- March 17, 2021
- Blog , The Trusted Navigator - Bernhard Koepp
Interest Rate Hiccups & When Good News is Bad News – by Bernhard Koepp, C.J. Lawrence 3-4-21 – YouTube Video & Transcript
In this video, Bernhard Koepp, CEO of C.J. Lawrence, discusses the rise in interest rates and its effect on the market. Normalization of the economy also means ‘Good is Bad News’ until rates stabilize. Rotation between stocks that have done well and more economically sensitive ones that haven’t, is quite extreme. Our portfolio positioning since Q4 2020 is to stick with winners but at a reduced weight and allocate into stocks like industrials and financials that are more correlated with the economic recovery. The volatility we are seeing is not the beginning of a new bear market but a normalization of market valuations and an economy going through the recovery and expansion phase of a “normal” business cycle.
Video Transcript
Bernhard Koepp:
Yeah, hi there, this is Bernhard Koepp from CJ Lawrence. It is March 4th, I wanted to give you an update on the markets and the economy. So the topic of the day is interest rates and inflation, so if you look at interest rates, they’ve gone up a lot in the last two or three weeks. When the chairman of the fed gave his speech a couple of weeks ago to Capitol Hill and to answering questions about the economy and the recovery and his outlook on interest rates, he was quite subdued. So he was saying that look, we’re going to keep interest rates low for a longer period of time and we would even let inflation run a little bit hotter than usual.
Bernhard Koepp:
So guess what? There is a market out there which is called the bond market, which has gone ahead of his projections, and basically pushed up interest rates in the yield curve. So just to review, the federal reserve only obviously, controls short term rates, the market, the bond market, controls longer-term rates. So if you go back to February 11th, which was about the point where interest rates started taking off, something interesting occurred. So every week the U.S. government goes into the market and offers new treasuries.
Bernhard Koepp:
So what happened in mid-February was the treasury auctions that the U.S. government was holding weren’t very well attended. So guess what? The investors or the investors who were buying our debt, these are foreign buyers or any buyers really, basically said, “Well Chairman Powell, it’s all very nice of you to say that interest rates will remain low, but we have a different view on inflation in the years ahead and growth. So we want more interest rate or more coupon than what you’re offering it to us.”
Bernhard Koepp:
So if we go through the yield curve, three year treasury rates were at 0.17% on February 11th. That’s obviously an incredibly low interest rate or zero basically, and guess what? That rate doubled basically on February 25th and at a high of 0.42%, still a very low number, but if you double interest rates, that really is a game changer when it comes to financing and for corporations who are borrowing money who have to think differently about the cost of your capital.
Bernhard Koepp:
So let’s go through the whole yield curve. Five year treasuries went from … Were at, on February 11th, they were 0.46%. They went to 0.83% by the end of February. Ten year treasury, which is probably the most important part of the yield curve, because that’s where mortgage rates are priced off of, so ten year rates were at 1.13% on February 11th and spiked up to 1.54% by the end of February. And if you look at long-term rates, which is the 30 year, they went from 1.9% to 2.2%.
Bernhard Koepp:
So the market has been in this rhythm right now. Every time rates spike up, today again, you had interest rates spike up seven basis points. I mean, it doesn’t sound like a lot, but in terms of the bond market, that is a significant move. So obviously, the bond market is ahead of the federal reserve here in saying, “Well, guess what? If you’re going to forecast a 5% or 6% GDP growth rate for 2021, interest rates need to be a lot higher.” So markets don’t like the step change in interest rates and typically one year in this kind of inflection point in interest rates, you get a severe rotation in markets and the sell off in the market.
Bernhard Koepp:
This does not mean we’re at the beginning of a new bear market, but it’s a reallocation of valuations across all the sectors. So if you think about the things that have done really well. So our technology stocks, our cloud computing stocks, our digital transformation stocks, our FinTech stocks, our biotech stocks. All of these things, carried us through the downturn, carried us through the low growth environment. Those PE ratios are under pressure now, or there’s a lid on these things.
