This week the Federal Reserve will make a decision on interest rate policy where is it expected to raise by 25 bps. This would be the first raise in nearly a decade, which is stifling to begin with. There has been a great deal of volatility of late, which is not uncommon before a rate hike decision. Keep in mind that 25 bps is really not very significant in the big scheme of things. Our key positions will fundamentally benefit from higher rates. Most analysts are predicting 2 to 3 rate hikes next year, which if it is backed by a stronger economy, would be enormously beneficial to the earnings of banks and insurance companies. Bank of America estimates it could see as much as $4-5 billion in net income if short and long-term rates were each 100 bps higher.
Two other dynamics are taking place that should be noted. Firstly, since the OPEC decision, oil prices have declined by about 11% to right around the lows hit in 2009. This combined with the El Nino that is making for a much warmer winter in the East Coast also has natural gas prices below $2 at the lowest prices since 2002. Clearly, this creates pressure on the industry and especially on those companies with high leverage ratios. At some point energy prices will go considerably higher. U.S. production is declining and the declines will increase every few months due to these lost rigs. The Saudis and Russians are getting hurt badly with these low prices and ultimately the situation is unsustainable.
The 3rd thing that has occurred is in the high yield credit market. We’ve been wary of the risks of bonds, particularly junk bonds for several years now and have mostly stayed away. A respected mutual fund institution Third Avenue Funds, had one of their credit funds down a whopping 27% this year. Keep in mind that debt is supposed to be less volatile than stocks generally although high yield is certainly the more volatile kind of debt. The fund faced redemptions from investors and because of the new bank regulations, credit markets have much less liquidity. This forced the fund to halt redemptions temporarily until they could execute an orderly liquidation. One must also be wary of bond ETFs. Flows into and out of these ETFs can cause major disruptions in bond prices due to the lack of liquidity, creating significantly different investment results than what would be expected. Many bond ETFs, which have normally traded at a premium to their net asset values, now trade at a discount because the market is not confident that it can get the pricing that would be expected at liquidation.
Like I said in my last email, there is going to be a lot of noise between now and mid-January. Higher rates means much higher earnings for our financial investments. All stocks sold off last week quite significantly but we’ve been through these periods of volatility many times before. Once the rate decision is made, I believe it takes away a nice bit of uncertainty and allows for better planning moving into 2016.