Charting The Course

No March Rate Hike. (Surprise, Surprise, Surprise.)

By Mitch Siegler, Senior Managing Director

Mitch SieglerThat was the signature line of Gomer Pyle (Jim Nabors), the good-natured, naïve fellow from Mayberry, North Carolina in the 1960s television program, The Andy Griffith Show.

Nothing really worked for Gomer the way he thought it would and nothing now is really working the way most of us thought it would. (And we’re not just talking about the Bern, Trump and the rest of the merry band.)

We weren’t surprised about the Fed’s March 16 decision to stand pat on interest rates and the Fed’s announcement that it now sees just two 2016 rate hikes, down from four in December. The conventional wisdom now is that June is the new March. Perhaps – but even Gomer might not leap to that conclusion based on the current fact set. The Fed desperately wants to raise rates so they’ll have a few spare bullets to fight a future recession. The conundrum – raising rates in the absence of inflation may actually bring on that recession. The Fed’s between a rock and a hard place.

Now, compared with their central banker pals in Europe and Asia, Fed governors have it good. Those other guys are really in a box having resorted to negative interest rates. Paraphrasing Henny Youngman, “take central bankers – please.” They basically say “give me your money. I’ll hold it for you and rake a little off the top. Then – and here’s the kicker – I’ll give you back less than you originally deposited with me.” Now, who in his right mind would take that deal?

Well, that deal is the new normal in Europe. The European Central Bank (ECB) just lowered its key overnight deposit rate from -0.3% to -0.4%. Now, all European banks must pay the ECB 40 basis points (bps) for the privilege of depositing their money. Oh, joy!

The ECB also expanded its quantitative-easing program with an additional €20 billion per month of bond purchases in a further attempt to stimulate a moribund economy. Meanwhile, ECB President Mario Draghi said interest rates would stay “very low” for at least another year. Super Mario thinks deflation is here to stay – the Eurozone would have faced “disastrous deflation,” if the ECB hadn’t gone even more negative, he said.

It’s a similar story in Japan, where the government gets paid to loan money. For the first time ever, the Japanese government sold $19.4 billion of new 10-year bonds with an interest rate of 0.1% at an average price of ¥101.25 – do the math and the effective yield is -0.024%. The government also sold 30-year bonds at an all-time low yield of just 0.47%. Like us, Japan runs a large budget deficit and has huge debt (240% debt-to-GDP ratio); these negative-yield bonds will help Tokyo a skosh because more than two- thirds of Japan’s government debt now carries a negative yield.

Percent DecreaseAnd it’s not only governments. In March, a German mortgage bank was selling bonds with negative interest rates. Berlin Hyp AG was offering €500 million (US$550 million) in 3-year bonds at a yield of -0.162%. Virginia, it’s a brave new world. When companies are able to jump on this crazy bandwagon, it’s a safe bet that it won’t be long before the miniscule interest rates you may be earning from your U.S. fixed income portfolio stand a good chance of turning negative as the rocket scientists at the Fed consider joining the other central banks at the NIRP (negative interest rate policy) party.

It’s not easy to swim against the tide in a world that’s awash in negative rate debt. There’s already $7 trillion of negative-yielding debt swirling about, almost 30% of the Bloomberg Global Developed Sovereign Bond Index. And, it’s an A-list of issuers, countries like Switzerland, Sweden, Denmark and Japan plus the European Central Bank. We’ve seen this movie before – for a brief period during the 2008 financial crisis, U.S. Treasury bill yields actually turned negative as investors, seeking a safe haven, poured into Treasuries sending prices skyrocketing and driving yields into the negative.

The “New Normal” in Real Estate

These upside-down central bank policies combined with the comic book environment that is American politics, circa 2016 (yep, truth is stranger than fiction) will likely exacerbate the already heightened level of market volatility making for a challenging investment climate. Meanwhile, we’ve observed several interesting shifts in real estate that are worth pointing out.

  • Office space per worker has plummeted – The real estate brain trust at Goldman Sachs Asset Management’s Alternative Investments Group found that companies lease substantially less space per worker nowadays than they did in the 1970s – a decline from 600 feet/worker to just 176 feet/worker in 2012. Law firms, in particular, are leasing about one-third less space than a decade ago because cloud-based storage has replaced law libraries and file cabinets. Implications galore for investors, landlords and tenants.
  • Cloud Computing

  • Cloud computing is also lessening companies’ office space requirements – At the recent Amazon Web Services (AWS) re:Invent 2015 conference, both General Electric and Capital One Financial Corp. mentioned that they were closing a significant number of their data centers and moving workloads to the AWS cloud. Moving to the cloud makes companies much more efficient since it frees them from building excess capacity for their peak usage requirements.
  •  

  • A housing bubble has given way to a housing shortage – The bubble in homeownership that was the catalyst for the 2008 financial meltdown has now been completely eliminated, even reversed. Subprime, Alt-A and other forms of liar loans which led to millions of homes sold to people who weren’t qualified to buy them or service the mortgages have given way to more stringent loan underwriting standards and demographic forces have brought about a dramatic decline in the homeownership rate (from 69.4% in 2005 to 63.7% in 2015). In many markets, there’s an outright housing shortage, driven by strong household formation and solid demand for homes that is once again stimulating new construction.

    Mortgage Increase

  • The inevitable mortgage interest rate increase is nowhere in sight – For the past couple of years, people raced to refinance in order to avoid the big rise in rates that everyone knew was just around the corner. It’s a question of when, not if, folks said. As recently as December, pundits predicted four rate increases in 2016 – now it’s looking like two, at most. Today, rates are incredibly depressed with 30- year mortgage rates having been lower just 5.9% of the time since 1976, according to Goldman Sachs. It would take a big increase in mortgage rates to put a big dent in today’s high home affordability. In fact, mortgage rates would need to increase almost three full percentage points to return housing affordability back to its long- term average.

    Turbulence brings volatility and volatility brings stress. But it also creates opportunity for those whose eyes are open. Surprise, surprise, surprise.

    Mitch Siegler is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. Reach him at msiegler@pathfinderfunds.com.