21 May Higher Rates and Preparing for Next Recession
Over the last week, markets have seen a significant jump in interest rates, continuing the year-to-date trend. The 10-year Treasury yield has increased to roughly 3.07%, as I’m writing this. Just a few years ago, there was talk of negative Treasury yields, as was common in many European sovereign bonds. Higher inflation data and a continued strong economy are the most prominent reasons for the increases in rates.
Interest rate changes are some of the most crucial factors in markets and the overall economy. One example of how minor changes can have large impacts on the real-world economy is in how it impacts the mortgage market. A 25 or 50 basis point shift in rates can potentially impact your monthly payment by hundreds of dollars. Larger shifts can impact housing prices and mortgage availability. Increased interest costs hamper both individuals and corporations, pressuring those that have taken on too much leverage. Higher yields result in declining prices for most fixed income investments, while also creating more competition for stocks, which can pressure valuations. On the positive side, higher yields benefit net-savers, as new fixed income issuances offer greater income.
Between 2005-2012, I was living in Newport Beach, CA and was in my mid-20s. Orange County, CA was then known as the subprime capital of the country, due to the plethora of companies operating from there. Whenever I’d meet someone at a restaurant or bar, if they asked me what I did for a living, I’d say finance. Their response was almost always, oh you are a mortgage broker, despite me always being in the investment industry? The reason for this was exemplified wonderfully in the movie The Big Short. Orange County was filled with young and slick people making a lot of money, often selling subprime mortgages or the homes bought with them. In the movie, the characters were hilarious and not far off the mark of people whom I regularly saw driving around town in their Hummer vehicle with a personal license plate referencing their 1800 mortgage number. (not joking at all) During the Great Recession, I personally saw the changes, as many of these people I knew ended up declaring bankruptcy and losing their expensive cars and houses. Almost nobody is immune to financial disasters, but I give this example of why it is so important to prepare for less favorable economic climates, while still enjoying the good. Discipline and foresight are what separates those that can overcome financial adversity, to those that fall on their face.
At T&T Capital Management, we have been preparing for higher rates and its ancillary impacts for some time. We have avoided piling into fixed income investments at unacceptable yields that didn’t compensate for interest rate or credit risk, which are now coming back to haunt market participants, as they see their low-yielding bonds generating losses. Many of our equity investments are in companies that benefit from higher interest rates, such as financial services companies. Due to our value focus, these companies are undervalued to start with, and offer a clear path for increased earnings and intrinsic value over the next 3-5 years. Even if the overall stock market becomes less favorable, we believe our strategies and incorporation of tools such as cash-secured puts and covered calls, should provide an ample amount of protection.
It has now been roughly 9 years since our last recession in the United States. While the current economic data is good, and I remain reasonably optimistic over the short and long-term future of the United States, we must be realistic that we are somewhat overdue for a recession. With investments, we prepare for these types of eventualities as I’ve discussed. As a financial advisor, it is important for us to communicate that it is just as essential for you to prepare on a personal level for your families. Below are a few basic steps that can potentially help you whether any storms that come your way:
1. Eliminate any lingering credit card or other expensive debt. Credit card debt is a financial abyss best avoided.
2. Don’t overreach on buying a home that is going to challenge you too much financially. It often doesn’t make sense to buy the most expensive house you possibly can qualify for a mortgage on, especially if it depletes all your savings. Most mortgages are relatively attractive uses of debt, due to their low costs. I’d expect to be able to make more money through investing than the interest costs on a mortgage, and it also helps that up to $1 million of mortgage debt is tax deductible.
3. Look at your bank statements and eliminate any unnecessary expenditures. A lot of us pay for everything with a credit card and then we might pay the balances each month before any interest accrues. Recently, I looked at the bills for my family and found a variety of costs that we were able to cut to create additional savings for investments that we wanted to make. For instance, we cut down on our cable bill dramatically. We eliminated our satellite radio subscription, which we rarely used. We had recently refinanced our mortgage in 2017 when rates were lower, which provided substantial savings. While my wife doesn’t appreciate it, we have foregone buying a new car because neither of us drive that often and she can almost always use my car. It doesn’t make sense to have two expensive car payments when those cars aren’t being regularly used, especially if you can easily work around it without much inconvenience. We cancelled a few credit cards that we never use but have annual fees. Lately used car prices have been dropping materially. It might be at worth considering getting a qualified pre-owned vehicle and taking advantage of the disconnect in value between used and new auto prices. There are many ways you can save and sometimes it just takes that extra effort to know exactly what you are spending money on, and make sure those expenditures are worth it.
4. Make sure that you have enough emergency funds to handle a few very challenging months or even a year. Each family has their own situation and risks, so I wouldn’t necessarily go by a rule of thumb. The less job security, the more important it is to have a backup plan. While it is not fun to think pessimistically, what would you do if you lost your job? Having a comfortable plan B dramatically reduces anxiety and allows you to get moving in the right direction right away. In today’s modern economy, jobs are more transitory than they were in the past; when if you worked for IBM, you were at IBM for life. Your investments with T&T Capital Management are all relatively liquid. In an emergency, they are 100% available to you. Naturally the more advanced notice of withdrawals you can give, the better we can manage the account to make sure you get as much profit as is possible from your positions, while selling them off at the more advantageous times.
5. Save and invest your money. The most critical factor that will impact your retirement is not how well it is invested (although that is very important), but instead it is how much you save to invest. Many people will save up money and open an investment account, and then they won’t add to it for years. Creating a monthly savings program allows you to continue growing and compounding your assets over the long-term. Sometimes it is just a matter of not thinking about it, which is why I recommend setting up automatic deposits into your investment accounts, assuming you are still working. Even as little as $100 a month can pay huge dividends over the long-term.
It is my commitment to you as clients to do everything in my power to protect and grow your hard-earned capital over the long-term. Many advisors that were out of the market many of the earlier years after the Financial Crisis when stocks were cheapest, now advocate that actively managing funds is idiotic, and one should only invest in index funds.
I remember working in the industry during college and after, after investors invested in index funds and mutual funds had lost 50% or more of their assets when the tech bubble blew up. Investors then realized that ignoring the price you are paying relative to value is a recipe for disaster. The same thing happened in 2008 of course but recency-bias is a powerful psychological characteristic, and recent years have had very good market performance. Just picking which index funds, and when, is an active management choice, so don’t fall for rhetoric. Ignoring valuations is always a terrible idea, as those that chased returns buying into Bitcoin at 15,000 late last year have learned, as their investment has been cut in half. As always, I hope that some of you will find this stuff helpful, and if I can ever assist you with anything, please don’t hesitate to contact me!