A Strong Dollar from Rising U.S. Rates

A Strong Dollar from Rising U.S. Rates

October 19, 2018

Dear Friends,

The S&P 500 had a great third quarter, outperforming most all other investments. A stronger dollar contributed to US stocks outperforming emerging market equities, oil, and gold. While the S&P was up 7.7% for the quarter, emerging markets stocks were down 1.1%, gold was down 5.1%, and oil was down 1.2%. Even bonds were down, with the 10-year Treasury off 0.9%.

Investors focused on important macro drivers, especially easing fiscal policy, still-easy monetary policy (despite the Fed increasing short-term rates), and solid profit growth. Trade-related issues and rhetoric took a back seat for investors, as it is now pretty clear that the rest of the world will bear the brunt of tariffs and trade escalation. US stock investors have become thicker-skinned about negative trade-related news.

Putting tariffs into perspective, a 25% tariff on $250 billion worth of Chinese manufactured goods would generate $63 billion in “taxes” on them. About $53 billion of that would be “new” because there was already a 3.8% import tariff. Corporations and consumers will absorb most of this tax. Why consumers? Consumers get hit because higher imported goods costs get passed through as higher prices. But because household net worth increased by $8.1 trillion in the last year (according to Federal Reserve data) and incomes increased by $400 billion (according to the Bureau of Economic Analysis), the new tax will barely make a dent in aggregate net worth and incomes. This explains why market participants are not overly concerned about broad economic damage wrought by tariffs and even seem optimistic that the US will negotiate better trade terms.

Within the market itself, third-quarter returns varied widely across sectors, which is common during periods of narrow market leadership. Healthcare, up 14.5%, had its best quarter in history, with technology and industrials also outperforming the broad market. Energy, materials, real estate, and utilities (investments that suffer from rising rates and a stronger dollar) all under-performed.

One area of investor concern has been the housing market because it is such a large component of people’s net worth. Naturally, the prospects for the housing market impacts household economic decisions. When rates rise, concerns increase about housing affordability and lending standards and what that means for the future of home prices. Affordability of and access to credit affect people’s willingness and ability to buy homes. The most recent housing-related data has been slightly weaker than anticipated, and investments tied to housing have traded down as a result.

It’s true that housing affordability has taken a hit through rising home price inflation and higher mortgage rates. However, when you put affordability in a historical context, you can see that it is still better than the 1992–2007 range (see chart below). This is largely because of generationally low mortgage rates. As long as mortgage rates do not increase significantly, job certainty remains intact, and wage growth picks up steam, the US housing market is unlikely to suffer a major setback. This is especially true because household formations are still running at a higher clip than housing starts and permits – signaling that demand is outstripping supply. Historically, this translated to higher future prices; though this is a negative for affordability, it is good for homebuilders in the shorter-run.

Lumber prices (a major new home cost component) were down 30% during the third quarter, which could help support new home affordability as mortgage rates increase. This, combined with low housing supply, rising wages, rising demand (and pent-up demand from multi-decade high levels of adult children living with their parents), easy lending standards, and still-low mortgage equity withdrawal levels, makes it unlikely that housing will cause the next crisis or recession.

We believe the equity investing backdrop remains strong. Although rising rates present a challenge, they are increasing gradually and predictably. We expect one more hike in December and three more in 2019, bringing short-term rates to 3.25%. This is still very low by historical standards. One major factor we will be monitoring is stock buybacks, which have been a significant source of market liquidity. The financial engineering benefits of doing stock buybacks declines in a rising rate environment, so their impact as a source of market liquidity for stocks is now more at risk. Beyond that, we believe our investment portfolio possesses great long-term value and offers significant upside potential.

Thank you for considering Highgate Securities Investments to help with your investments. If you would like more information about our services and approach, please visit our web site at www.highgatesi.com or call us at 303-968-1230. We are happy to provide a no-obligation consultation to evaluate how we might be able to benefit your investment situation.

Best regards,

John Goltermann, CFA, CPA, CGMA

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