Bernhard Koepp:
So the earnings of these companies still are very, very good, and it’s very important. I mean, my partner, Terry Gardner, put out a video the other week where he says, “Don’t abandon your winners.” And that’s something that’s very important here. It’s very important not to be too reactive to what’s going on in the market in terms of the internals, meaning the rotation, but the earnings growth is still going to be with these powerful growth companies. I mean, these are the Microsofts, the Adobes. The earnings in these companies are still going to be exceptional going through this phase, but we’re seeing now a rotation into the more economically sensitive companies.
Bernhard Koepp:
So let me just review a little bit on the economy where we are. We’re gauging the recovery, so one of the data points that we look at is the leading economic indicator and the leading economic indicator is a basket of forward-looking and data points, which basically tells us where are we in the recovery for this coming out of the recession that sort of culminated or came to a head in March of last year.
Bernhard Koepp:
So if we go back to looking at recovery periods, 2001, that was a pretty long period of recession. It was also a pretty painful time for market practitioners and investors, so the leading economic indicator, the data that was coming out of the economy, basically broke even after 46 months. If we fast forward to 2008, which was a severe recession, if you remember, and you had all of the structural issues relating to the mortgage markets and housing bubble and all these things that took a much longer period of time to repair. It took 136 months for the leading economic indicator data to be break even. So it was 136 months to recover.
Bernhard Koepp:
So now coming to the 2020 recession that was induced by obviously the COVID crisis and the pandemic, we are at a 17 month recovery period. Only 17 months, so that’s quite remarkable. So if we think about how this recession and downturn occurred, it is more akin to a disaster, or almost like an environmental disaster or I mean, a flood or a fire or something like that. It was not your typical cyclical downturn that we could model in the traditional way.
Bernhard Koepp:
So I think every economist on the street has been surprised by certainly the severe downturn. I mean, remember, we used to talk about the tilted V recovery, but I think economists were always also surprised how quickly the part of the economy that never shut down pulled the economy forward and got us to the point where we can really talk about normalization though. So all of those things are quite impressive.
Bernhard Koepp:
The second point when we look forward into 2021, obviously, the consumer is a big driver of the U.S. economy, so we’re always looking to the data on the consumer and household, the household balance sheets, how that looks. The savings rate at the end of February hit 14%. Obviously, Americans, we don’t like to save, and this was a forced saving because we couldn’t go out to stores and shop. We couldn’t go on trips. We couldn’t travel. So you had this accumulation of savings, which was quite abnormal, but to the tune of $2 trillion.
Bernhard Koepp:
So before we even talk about stimulus and obviously the Congress and the Senate are talking about stimulus right now and trying to approve an additional $1.9 trillion of stimulus. We already have something like $2 trillion of accumulated savings in people’s savings account. That’s a lot of money. So in terms of if we look a little bit further in terms of household balance sheets and how the debt looks like there, back in 2008, we used to look at the data on what is total household debt as a percentage of the total GDP, and it was 100%. So Americans, we were leveraging up our house. We were taking out equity out of our homes to buy luxury goods, an additional car, to go on vacation, all sorts of things. So this was a very unhealthy kind of environment for the consumer and the consumer was way over in on his head.
Bernhard Koepp:
So the interesting thing today is if you look at total household debt versus the U.S. economy, it’s about 75%. So we’ve de-leveraged as the consumer they’ve de-leveraged, so from a consumer health point of view, we’re in a much better shape than we were certainly coming out of the 2008 crisis. So the outlook remains good.
Bernhard Koepp:
I mean, the data on vaccinations is very good. We’re now talking, in some quarters, we’re talking about actually about a glut of supply of vaccines. The problem is still, of course, getting the vaccine into people’s arms. Look, I got my vaccine shot on Friday, which was a moderna shot. I got my first one and I’m supposed to get my second one in March. So the vaccines are getting into the population and you have companies like Merck who have not developed the vaccine. They’re stepping up to actually produce more supply for the populations.
Bernhard Koepp:
So the infection rates and death rates have come down a lot. There are some worries certainly about different strains all over the place, but I think it’s safe to say in the next three months, by June, we will have enough people vaccinated and we’ll have enough herd immunity that we’ll have this under control. So that sets up a pretty decent economic [inaudible 00:11:39].
