernanke’s comments indicate that the end of that program may be closer than we thought a couple of months ago. In addition, Bernanke’s term will expire in early 2014 and he will probably not seek another term, so who will be the new Fed chairman and how will his or her policies affect us?
After Bernanke’s comments, it now appears that the Fed might begin taking a tighter stance to their monetary policy towards the end of this year. The “tightening” actions the Fed might take, could include not just ending the bond-buying program but could also mean the Fed will start increasing interest rates. And once they begin to tighten, they can potentially cause economic activity to slow down and lead us into a recession. No problem you might say, because all they would have to do is reverse their actions if things slow down, right? In theory that is true but if things slow down too quickly, reversing the Fed’s actions might not be enough to prevent a recession. And, with the added uncertainty of a new Fed chairman, who knows how that situation might be dealt with.
In our view, given that the Fed likely won’t do anything different until the end of the year, and maybe nothing different at all this year, all of this panicking seems a little premature. Our view continues to be that the US economy will experience slow growth. Many people are concerned about dramatically higher interest rates, but higher than average rates usually come with higher than average growth, which we don’t see. So in our opinion, this recent volatility is just part of a normal correction process and is not likely to become a bear market (20%+) type of correction.
Impact on REIT’s
Given that interest rates are so low it is almost certain that they will go up to more historically “normal” levels at some point. Whether that happens over the next couple of months or years, or if it takes much longer, no one can say for sure. Regardless, it’s a good time to look at how REITs have performed in previous periods of rising interest rates.
In researching this topic, we came across a study that was put together by a company called Cohen & Steers using data from Bloomberg (see full article at http://www.havermannfinancial.com/type_of_newsletter/financial-articles-of-interest/). The study looked at data from the mid 1970’s thru 2012 (keep in mind that data on REITs does not go back any further than the ‘70s). The study found that there were 6 periods of time since the ‘70s that we had rising interest rates. It measured returns over those periods for Stocks (S&P 500 Index), Bonds (Barclays US Aggregate bond index) and REITs (NAREIT Equity REIT index).
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, one must also keep in mind that they are looking at total return over the given period. So if you look at the returns over the 135 months that the 10-year treasury yields were rising, those returns are spread out over about 11.25 years. In the case of REITs, they went up 56.5% over 11.25 years, which amounts to about 5% per year. And since the dividends of the REITs likely averaged more than 5%, their stocks were essentially flat, if not down a bit – not great but the 5% is still better that the S&P 500 or bonds over that same time period.
We of course do not care if the return comes from dividends or growth and are more concerned about total return and return relative to our other options. By those measures, the performance of REITs in an increasing interest rate environment looks pretty good.