INSIGHTS

On September 18, 2015

Regardless of Fed Rate Decision, Opportunity Exists

“The less there is to justify a traditional custom, the harder it is to get rid of it.”

- Mark Twain

One of the more profound traditions that exists is the proliferating of a narrative as common knowledge without much critical analysis to affirm its validity….let alone relevance. As a parent, I am reminded of just how deep this tradition is and what outlandish claims can be accepted as truth.

While most can argue effectively that the Fed should or shouldn’t raise rates at this time, one thing that won’t occur is their intentions of moving off of ZIRP (Zero Interest Rate Policy). It won’t catch the markets off guard as it did in 1994, both in timing and severity. 

The markets’ volatility and complexity often lead to a “grape vine effect” in which an audience starved for the conspiracy theory affirmation will shun all mundane explanations. Locating common narratives that we feel may be false, or at minimum, completely priced in often offer tremendous value for the critical thinker willing to buck the trend.

The Fed raising rates will ____________. People will often filled in this fill-in-the-blank with negative results for domestic equities, emerging markets, foreign currencies, interest rate instability for all debt, etc.…. However, look at an analysis done by Credit Suisse on past impacts on global equity markets nine months prior and 12 months after a Fed rate hike (note 2013 is used for its general interest rate spike when the 10-year went from 1.60% to 3.02% in eight months). Compared to the previous cycles, the global markets have sold off earlier and more severely, offering an opportunity for those who believe the Fed raising rates is not going to catch the markets by surprise.

Source: Federal Reserve, Credit Suisse

To see just how much anticipation has been in the global markets, consider the chart below showing Global Risk Appetite and when Fed Fund hikes occur. We have never seen the Fed begin rate hikes when the global risk appetite is below its zero line.

If we extrapolate this out, consider the impact of the Fed raising rates on commodities and materials. We have mentioned this on several occasions, however, the narrative has only grown stronger when recent history does not bare it out.

Consider the impact on commodities when the Fed has raised interest rates in the past. The last three significant periods of rate increases has shown substantial increases in commodities. 

Source: Bloomberg

Although there are a multitude of reasons why commodities and materials are attractive; a few stand out.

One thing that has gone completely unnoticed is the huge increase in household formation in the United States over the last year, jumping to 1.683 million annually, according to data from Bloomberg. I believe this may be the most prominent reason to consider being overweight commodity and materials.

That’s double the average since the end of The Great Recession.

As evidenced by numbers this week, the housing sector has quite a bit of punch left in it. The builders’ confidence index compared to annual housing starts looks to affirm the view that materials are primed. The anxiety of builders is under building by 26% over the long-term average.

Source: Bloomberg

In the chart above, the yellow line is housing starts annually and the white line is builder confidence. The period of 1998-2005 averaged 1.676 million new homes annually when the confidence number was averaging 62, its current level. One could argue we get to that level of 1.676 million new homes being built based off of the new household formation, but we don’t foresee see that type of construction taking place.  We believe builders could get to 1.45 million new housing starts, which would be roughly $115 billion in annual sales increases from today’s levels; roughly increasing demand on materials by $75 billion annually. We believe it is unlikely this information is factored into the bears’ case for commodities or materials. Further, when housing has averaged 1.45 million new builds annually since 1985, GDP averaged 3.31% compared to the long-term average of 2.6%. This is an increase in GDP just a little more than our calculation of housing’s potential contribution above.

With residential housing investments averaging 5% of annual GDP, a growth of this sort would add 0.6% increase in GDP from current levels. The carryover impact on servicing housing, which is another 10-12%, would be amplified as well and the materials universe would have an even bigger impact. We believe this narrative is completely disregarded by the majority.

One last point to the value we see in the materials and commodity sector is the large pullback over the last couple of years. The current level matches where it was in 2001. Since then, global GDP has grown 135% from $33 trillion to a 2014 ending value of $77.8 trillion. Surely, despite technology increasing, we are using more base materials and commodities than we did then?

One other narrative which isn’t consistently confirmed by history is the U.S. dollar and its incredible rally on the news our rates will be rising comparative to global rates. We do see long-term rates rising ultimately, but the rate of increase in the dollar should bring everyone to at least gauge how much is priced in. It turns out, the move in the dollar has followed almost exactly the same pattern as 1993/1994.

The U.S. dollar’s increase is already pricing in interest rate hikes. However, the dollar’s rise in 1992-1993 anticipated the Fed hiking rates in 1994. Once that began, the dollar almost fell back to its pre-hike levels. This is in the backdrop where the Fed Funds rate went up 300 basis points in 13 months. Is the gauge of the U.S. dollar’s rise anticipating a hike of 300 bps (basis points) in 13 months? We don’t believe so and it could catch the largest speculative bullish position in the U.S. dollar with no ammunition to continue its run.

We have also seen a shift in the leading and lagging moves in the dollar and interest rates. Prior to 1992 it appears rates were leading currency moves, while since then we have seen the opposite.

So as we embark on the markets now increased anxiety over the Federal Reserve’s rate trajectory and global economic ramifications, it is time to evaluate how much future actions are priced in. We see the recent pull back in equities, here in the United States, Europe, China, and select other emerging markets as buying opportunities. As detailed here, there are several areas that appear to be pricing in an interest-rate scenario that may take four years to materialize, if at all. Again we will quote Mark Twain, who may have been the best at delineating between the minority truths and majority falsehoods in human nature.

“Whenever you find yourself on the side of the majority, it is time to pause and reflect.”

- Mark Twain

CRN: 2015-0901-4927 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.