Greece and Interest Rate Talk

Greece and Interest Rate Talk

 

Greece

One of the questions we’ve been asked about quite often in recent weeks is “What about Greece” and how will Greece affect the stock market. We have said all along that we believe that Greece will not have a huge effect on the US stock market in the long run, but in the short run it can definitely cause some volatility. The volatility has certainly been hitting the market over the past couple of months and that has been partly due to the issues in Greece heating up.

To briefly recap the story of Greece, they have had trouble making payments on their debt in recent years and many people fear that Greece will default on their bonds. This worry is well-founded as the European Union has had to put together several bailout packages for Greece in order to help them make payments on their bonds. To make matters worse, interest rates in Greece are high due to the default concerns. Currently the Greek 10 year treasury is yielding close to 12% while the rest of the European countries are paying closer to 1 to 2% on their 10 year bonds.

Just Wednesday of this week, the Greek parliament approved the most recent round of bailout money from European creditors. This will give them additional funds spread out over the next 3 years, but will also put Greece further in debt and tighten the noose with more austerity (more tax increases & spending cuts for Greece). It’s difficult to see how Greece will emerge from this without defaulting on some bonds, which could lead to them exiting the European

But keep in mind that Greece is a small economy with an annual GDP of about $240 billion, which is equivalent to the GDP of a state like Connecticut (24th out of the 50 US states). So while their problems are serious, it’s not likely that any problems in Greece will be disastrous to the US or the European Union (EU). In fact, one could make the argument that if Greece drops out of the EU, the EU will be better off and their currency will get stronger. This is obviously not true if you are a holder of Greek bonds, but from our perspective, I don’t see any major long-term problems resulting from this.

Interest Rates & REITs:

Another issue that has been affecting markets in recent months has been worries over interest rates. The economy in the US has been improving over the past few years and many feel that it is time for the Fed to start increasing interest rates. This is good news in the sense that it means that the Fed feels our economy is strong enough to handle higher rates. However, it is potentially bad news because higher interest rates could have the effect of slowing the economy down and could end up causing another recession. The Fed has hinted that they might raise rates later this year in September or in December, depending on how the economic data looks over the coming months.

What does this mean for stocks & REITs? We have talked about this in previous updates, but historically, stocks (including dividend stocks & RIETs) have done pretty well during periods of rising rates. The bigger concern is if rates increase too quickly, which could happen if inflation were to go up too quickly. In periods when interest rates are moving up quickly, most stocks do not do well.

Think of interest rates as competition for stocks. Right now, the US 10 year Treasury yields about 2.4%, while the S&P 500 dividend yield is about 2% and dividend stocks & REITs are around 3 to 5%.   So if rates moved up quickly and the 10 year treasury was suddenly yielding 4%, then the dividend rates on stocks & REITs would not look as attractive, and many investors would be tempted to move some of their money out of stocks & into bonds. On the other hand, if rates were to move up gradually over the next 3 to 5 years then corporations would have more time to adjust to the new rates and the improving economy should help increase the revenues & earnings of corporations and their stocks should do well.

So the big concern right now with interest rates is not that they might go up some, but how high will they go and how quickly. This concern has lead to a poor start to the year for dividend paying stocks & REITS (both down 3 to 6% or so), after a solid year for them last year, while the S&P 500 is closer to 0% thru June.   Our research shows that REITs have actually performed better than the S&P 500 during periods of rising rates so we would expect to see REITs perform better during the second half of this year and during the coming years. Remember, rising rates usually means an improving economy, which is good for REITs as they can increase their rents, fill up their buildings and gradually raise their dividends.

I follow several economists to aid in decision making, but one of the better ones I believe is Jeremy Siegel. Siegel is a professor of Finance at the Wharton School of Business in Pennsylvania. He writes a weekly newsletter and is frequently a guest speaker on financial news channels like CNBC & Bloomberg. He is usually an optimistic person and has been accused of being too bullish, but I remember that he was bearish in late 2008 and was one of the reasons that I decided to move all client assets to cash in October of 2008. I remember in early 2012 when the Dow Jones Average was at about 12,500, Siegel was predicting that the Dow could hit 17,000 by the end of 2013 and that he thought it would at least get to 15,000 in 2013.

At that time in 2012, most economists were very cautious and most were predicting a flat or down market for the next couple of years. Many commentators were snickering at his prediction and I can’t think of anyone that was as bullish as Siegel at the time. And by the end of 2013, the Dow nearly hit the high end of his range of finishing at 16,576. I can think of many predictions he has made over the years and he is usually pretty accurate.

Most recently, Siegel has predicted that interest rates will remain low over the next decade or so – not that the Fed won’t raise rates, but that the Fed won’t be able to raise them too much before they have to stop or start lowering them again. This is consistent with our thinking, as we have mentioned in previous updates. We believe that the phenomenon of the Baby Boomers ageing & retiring will have a softening effect on the economy & on interest rates. This ageing population is taking place not just in the USA, but also in many European Countries, in China & in Japan – we will talk about this more in future updates and in future meetings if you are interested.

Another prediction recently made by Jeremy Siegel is that the Dow Jones Industrial Average will hit 20,000 by the end of this year. Right now the Dow is around 18,000 (up about 1% for the year), so that would mean potentially a gain of around 10 to 12% for the year if he is correct.