Bernhard Koepp:
So why is the market not going up? So the market right now is in this mode, which is quite normal actually, where good news is bad news. So the market hates it when you have the step function of interest rates going up, and the market does not know where is the end point of interest rates. So if we look at pre-pandemic interest rates, we were between 2% and 3%. it’s quite likely that we’ll end up there. There’s some support on the tenure side at 1.55%, so we could see some stability here, but right now we’re seeing the seesaw effect in the market where every time we have interest rates on the long end spiking up, you have a reaction in the market on the downside.
Bernhard Koepp:
So this again, does not mean we’re at the beginning of a new bear market, it’s just a recalibration of valuations and PE ratios across the different sectors, more cyclical sectors on the one hand that are beneficiaries. So if you’re an industrial cyclical or you’re a financial bank or a financial services company that’s dependent on spread, meaning the interest rate differential between long rates and short rates, you’re in a good shape.
Bernhard Koepp:
So if you’re on the other side, you’ve been a tech company or a FinTech company or a cloud computing company, your earnings are still going to be very, very good. So this is why it’s important not to abandon your winners, but just you cut them back and you rotate some of that exposure into the cyclical part of the economy so that you can gain some of that exposure and returns in those out of favor sectors that we had in the past year.
Bernhard Koepp:
So portfolio positioning, we’ve talked about this already in the past. We’ve been doing rotation already in the portfolio since the fourth quarter of last year. We’ve been cutting back, trimming back, positions in some of our highly appreciated tech positions in favor of things that are economic reopening plays. I mean, just to give you an example, Boeing. I mean, Boeing is the classic reopening play. Boeing’s earnings and revenues are very much correlated to travel activity and when travel activity goes up, which is obviously to be expected, the orders for airplanes goes up.
Bernhard Koepp:
It’s quite natural. So the PE ratio actually of Boeing is very high right now because the E is very low, but in the next year, as we go through the recovery, the E is going to go up a hell of a lot. So you’ll see PE compression there, but the stock, it’ll move the stock up and cyclical stocks you buy when the PEs are very high and you sell when the PEs are very low. Growth stocks, you tend to buy when the PEs are lower and you trim them back or sell them when the PEs are very high. It’s exactly the reverse.
Bernhard Koepp:
So we’re seeing a lot of that right now. So look, we remain very constructive. I think it’s very important as an investor to be patient. We position the way we call a barbell position. On the one hand, we continue to like our growth stocks. I mean, if you look ahead into 2022, growth rates are going to come back down to normal kind of GDP growth rates of 2% to 3% after a very big year, 2021.
Bernhard Koepp:
So in that environment, you’ll get a return to more growth, oriented type exposure that will do very well versus more cyclical exposure. So we don’t want to do a wholesale change into value type investing or cyclical exposure because if you look into the future, we’re going to have more pedestrian growth rates, certainly in GDP, which favors, the types of exposures that have gotten us here, technology, the ones that are doing cloud computing, digital transformation, and so forth. So we want to stay the course there.
Bernhard Koepp:
So look, we remain very constructive that we will get positive returns out of equities in 2021 versus other asset classes. The difficult asset class right now is actually bonds and if you look at what the longer dated bonds have done in the last two to three weeks, that’s actually where you had massive sell offs. Most of our tech stocks where the froth has come down, come off a little bit, are still actually showing very nice returns.
Bernhard Koepp:
So we want to be careful about long duration type assets, asset classes, and that certainly is longer-term bonds, and we want to be patient and continue to be long equity securities. So that’s what we’re seeing right now. If you have any questions, please give me a call on 212-888-6342 or shoot me an email at bkoepp@CJLawrence.com. Thank you for listening and take care.
Bernhard Koepp:
Thank you for your support. If you have any questions, you could shoot me an email at bkoepp@cjlawrence.com or give me a call at (212) 888-6342. Thank you very much. Bye.
Bernhard Koepp is CEO and Portfolio Manager at C.J. Lawrence. Contact him a bkoepp@cjlawrence.com by telephone at 212-888-6342.