April brought a little more stability as volatility eased, but the tug of war in the media regarding everything from politics to the weather kept investors on edge for most of the month. If you are optimistic about the future, there were certainly enough headlines to justify that position and if you are of the opinion that the best is behind us, you could find the data to validate that argument as well. With no clear leadership and lack of conviction on either side of the trade, the major indices closed out the month with little changed. The real newsmaker for the month was 10 -year treasury rates, which breached the 3% mark for the first time since 2014. This, combined with oil trading at the highest level that we have seen since 2014, stole the headlines and led to caution about the combined effect of higher energy prices and higher interest rates acting as a one-two punch against the momentum of the economy.
On April 24th, 10-year treasury rates finally crossed over 3% for the first time since January of 2014. At the same time, 2-year treasury rates set a multiyear high, topping 2.5% for the first time since 2008. To put some context to the move in short term rates, 10-year rates started the year at 2.4%, basically where they spent most of 2017. Just four months into the year and short-term rates have surpassed where long term rates started the year. This is just one of the many reasons for the stock market to have a reason to pause. Higher interest rates benefit those who save but, eventually have a slowing effect on the economy as it increases the cost of money for borrowers. This comes at a time that as a country, we are borrowing at record levels to finance our debt. In a CNBC interview on April 25th with Gary Polack, head of fixed income trading at Deutsche Bank Private Wealth Management, he stated, “this week’s Treasury auctions of two-year, five-year, and seven-year notes are likely to set a record in terms of size.” An increase in the supply of new debt can put downward pressure on prices, leading to even higher yields. Long term treasury rates set rates for home buyers in the mortgage market, leaving many to begin to question the health of the housing market in the coming months.
The rise in mortgage rates comes at a time when inventories are tight and a robust labor market with rising wages has buyers out looking for homes. Home prices accelerated again in February, marking the 70th consecutive month of rising prices. The S&P CoreLogic Case-Shiller National Home Price Index, which covers the entire nation, rose 6.3% in February. “With expectations for continued economic growth and further employment gains, the current run of rising prices is likely to continue,” according to David Blitzer, managing director at S&P Dow Jones Indices. The previous housing boom lasted for 182 consecutive months from January 1992 to February 2007, indicating the current strong price gains could have a long way to run. The rising mortgage rates, along with new tax legislation that reduces the incentives for home ownership, will certainly challenge this notion. The median price for an existing home in March was $250,400, up from 5% a year earlier. Economist, Chris Rupkey, noted that wages are rising at about half the rate of home prices, making homes less affordable by the day. Based on a 5% increase in the prices from a year ago and the increase in the mortgage rate, the monthly payment for the same home financed with a 30-year mortgage has increased by $174 per month.
Here in New York, the health of the real estate market may face some headwinds of its own. In a recent article in the Wall Street Journal, economists, Arthur Laffer and Stephen Moore, predict that over 800,000 people will flee New York and California over the next three years. Tax legislation limiting the deduction of state and local taxes to $10,000, will increase the tax burden on high income earners in high tax states. It is their position that, “In years to come, millions of people, thousands of businesses, and tens of billions of dollars of net income will flee high tax states for low tax states.” Their theory is challenged on the basis that both states have always been high tax states and that the number of millionaires in both states has been growing not shrinking. The impact of the strength of the economy, the cost of rising interest rates, the effect of tax legislation, and the affordability and desirability of specific markets are all questions challenging the housing market from the entry level home to the high-end market. Housing’s far reach throughout the economy make this topic one that we will continue to monitor as it will have an impact on the economy and the markets. With the Fed set to raise interest rates several more times this year and GDP coming in slightly above estimates, the interest rate debate will continue.
With summer driving season just around the corner and consumers armed with the additional take home pay from the new withholdings going into effect recently, the rise in gas prices threatens to take the expected increase in spending right out of their pockets before summer is officially even here. Oil prices have doubled from two years ago and are up $30 per barrel since the low of last season. We are now paying more at the pumps and analysts say we should expect to keep digging deeper into our pockets throughout spring. With the 5.8% rise we suffered in April, gas prices are at the highest level we have seen since October of 2014. According to an analyst at Deutsche Bank, if the per gallon price were to rise by an additional $1.05 it would wipe out the gains from last year’s tax cuts for most consumers. Favorable economic conditions around the world, combined with OPEC and Russian production cuts in place through the end of the year, create an environment for steady and possibly rising prices. Demand for oil is forecasted to continue to rise. This provides the potential that the United States may reach a new milestone this summer by having a full week that the demand averages over 10 million barrels per day. It is estimated that by the third quarter, due to the unusual strength around the world, demand could outstrip supply by about a million barrels per day. The good news is that experts expect the pain to be temporary, as higher prices will lead to higher production.
With fears of higher commodity prices and rising interest rates, the market is starting to worry about inflation. Given our discussion focused on housing and energy, I thought it would be interesting to look back to the past at the inflation adjusted cost of these two essential parts of the economy. In 1976, a gallon of gasoline was $.60 and adjusted for inflation it would cost $2.65. The national average price one week ago was $2.77, not much higher than the inflation adjusted price from over 40 years ago. The average cost of a home in 1960 was $11,900, which, adjusted for inflation would be equivalent to $98,681 in today’s dollars. According to Zillow, the median home value today is $210,200. For those of you who are baseball fans, you will find this next statistic very depressing. In 1976, you could have bought a ticket for a box seat to a Yankee game for $5.50, this would be a $24.27 purchase in today’s dollars. I would bet anyone that is a Yankee fan would be happy to pay that to see a game today, however, you would have had to shell out $245 for a box seat last year.
Our strengthening economy is being met with some challenging headwinds. It should therefore not be surprising that as of the end of April, the markets were marginally negative for the year. It is normal for investors to take some time to digest a big year like the one we had last year. We view rising rates as a normalizing process. We have suffered the consequences of a deflationary economy for the last several years and a little inflation is a good thing. Rising home prices are a natural function of a strengthening economy and are generally stabilized by affordability and supply. These are all things that are part of the latter stages of a recovery. It does not mean it is the end of this expansion but, more likely that future return expectations need to take into consideration that the economy has mounting challenges.