10-15 Associates

How Low Will They Go?

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There is an old saying on Wall Street: “sell in May and go away.” This would have been one of the years that such advice would have worked very well.

All three major indices suffered losses for the month, and it didn’t help if you were diversified into international markets, as the vast majority of markets around the world were down. The Nasdaq was hit the hardest, losing 7.93% for the month, while the Dow and S&P 500 gave back 6.69% and 6.58% respectively. Although markets are still higher on the year, the change in sentiment was evident all month. Oil was the biggest loser, with WTI declining 16.29% for the month. The fears of an economic slowdown due to the uncertainty of a lack of a trade deal caused economically sensitive sectors such as commodities to react more aggressively. Perhaps that biggest surprise of the month was the collapse of interest rates. Since the reversal of policy by the Federal Reserve, markets are now pricing in rate cuts later this year.

Ten-year treasury rates closed out the month at 2.12%, down 15.08% for the month and down 20.85% for the year. Equity investors pay a lot of attention to what is happening in both the commodities and interest rate complex, so the signal from these two sectors did nothing to ease the fears of a slowdown ahead.

For the last decade, the Federal Reserve’s role has been a powerful and growing force on the impact of the financial markets. The residual effect of aggressive monetary policy around the world is still creating complex and difficult to interpret markets. As U.S. rates declined over the last month, investors questioned if the cause was linked to bond investors forecasting a recession, or simply the connectivity of U.S. rates to worldwide interest rates. According to James Grant in an article in Barron’s this past month, the quoted value of negative-yielding debt hit $10.6 trillion, the highest since September 2016 and almost double the volume last October. It is still incomprehensible to most of us that an entity or government would pay you to borrow money. The theory behind negative interest rates was that by inhibiting savings and stimulating spending, it would work as an economic jolt to the economy. The problem is that human behavior cannot always be predicted. While negative rates are not unprecedented, they are rare, and consumers interpreted it to mean that something was wrong. When something is wrong, you save more, not less. In addition, savers need to accumulate more principal to compensate for less interest. At an earnings rate of 1% it would take approximately 72 years for money to double. If the rate is at .01% it would take approximately 7200 years for money to double. For negative rates, it works in reverse, at minus 2% your principal would be cut in half in approximately 32 years. Think of this in context of the 2% inflation rate the Fed is looking to achieve. With little to no rate of return and some inflation, investors are struggling to preserve capital.

From an investment perspective, one needs to think about who is buying all this negative interest rate debt. It would be hard to believe that investors trying to accumulate capital would pay for someone to hold on to it for them. The answer may be quite shocking for investors who are working hard every day and socking away money into their 401K. A very popular choice for many participants is target date funds or passive index funds. Index investing has gained popularity over the last decade offering a low-cost ease of management option. Any passive strategy that has a bond component is designed to mimic an index, and for bonds, most are tied to the Barclays Global Aggregate Bond Index. This index, along with others are buyers of this debt, therefore millions of Americans saving for their retirement are active buyers that hold a majority of these negative yielding bonds. The long-term implications of this are not yet understood.

On a positive note, low interest rates feed directly into the housing market. It should not be a surprise therefore that the data showed an improvement in the housing market. Housing starts rose 5.7% last month, driven by gains in the construction of both single and multi-family housing units according to the U.S. Department of Commerce. Building permits rose as well after declining for the previous three months. Mortgage activity increased, led by refinances, which saw not only a jump in activity but an increase in average size, as borrowers with larger balances responded to lower rates. Investors have reacted as well, adding $169 billion in new assets to bond funds according to data from ICI. This comes as a time when the millennial generation is coming of age. This year the oldest millennials are turning 38—a prime age for young families and household formation. The youngest millennials, in their early 20’s, are finishing up college and graduate school and are entering the workforce at a time when jobs are plentiful and the demand for young workers is the strongest in years. Both should continue to drive demand for single family and multi-family housing. According to Accenture, millennial spending will account for $1.4 trillion in U.S. retail sales in 2020, representing approximately one quarter of total spending. The impact will be felt in everything from housing and dining to fashion.

As the younger generation advances into the workforce, the baby boomers are aging into retirement. The challenges to “age in place” and find suitable housing options is driving new innovations for a much more active retirement than in past generations. Innovative solutions including communal communities, condos equipped with aging-friendly equipment, communities linked to universities for retirees to go back to school, and multigenerational housing are springing up around the country. It is estimated that beginning in 2035, 2.5 million seniors per year will be leaving their current residence and there are not enough new housing options available to meet that demand. Although 80% of adults over the age of 50 would choose to stay in their home as they age, only 50% of those people expect that they will be able to. Spending by the baby boomer generation to solve for better solutions in the next decade along with the need to care for an aging population will create new and innovative options to meet the growing demand.

Long-term demographic trends may be a much more useful way of thinking about financial markets. Daily headlines create short term trading opportunities that can vanish as quickly as they appear. Understanding and evaluating long-term spending patterns can help keep the focus on where dollars will be invested over longer-term periods of time. The current crush of headlines will continue to dominate the media and cause short term volatility in both directions. Until this creates a material impact on the trajectory of the economy, it should not change your investment philosophy.

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