The first Fed rate hike in nearly a decade came and went December 16, putting an environment of ZIRP (zero interest rate policy) to an end, a policy that grew out of the Financial Crisis and the depths of the Great Recession late last decade.
The Fed had paused plans to hike the federal funds rate for much of 2015 as a result, in our view, of getting a more informed read on the potential implications of emerging market developments–namely dislocations in the local Chinese equity markets (FXI) and recessionary conditions in Brazil (EWZ)–and the stock market crash (SPY) in the US in August that sent equities of some of the most well-known stocks including Apple (AAPL) and General Electric (GE) tumbling. With several months now past since those events, the latest read on US economic data indicates to Fed officials that the impact from the aforementioned events may not be too severe, giving the committee the confidence to inch toward a higher interest-rate environment, if for the sole reason to generate some monetary-policy flexibility in the event US economic growth sours, or in the event of a broader global financial calamity not yet known.
After months (if not years) of telegraphing and “talking about talking about” raising rates, the Fed finally did it, increasing the target federal funds rate to the range of ¼ to ½ percent, noting to perhaps soften the blow to the equity markets, that “the stance of monetary policy remains accommodative after this increase.” Though many market observers are hoping for a scenario of “one (raise) and done,” we think Janet Yellen and team wouldn’t have taken the first step at all if they didn’t have a higher target interest rate in mind.
In the release, the Fed noted that “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” Valuentum believes the hike will be the first of many in the coming years, though as the release explained “the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.” Junk spreads, which are north of 700 basis points, according to Moody’s, could limit the pace of increases, as the absolute cost of borrowing would be prohibitively expensive.
Though one of the most anticipated pieces of news in some time, it’s important to note that the modest rate hike by the Fed, by itself, should be nothing to panic about — alone, a quarter point really shouldn’t mean much at all to the broader equity markets. That said, however, a prolonged contractionary monetary policy is a much different consideration and surfaces several concerns — 5 of our biggest are listed below.
1. Continued Rout in Commodity Prices
We need to cover some economics first.
In the event of ongoing interest rate hikes by the Fed, yields on US government-backed debt and corporate bonds (in absolute terms), which are tied to the risk-free rate in the US, will generally increase, all else equal. This scenario would then serve to attract non-US capital to the US dollar, which would be needed to buy the incrementally higher-yielding US assets, in turn driving the value of the US dollar higher relative to other currencies.
For corporations operating in non-US dollar terms, dollar-denominated commodities are then more expensive to them due to the exchange-rate shift. All else equal, this would then result in a price-driven reduction in demand for such commodities until inevitably the US dollar denominated commodity price reaches a sufficiently low level until a new equilibrium is set, where demand then equals supply again.
Though widespread economic generalizations are neither absolute nor precise, the likelihood of a continuation of the rout in commodity prices from crude oil (USO) and natural gas (NGAS) to iron ore and beyond, in the event of ongoing rate hikes, is enhanced, if not accelerated. The weekly petroleum status report from the EIA, for example, released December 16, continues to note that “at 490.7 million barrels, US crude oil inventories remain near levels not seen for this time of year in at least the last 80 years.” OPEC’s new strategy of producing to put weaker US domestics out of business is also pressuring the price of the black liquid, like no other time in economic history (price stability is no longer its objective).
Further, just this week, the Journal noted that natural gas prices “plunged to a 16-year low,” and our contention is that global conventional and unconventional resources of natural gas are sufficient for more than 200 years’ worth of demand at current rates, which in our view, is enough to pressure prices for some time (well beyond this unseasonably warm winter season). Weakening construction activity and steel-making in China coupled with ongoing over-production at the largest iron ore companies, including BHP (BHP) and Rio Tinto (RIO) could keep iron ore prices at 10-year lows or lower. The implications on mining equipment spending may challenge Caterpillar’s (CAT) dividend, just as it has done with Joy Global (JOY).
On a very high level, a multiple rate-hike scenario in the US could cause more pain at US commodity producers and reverberate through the energy services and mining equipment supply chain, a concern that would only be exacerbated by the direct result of tightening credit, itself. According to Bloomberg, for example, the oil industry “needs half a trillion dollars to endure (the) price slump.” Such debt capacity may simply be unavailable or prohibitively expensive in coming years; the credit rating agencies, for one, are already expecting a significant ramp in high-yield defaults, and it might get a lot worse if the Fed hits the brake too hard.
