The broader US markets continued their roller-coaster ride Wednesday with the Dow Jones Industrial Average (DIA) closing up more than 600 points. There are a number of dynamics at work that explain the large move, which only partially retraces the large declines over the past couple weeks.
First, the extreme level of volatility that we are experiencing today in the markets is a direct result of the Fed’s actions to prevent the onset of a modern-day Great Depression toward the latter part of this decade and into this one. By slashing interest rates and engaging in round and after round of quantitative easing for the past several years, the Fed coincidentally pushed yields on fixed-income instruments to insufficient levels for retirees and near-retirees, luring them back into the equity markets, where dividend growth equities could be had.
The big problem, however, is that instead of flocking to organically-derived dividend payers such as Apple (AAPL) or Microsoft (MSFT), for example, which pay out dividends as a portion of earnings or free cash flow, most retirees and near-retirees–having suffered capital losses during the depths of the Financial Crisis–jumped on the master limited partnership (MLPs) and real estate investment trust (REIT) bandwagon, entities that pay out dividend/distribution yields sometimes well north of 5% or 6% or higher–several percentage points greater than that of the average S&P 500 corporate payer. These instruments offer higher levels of income to compensate for the capital losses incurred during the crisis.
However, the valuation paradigms on MLPs and REITs, rightly or wrongly, center on defined measures of “distributable cash flow” and “funds from operations,” respectively, instead of on traditional corporate free cash flow. As a result, MLPs such as Stonemor (STON) or Energy Transfer Partners (ETP) and REITs such as Simon Property (SPG) and Healthcare REIT (HCN) can pay out distributions/dividends that significantly exceed accounting-based earnings or traditional, tangible free cash flow. Because interest rates on fixed-income vehicles are so low, MLPs and REITs have become “priced” more like bonds, using their distribution/dividend as the corresponding growing “coupon,” than on the basis of a tangible, free-cash-flow-based intrinsic value framework. As a result, MLPs and REITs have become significantly more interest-rate sensitive than even the most leveraged, variable-debt corporates, in our view.
With billions of retiree and near-retiree funds sitting in these instruments (and as a result, hanging in the balance), the Fed is walking a tight-rope on what to do about interest rates. Once it starts hiking interest rates, the corresponding response across the MLP and REIT equity arenas may cause a mass exodus and chain-reaction-selling across the equity class, itself. After all, the Fed would set a trajectory in which eventually risk-free (Treasury) assets would yield more than risky (dividend paying) assets over time, which wouldn’t make any sense. The lost wealth as a result of declining MLP and REIT equity prices stemming from a rate hike and ensuing contractionary monetary policy may actually be greater than any perceived “option value” gained by having a large interest rate base to work from in the event of another crisis.
The bigger problem, however, is that the next crisis is already here. We’ve covered China quite a bit already, but the situation, while stabilized at the moment, remains one of outright panic. The implications of China’s equity market collapse are so profound that, in our view, they’ve actually given pause to the idea of a rate hike by the Fed next month. In fact, just as the market began sliding again intra-day Wednesday, New York Fed President William Dudley’s statement that the prospect of a September rate hike seemed less compelling (than it was a couple weeks ago) hit the wires, sparking a rally into the close.
Quite simply, bad news has become good news again. Can you believe it? The more global economic risks that are on the table (i.e. collapsing crude oil prices, currency wars, emerging market crisis), the less likely the valuation paradigms surrounding MLPs and REITs–and by extension, the residual impact to the equity market–will be deflated under the event of a rate-hiking process. So here it is: the news out of China has become so bad that the US markets, in getting the Fed to “think twice” about rate hikes in September, has transformed the terrible news into a “silver lining of a bounce.”
All-in, the “rate-hikes-on,” “rate-hikes-off” game is playing out in the equity markets again, but we’re not biting. We’re sticking to the fundamentals, and even if the Fed decides not to hike rates this September or even into early 2016, it has little ammunition left after multiple rounds of QE to effectively “liquidate away” the collapse in commodity prices, the recent China market crash, and the global currency wars that have ensued. Its back is against the wall–whether it likes it or not.
The Fed is in a pickle.