By Justin Pawl, CFA, CAIA, CFP®
I’m trying a slightly different format. More detail about the market moving and key economic events from the prior week, plus a deeper dive into a specific topic or two. Let me know if you like it, hate it, or don’t read this blog .
Last Week Today.
- Apple announced a $90 billion stock buyback program, which is larger than the individual market capitalizations of ~400 S&P 500 constituents (e.g., the total market capitalization of Cigna Corporation, the 93rd largest stock in the S&P 500, is $87.7 billion).
- President Joe Biden announced his third round of stimulus. The American Families Plan contains $1.8 trillion of spending and includes a significant wealth redistribution component, also known as higher taxes for the “wealthy.” Combined with the already passed $1.9 trillion American Rescue Plan and the proposed $2.3 trillion American Jobs (aka, infrastructure) Plan, the Biden Administration’s proposed fiscal stimulus totals $6 trillion. For context, the annual GDP of the U.S. is ~$21 trillion. While not advertised, these proposals increase the role of government in our lives, and it’s worth remembering Ronald Regan’s quip about the nine most terrifying words in the English Language “I’m from the Government, and I’m here to help.”
- The April Consumer Confidence Index rose ~13 points to 121.7 (vs. expectations of 113.0). Combined with the rise in March, this is the largest two-month gain on record, though the index has not regained its pre-pandemic high ground.
- The Federal Reserve held its third meeting of the year. The overall tone was more optimistic about the economy, but it did not change, nor even hint at changing, current monetary policy.
- Q1 GDP rose a very strong 6.4% annualized. The reading was below consensus expectations of 6.7% but strong enough that total economic output has now fully recovered from the pandemic and lockdown. It’s worth noting that the effects of the lockdown and continued social distancing linger. While spending on goods exceeds pre-pandemic levels, spending on services (a larger piece of our consumer-led economy) remains depressed.
- The Fed’s favored measure of inflation (Core Personal Consumption Expenditures) rose 1.8% year-over-year in March.
- It was a soft week for global equities to close out an otherwise solid month that saw U.S. stocks leading the way, with the S&P 500 rising 5.3%. Developed international stocks (MXEA Index) gained 3.1%, and emerging markets (MXEF Index) rose 2.5%.
- Yields rose slightly for the week but declined in a subtle curve flattening during April. The yield on the benchmark 10-year UST is 1.63%, squarely in the middle of the 1.53% to 1.76% trading range since mid-March.
- Commodities were mixed for the week but solidly positive for the month. Industrial commodities (Copper +12.1%, WTI Crude +7.5%) outperformed safe-haven gold (+3.6%). Overall, commodity demand is robust, creating extreme pricing “backwardation.” The premium paid for commodities that can be delivered today versus the future is the largest since 2007. Typically, commodity prices are in “contango,” where future prices are higher than today because of the cost of storage and uncertainty around future demand.
Source: Bloomberg, L.P.
For additional asset class performance detail, click on the table below.
Real Estate to Cap Bond Yields? While most are familiar with real estate as an asset class, few appreciate the massive size of the global real estate market. The value of global equities and Global GDP is about $90 trillion each. Combined, they equate to approximately $180 trillion, which is a difficult number to wrap your head around…. until you realize that the global real estate market’s total value is $290 trillion (BCA Research). While total value of real estate has exceeded that of global stocks and GDP for a long time, since the Mortgage Crisis in 2007 – 2009 the spread has widened dramatically.
Anyone that knows someone who’s tried to purchase a home in the last year understands how tight the market has become. Multiple bids are the norm, and homes rarely sell for less than the asking price. Tight supply has made for a seller’s market, making home price appreciation look like Bitcoin in some cities.
Sources: Foleynomics and Covenant Investment Research.
Although the adage about real estate prices is “Location, Location, Location,” price appreciation is not limited to residential properties or the U.S. Indeed, real estate has become unhinged from economic fundamentals globally.
To this end, rental price appreciation is significantly underperforming real estate price increases, driving down the yield on real estate assets. To illustrate this point, hypothetically, assume a building generating $350,000 in annual net income was sold for $10 million in 2016. The rental yield on this property would have been 3.5%. Using the chart below as a rough estimate, fast forward to 2020 and assume the annual net income increased to $450,000. That equates to an ~5.2%% compounded growth rate in rental income, which is not bad. Yet, at today’s market yields, the property would be worth $15.0 million, and that same $450,000 would equate to only a 3% annual yield for the buyer. In this example, the property’s net income increased by 28.6%, but the property’s market value jumped 50%.
Fundamentally, lower bond yields are driving higher valuations across most asset classes. For real estate, rental yields have trended lower with global bond yields. Real estate prices (like bond prices) tend to be inversely correlated with yields, and higher real estate prices are driving declining yields.
But what happens if bond yields continue their recent trajectory higher? One would expect real estate prices to decline (along with other risky assets with stretched valuations). Given that global real estate dwarfs the combined size of the global economy and global stock markets, a decline in real estate prices has the potential to act as a massive deflationary force that would put downward pressure on yields worldwide. One need only look back to the Mortgage Crisis to understand how a decline in real estate prices can impact interest rates. From 2001 to 2007, the yield on the 10-year Treasury averaged ~4.5%. Following the massive decrease in real estate prices from 2007 to 2009, the 10-year bond yield has averaged closer to 2%.
We’re not predicting a repeat of the Mortgage Crisis. However, while some believe interest rates will move significantly higher from today’s levels, it’s worth considering the potential negative feedback loop that real estate prices may have on interest rates: higher interest rates –> lower real estate prices –> lower interest rates. That’s not to say that a rise in interest rates would immediately impact real estate prices, or that lower real estate prices would immediately unleash deflationary pressures on the global economy. Both the interest rate market and the real estate market are enormous and the interactions between these markets will play out over a period measured in years not days.
The future outcome for interest rates is as uncertain, if not more uncertain, that it’s ever been. Competing forces of money printing, higher debt levels, demographic trends in developed markets, etc. create a wide range of potential outcomes that include hyper inflation at one extreme and negative interest rates at the other. Accordingly, for traditional fixed-income investors today the environment is extremely challenging. Yields on U.S. government bonds maturing within ten years are lower than the inflation rate, meaning these investments lose “real” money. One must invest in bonds maturing in 20 years or more to realize a positive, but still paltry, real yield. Still, if interest rates move higher, investors in these long-dated bonds stand to lose significant principal on the “safe” fixed-income portion of their portfolio. There are solutions to this conundrum. But the solutions entail departing from the mindset of investing in what has worked best for the past 30 years.