Though we may comment from time to time, we’ve dropped some of the lowest quality oil and gas names, Legacy Reserves (LGCY), Linn Energy (LINE) and Ultra Petroleum (UPL), from our valuation coverage universe.
2. Ongoing Pressures on Emerging Market Currencies
From a global perspective, for those whose wealth and income is generated in US dollars, one can arguably buy more with one US dollar today than at any other time in more than a decade, according to a popular index that measures the value of the dollar versus a basket of other currencies. Ongoing rate hikes by the Fed means, in our view, that assets may continue to fly into US greenbacks from all over the world, for better risk-adjusted yields but also for capital preservation. The dollar has been strengthening for some time against the euro, the pound, the loonie, the aussie, the rand, and the list goes on and on. There’s very little doubt in our minds that the US dollar will remain the world’s reserve currency for the foreseeable future (sorry conspiracy theorists).
To long-time market observers, the summer of 2015 has acted as a bout of nostalgia, as emerging market currencies dipped to levels not seen since the currency crises of the late 1990s–the 1997 Asian financial crisis and 1998 Russian financial crisis–that led to the collapse of hedge fund Long Term Capital Management. From our perspective, in the event that emerging market economies, including those of Brazil, most of Latin America, and Asia continue to weaken, rate hikes in the US may inflict significant damage to their respective currencies as asset flight from those countries take hold. Simultaneous weakness in commodity-based economies such as Canada (EWC) and Australia (EWA), as a result of several of the secular drivers noted above, could drive the US dollar to nosebleed levels against a basket of emerging-market currencies.
We’ve witnessed the US dollar gain a tremendous amount of strength during the past few years, and we would not be surprised to bear witness to a “US dollar value spike” in coming years, as assets in higher-risk geographies flow back into America. From where we stand, the Fed is walking a very tight rope, and the summer of 2015 hinted at what an international currency crisis would mean for US equities: on Monday, August 24, the Dow Jones Industrial Average (DIA) opened 1,000 points down and followed that up Tuesday with another 200+ point drop. It could be much worse in the event large hedge funds are caught by surprise and forced-selling ensues should a more severe currency dislocation ensue.
3. Deflationary Possibilities Are Difficult To Dismiss
This isn’t a popular observation, but the cost of living in the US isn’t that bad, all things considered. Let’s walk through a few anecdotes.
Though rent and transportation costs can vary by region in the US and around the world, rent conditions in the US aren’t that tight, at least from our perspective. For one, housing prices have yet to recover from the go-go years of late last decade, and many housing developments and subdivisions remain unfinished, abandoned in many cases. The foreclosure market (unfortunately) still looks robust, and bargains can still be had, even in some of the “nicest” areas of the country. The price of gasoline has plummeted, and one can lease a brand new daily driver, a new Nissan Sentra, for as little as ~$60 month (~$2/day) with very little down, for example.
Though commodity cost inflation continues to challenge some restaurants (e.g. Buffalo Wild Wings–BWLD–and chicken wings, for example) and food products companies alike (egg prices, for example, have surged), the reality is that one can order 10 chicken nuggets from Burger King (QSR) for just $1.49. If chicken nuggets aren’t your “thing,” two pizzas from Little Caesars can feed a family of 4-6 and only set the buyer back $10 plus tax. A senior coffee at McDonald’s (MCD) costs less than a $1, and Mickey D’s has been known to give coffee away for free as a loss-leader to stimulate demand.
This is what we’re trying to say: If significant and prolonged accommodative monetary policy has done little to send living, transportation and food costs “through the roof,” what will happen under an environment of ongoing contractionary monetary policy, one with rate hike after rate hike? In this context, we have a difficult time dismissing deflationary concerns, even if such on-the-ground references are regionally-oriented and anecdotal. What about inflation? In our view, there have been two primary areas: wage levels (think: the Fight for $15) and the US stock market (the S&P 500 has literally tripled since the March 2009 panic bottom). Could this contractionary monetary cycle be the one that sparks a feared spiral of ever-lower price levels?
