This article was originally published on RealMoney.com on January 5th at 11:00am EDT
Looking back on predictions made a year ago for 2014—whether on interest rates, equity markets, or oil prices, we can see that the general consensus does not always prove accurate. The majority of professional forecasters said interest rates had nowhere to go but up in 2014, though they couldn’t agree about how rapid the ascent might be; stock markets were expected to struggle, mainly due to uncertainties about the effects of rising rates; and I can’t name a single person or institution that cautioned against such a seismic shift in energy markets.
The general consensus was, generally, wrong.
So let’s delve into today’s general consensus and then explore some alternative themes that could be more likely to play out, if only because they’re not getting as much attention.
General Consensus 1: Rates will finally rise now that QE has ended; US banks will be the primary beneficiary.
It is being seen as a foregone conclusion, again, that rates will rise now that the Fed is no longer a buyer—though they are still a holder—of Treasury Bonds and Mortgage-Backed Securities (MBS). Further, the most widely held assumption is that rising rates will be good for our banking institutions, as they will be able to command more interest on their loans. I don’t understand how industry professionals are comfortable drawing this conclusion so quickly.
Banks are also borrowers—they borrow from the Fed at the shortest-term rates and lend funds to companies and consumers at longer-term rates (which are, ideally, much higher). But what happens when they are not much higher?
There is substantially more pressure on the long end of the curve than the short end right now. Foreign buyers have stepped up and more than compensated for the Fed’s exit as the biggest buyer at long-term Treasury auctions. The reason for this action is twofold: 1) Rates everywhere else are even lower than here in the US, so global fixed income investors get better rates as well as better credit by buying here; and 2) As the USD strengthens against foreign currencies, holders of Treasuries in foreign markets have appreciation potential by owning an asset priced in Dollars against their own currency. We pointed out this phenomenon here back in September.
Bank stocks are cheap, but could get cheaper.
But our banks are still trading at historically cheap multiples, you might say. There may be good reason for that—is the market pricing in more pain for the financials? While the huge, and formerly unknown, fines and legal costs related to the subprime meltdown appear to be behind the big banks, there could be still other headwinds outstanding. Like margin compression.
So who does well when lenders suffer? Borrowers. Particularly those borrowing on the long end of the curve, like homeowners. Is it possible mortgage rates have not yet seen their lowest point?
Alternative Theme 1: Rates won’t rise, but the yield curve will flatten—creating problems for banks, and another tailwind for homebuyers and refinancing.
General Consensus 2: Low oil prices will cause serious problems, and we will see small- and mid-sized shale producers go bust and a number of defaults in the high yield market. The potential radius of contagion is unknown.
Low oil prices most likely will cause serious problems, but not for the United States. Look out for energy-related defaults and bankruptcies in economies heavily reliant on oil exports, like Brazil, Russia, the Middle East, and Africa. China and Europe, as net importers, should benefit.
But the phenomenon we discussed above in Alternative Theme 1 could be a real life preserver for our domestic producers. Of course those with poor management teams and/or less than desirable assets may go under—but that’s true in any industry. The concern is that spreads will blow out—that rates in the junk bond market will head back up to the nosebleed section, pushing some of these troubled producers to the brink. However, it’s my feeling that lower long term Treasury rates may prove helpful in enticing investors back into the high yield space before rates get too high (and bond prices get too low).
The BofA Merrill Lynch Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The BofA Merrill Lynch High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).
What if the above chart is a depiction of high yield bond spreads “blowing out” in today’s interest rate environment? A high yield spread above 5% is not abnormal by historical standards, but consider that a 5% spread is pretty meaningful when the 30-year Treasury is below 3%. Implied returns for high yield bonds over the Treasury at current levels is 280% (7.75% / 2.75%). Implied return over the Treasury just one year ago was 100% (8.00% / 4.00%).
I believe there is a good deal of relief in sight for debt-laden companies, especially in the energy space. And it wouldn’t surprise me to see a return of the Leveraged Buyout as well-capitalized private equity firms start pulling the trigger and snapping up distressed companies, immediately cutting their targets’ debt servicing costs in half. We saw a bit of that last week as Blackstone (BX) agreed to provide up to $500 million in financing to cash-strapped Linn Energy (LINE).
Alternative Theme 2: Problems in the US due to low oil prices will be minimal, if anything we will see a pickup in M&A activity as long-term opportunities far outweigh short-term risks. Opportunities abound.
General Consensus 3: US Equities are the place to be, and it should be another strong year as economic growth continues and earnings keep up. The strong dollar is merely a sign that the economy is on the right track.
The trouble with this argument is how easy it is to make it. I contend that US Dollar strength will be the biggest problem for our equity markets in 2015, particularly the large multinationals.
As you can see above, over the past five years each time we have seen a spike in dollar strength, a dip in the S&P 500 was close behind. Not only may the Fed have reason to reconsider rate hikes, further quantitative easing may be needed if only to keep up with the currency debasing going on around the world. And maybe this time around QE would not be strictly in the form of buying Treasury and Mortgage Backed Securities.
Would it be possible for the Fed to inject another trillion dollars of stimulus into the economy by buying high quality bonds in the energy sector? The purpose, and benefit, would be twofold: 1) The provision of a long-term lifeline to struggling domestic producers would be enormous towards our energy independence goals; and 2) Another trillion dollars in the system would help, a little, to fight against USD strength.
Unlikely. But stranger things have happened…
Alternative Theme 3: The strength of the US Economic recovery is real, but the stocks of our large-cap multinationals are fully valued. Relative weakness in the currencies of our companies’ foreign customers may weigh heavily on 2015 profits. Consider US small caps to capture US growth without as much exposure to currency risk. Also, European and Chinese shares have the dual benefit of their weaker currency positively impacting exports and cheaper oil providing a huge break to corporations and consumers.
A prediction is something one confidently believes will play out. While I do believe each of the Alternative Themes above is a possibility, the only prediction I would feel comfortable making is that it’s highly unlikely any of the General Consensuses will come to fruition.
If you have questions or would like to engage in a dialogue, please don’t hesitate to give us a call.
Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main
Adam Scott’s profile on RealMoney can be found here.