October 30 – November 5, 2015

Low Short-Term Rates Here to Stay? Credit Risks Increase with Increased Asset Pricing, and First-Time Home Buyers are Having a Tough Go At It.

This week three articles that stood out were 1) a post on Barry Ritholtz’s The Big Picture by David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors, “Low Short-Term Rates for a Long Time?” laying out the implications of continued dovish economic policy decisions,  2) was Eric Platt’s “Growth in leveraged deals prompts credit risk warning” in The Financial Times about the increasing credit risks in the leveraged buyout (LBO) sector, and 3) “Number of First-Time Home Buyers Falls to Lowest Levels in Three Decades” by Laura Kusisto in The Wall Street Journal illustrating a symptom of rising asset prices.

*Note: bold emphasis is mine, italic sections are from the articles.

Low Short-Term Rates for a Long Time? David Kotok. The Big Picture. 4 Nov. 2015.

David Kotok is Chairman and Chief Investment Officer of Cumberland Advisors, “an independent, fee-for-service money management firm managing over $2bn in assets.”  Basically, Kotok is calling to attention that much of the world is pushing forth economic policies to generate growth and the effect is that short-term interest rates will continue to remain low.  Further, a gradual liftoff from the Fed will result in continued appreciation of the dollar in comparison to other major currencies, i.e. the yen and the euro.  Additionally, with this trend in mind, there is a bias for continued asset appreciation.

“Market-based indicators suggest an implied rate of around 1% in early 2018. The FOMC dot plot gets you to about 2.5% in 2018 – but few market agents believe it.”

“Think about the dot plot in terms of future currency exchange rates. If the FOMC dots are correct and the US policy rate is 2.5% in 2018 while inflation is low and the federal deficit is down and stable at about $500bn, where is the dollar? The yen is expected to still be at near-zero short-term rate in 2018. The euro will still be in a negative rate regime. A suggested exchange rate would be dollar/yen at 135 and dollar/euro at 100 or even 90.”

Because the Euro is easing and “the use of negative rates in an open commercial union means an adjustment process for non-currency zone members who are part of the union. That requires each of those countries to take their national policy rate below the ECB. That is why Denmark, Sweden, Switzerland are lower and why other neighbors are headed lower. In the case of Europe this has now spread beyond just the short-term rate. About $1.9tn value of intermediate-term bonds are now trading at negative rates. (Bloomberg)”

“Among other advanced economies, the UK is easing (market expectations are pricing in a short-term rate of a little over 1% in 2018, according to Oxford Economics). Australia and New Zealand are easing, too. Among the emerging economies, China, the world’s second largest economy, may be down to 3% in 2018. Indonesia, India, Korea, Hungary, Poland, Russia, Turkey, and Mexico are all easing.”

“Zero and negative interest-rate policies have profound implications for asset pricing. In a theoretical model, the price of a long-term asset is infinity if the discounting rate is zero… Markets never expect zero forever.”

“In fact, the expectation of higher rates in the future may have kept longer-term rates higher than they otherwise would have been. As long as this circumstance persists, shorter rates will remain very low, and asset prices will have an upward bias.”

Growth in leveraged deals prompts credit risk warning. Eric Platt. The Financial Times. 4 Nov. 2015.

Of course with abundant low-cost financing available and increasing asset prices, many private equity/alternative asset management groups are flush with cash (with the exception of those exposed and focused on commodity investments).  The result is a highly competitive investment environment that is further driving up asset prices and thereby increasing credit risk (side note, see last week’s post that covered Debt in China and how despite increasing debt levels the weighted interest rate is declining).

“Credit risks are rising to the fore as private equity groups seek to put a near-record $540bn cash pile to work, pushing leverage back to levels not seen since the boom of 2007.”