4. Continued Pressure on Multinational Reported Operating Earnings
One of the biggest themes of 2015 has been the analytical focus on “currency-neutral” performance. From Coca-Cola (KO) to Pepsi (PEP) to Procter & Gamble (PG) to Kimberly Clark (KMB) to Philip Morris (PM) to Johnson & Johnson (JNJ) and beyond, multinational equities have witnessed reported top-line and operating-income growth shrink due to pressures from currency translation.
Though many have excused negative foreign-exchange headwinds as a transient, impermanent event and perhaps rightfully so, ongoing rate hikes in the US could drive the US dollar to new heights, which would then act to pressure reported operating results at some of the largest multinationals. It’s very possible that currency headwinds may turn into a way of life for global firms housed in the US next year, and for as long as the US dollar strengthens. Typically adjusted to reflect currency-neutral performance, earnings estimates in coming years may not be factoring in this reset.
Will investors continue to accept with open arms currency-neutral performance, or will this contractionary monetary cycle result in a structural shift that pushes the US dollar permanently higher, where reported results become the “new norm?”
5. The Tipping Point in Yields
From our September 3 observations:
We give Ben Bernanke and team a lot of credit for successfully delaying a prolonged global economic recession following the worst financial crisis of our generation late last decade, one that swallowed up such household names as GM (GM) and AIG (AIG), but such policies always come with unintended consequences. New Fed Chair Janet Yellen may have to deal with the true aftermath, and it’s been thrust upon her, perhaps unfairly.
…retirees and near-retirees, after suffering significant capital losses during the Financial Crisis, have been lured into higher-yielding dividend-paying equities, the prices of some almost completely supported by debt-infused dividend policies. What’s worse, many retirees and near-retirees have seemingly been schooled by their financial advisors to completely ignore market volatility and focus on long-term goals, with the assumption that the income streams associated with these lofty high-yielders are supported by organic means.
The problem is that with respect to most MLPs, the preferred vehicle of choice for some retirees and near-retirees seeking income, it is our contention that their equity prices are being propped up by a distribution that can only be sustained via external capital market issuance in the equity or debt arenas. Not only that, but most capital-market-dependent dividend payers are being priced as fixed-income vehicles on “growing coupons” that are, in our view, financially-engineered, inorganic dividends. Said differently, such equity instruments are fetching valuations that have become materially disconnected, in our view, from traditional organic free cash flow measures of their underlying operations. With their distributions used as “growing coupon payments” for retirees and near-retirees, their equity prices have inevitably become more debt-like than could have ever been imagined.
A contractionary monetary tightening cycle, in our view and by extension, will be devastating to those same retirees and near-retirees that flocked into high-yielding dividend payers, after losing significant capital during the Great Recession. Not only will these “debt-like” dividend-paying equities be repriced substantially lower in the event of contractionary monetary policy as interest rates rise, but the lending environment will also tighten under such conditions, in our view, further exacerbating tangible project NPVs and organic free cash flows of these entities as well. Such conditions, in our view, would spell massive declines in some of the highest dividend-paying stocks as 1) the debt-infused bubble is popped (and shares/units are repriced lower and re-valued as “true” equities), and 2) their economic profit streams are squeezed due to higher borrowing costs and costs of capital…
…(as) the Fed starts to raise interest rates, we’d expect (the possibility of) significant asset-flight out of equities (to increase), led by selling in unsustainably high-yielders spreading to speculative “lofty-multiple” entities and beyond, something we’ve been talking about for some time…. one of the largest pension funds in the US, CalSTRS, was reported to be considering large asset allocation shifts away from equities, likely the first public announcement of many more to come.
The list of 5 concerns are not predictions, but mere possibilities, even as a couple of them are more probable than the others. As we’ve outlined many a time before, there’s never a good reason to panic about anything, and economic prognostications are fraught with risks and uncertainties. As we can only expect, the Fed will continue to monitor the data and adjust policy accordingly, and barring exogenous economic shocks from China or currency crises from weakening emerging economies, a rate hike here or there shouldn’t do too much damage to equities. That said, we’re still wearing our seatbelts with near-30% cash positions in each newsletter portfolio, just in case the Fed hits the brake too hard.
Related ETFs: TLT, UUP
A version of this article appeared on our website December 17, 2015.