Will The Bull Market Continue?

Confidence roars

Image courtesy David Ohmer

by Ron D’Vari, CEO, James Frischling, President &  by Zareh Baghdassarian

U.S. economic growth is expected to continue, fueled by robust household and corporate balance sheets, improving unemployment and wages, steady low inflation and lower energy prices. Consumer confidence in 2014 was propelled by the favorable economic and labor market conditions.

The component of consumer confidence reflecting the present situation has reached its highest level since February 2008. While consumers were less optimistic about the short-term outlook in December, they are more confident than a year ago. We project U.S. GDP growth of 3.2% – 3.5% with core inflation staying in 1.4% – 1.6% range, falling short of the Fed target of 2%. With improving labor markets expected to be followed by wage markets, the 2015 outlook for U.S. housing remains positive, if somewhat tempered.

The U.S. housing market has continued gaining back the equity it lost during the financial crisis but at a slower pace than the year before. Some of the housing gain was due to investors rushing into the market because of bargain prices, rising demand for single-family rental properties and low interest rates. Investor demand for single-family rentals has slowed since, with normalization of home prices and fewer bargains.

2015 growth will have to be driven by existing homeowners that need to trade up and first-time buyers becoming more eligible courtesy of looser credit standards. We expect new home sales to increase to more normal levels from their low levels. Existing home sales will increase more modestly. We expect the world economic landscape to remain in flux, requiring adjustment to Asia’s growth slowdown, continued pressure on oil-producing economies and Europe’s struggle with disinflationary forces. A relatively strong U.S. economy is expected to pull the global economy up, but the threat of deflation outside the U.S. is real and must be watched.

The implications are:

• a) continued low global interest rates and further easing in Europe;
• b) strong U.S. dollar;
• c) moderately rising home prices; and
• d) continued rotation out of bonds into stocks.

This should lead to modestly rising stock prices in 2015 but with increasing volatility. The credit markets will lose steam and come under pressure, especially the high-yield corporate market.

Fed's dominance of the mortgage market- What's changed?

The Federal Housing Administration (FHA) recently announced it will reduce the annual premiums new borrowers pay by 50 basis points. The primary goal of this move is to help make homeownership more affordable for middle- and lower-middle income families. The FHA historically served these consumers and rolling back the insurance premium, which was raised at the start of the Great Recession, is expected to benefit hundreds of thousands of borrowers who have been priced out of the market.

When you combine this move with the recent lowering of down payments required by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, you quickly see that the government isn’t reducing its current dominant place in the mortgage market, it is expanding it. According to the Mortgage Bankers Association, the government has in excess of 90% of the market share. With such a high percentage controlled by the government, this market may be better described as a “utility” and the extent of such domination as a “monopoly”.

Both market professionals and government officials claim to agree and state publicly that the government’s market share needs to shrink and private capital needs to return to the housing market. However, whether it’s the regulatory environment or a lack of demand from investors for non-agency product that is holding private capital back, government agencies reducing premiums or lowering down payments are not going to reduce its dominance of the mortgage business. Saying one thing and doing another is called hypocrisy.

The actions of the FHA and the GSEs suggest that the government feels the housing market is too important to be left in the hands of the private sector. As the current U.S. homeownership rate is at its lowest level in almost 20 years, maybe it’s time to rethink that.

Rating agencies belated energy sector downgrade creates opportunities

The big investment story from Q4, which has carried into 2015, is the dramatic decline in crude oil prices. Since mid-June, WTI crude has dropped by more than 55 percent to $46 a barrel (at the time of writing). Given the new supply/demand realities, bond analysts and investors are getting more comfortable with the notion that no rebound in oil prices may be forthcoming for an extended period of time.

The market has already reacted dramatically and priced in an increased probability of default for many of the lower-rated high-yield energy issuers, yet the three credit rating agencies have yet to issue a single rating downgrade. What are they waiting for? The first rating action taken was on January 6, as Moody’s took the initial step in placing Transocean’s (NYSE: RIG) BBB-minus rating on review for a one-notch downgrade, swiftly followed by S&P taking a similar step a day later by placing the company on “CreditWatch Negative”.

The market reacted powerfully across various social media platforms, triggering a Bloomberg Social Velocity alert due to an unusually high number of postings on the company. The bonds, however, traded in line with their monthly average: their 6 1/2’s in 2020 are trading around a price/yield/spread of 90.99/8.485%/+700, drastically cut from their highs seen through crude oil’s peak six months ago at 116.33/3.619%/+186. Based on current trading levels, a downgrade to high-yield/speculative has already been priced in by the market.

While Transocean’s management team is taking positive steps in reaction to the poor macroeconomic environment, the fundamentals of all companies within the energy sector, and their ability to service high debt levels, are on a declining trajectory. With crude oil down for seven consecutive weeks and no bottom in sight, a sector-wide downgrade is all but unavoidable as the rating agencies are under pressure to react and downgrade the entire sector on a wholesale basis. Not surprisingly, by the time the rating agencies actually make their move, the news will have been fully discounted by investors. Many companies have already reacted forcefully to the new environment by slashing dividends and curtailing capital expenditures.

Linn Energy, a name that we follow at NewOak, has done just that. The company has cut its dividend by 56.9%, its capital spending budget by 53%. More importantly, it has entered an agreement with the Blackstone Group which provides it with a $500 million war chest to allow it to purchase cheap, distressed assets in this market. Ironically, some of the affected bonds actually may trade up on the news. As usual, the rating agencies belated response may create interesting investment opportunities for forward-looking investors who are able to look beyond the present market environment.