“…private equity funds are more likely to drive up demand for assets as they compete with corporate issuers for acquisitions, potentially resulting in even higher purchase price multiples and weaker credit metrics on new deals.” – Allyn Arden, analyst at Standard & Poor’s

“The debt burden of the largest 20 companies taken private since the start of 2014 has climbed to an average of 7.6 times earnings before interest, tax, depreciation and amortization, above the 6.2 average for the largest deals in 2010-11 and about a point below the 8.7 times average recorded for the biggest transactions in the 2005-07 boom.”

The Federal Reserve, FDIC, and the Office of the Comptroller of the Currency set a ratio guideline of 6 times leverage in 2013 which defines a deal as risky.

As a result, debt is becoming more expensive (unlike in China)… “in the first nine months of the year the cost of LBO credit climbed to 479 basis points above Libor, up from 388bp in 2013.”

“With $539.4bn in dry powder sitting on the sidelines, according to data from PitchBook, the concern is PE managers will overpay for assets that will fail to grow into its new, often highly levered, capital structure.”

Number of First-Time Home Buyers Falls to Lowest Levels in Three Decades. Laura Kusisto. The Wall Street Journal. 5 Nov. 2015.

Then of course, as asset prices rise it should not be surprising that it is becoming harder for first-time homebuyers to ‘get in the game.’  Couple that with a hesitation to invest in property having just witnessed the housing market collapse in 2008-2010, slower wage growth (relative to asset price growth), increasing rent costs (resulting-from higher asset prices and resulting-in higher asset prices) that is making it harder to save money, and voila first-time buyers are declining as a portion of all buyers…

“The share of U.S. homes sold to first-time buyers this year declined to its lowest level in almost three decades, raising concerns that young people are being left out of an otherwise strong housing-market recovery.”

“First-time buyers fell to 32% of all purchasers in 2015 from 33% last year, the third straight annual decline and the lowest percentage since 1987… The historical average is 40% (according the National Association of Realtors, which has been tracking the data since 1981).”

“The median price of previously built homes sold in September was $221,900, up from 6.1% from a year earlier, according to the NAR. The median price for a newly built home rose to $296,900 in September from $261,500 a year ago, according to the Commerce Department.”

“The short answer is they can’t afford it,” – Nela Richardson, chief economist at Redfin, a real-estate brokerage.

“A quarter of first-time buyers said their biggest challenge was saving for a down payment. Of those, a majority said student loans were the main obstacle.”

“Economists also said rents, which have jumped 20% over the last five years, have made it difficult for younger households to put money aside.”

“The typical first-time-buyer household earned $69,400, up from $68,300 in last year’s survey. They purchased a 1,620-square foot home costing $170,000. The median repeat buyer purchased a 2,020-square-foot home costing $246,000.”

Other Interesting Articles

Bloomberg Businessweek

The Economist

A Wealth of Common Sense: Howard Marks & Warren Buffett on Paycheck Movie Sequels 11/3

The Atlantic: We Need An Energy Miracle – Interview with Bill Gates

Bisnow: Norway’s biggest fund suffers biggest loss in years 10/29

Bloomberg Business: Spending on NYC Residential Construction Jumps, Extending Record 10/28

CoStar: Private Equity Funds Sitting on $244 Billion of Cash Earmarked for CRE 11/4

FT: Tech ‘unicorns’: life in the goldfish bowl 10/29

FT: Harsh realities finally push US champions of shale oil into retreat 11/1

FT: Falling labour participation raises US jobs dilemma for Fed 11/3

FT: Consensus thinking risks market shocks 11/4

FT: Silicon Valley’s boom will leave some investors behind 11/5

NYT: China Ranks Last of 65 Nations in Internet Freedom 10/29

NYT: China Burns Much More Coal Than Reported, Complicating Climate Talks 11/3

WSJ: Mutual Funds Flail at Valuing Hot Startups Like Uber 10/29

WSJ: Don’t Look to China for Oil Rebound 10/30

WSJ: Corporate Bond Market Booms, a Bright Sign for U.S. Economy 11/1

WSJ: Why China’s Banks Are Laying Profit Growth Goose Eggs 11/1

WSJ: How China’s Best-Laid Plans Could Go Awry 11/4

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