Second quarter GDP growth (annualized) for the US was revised downward last week from 1.2% to 1.1% (first quarter was 0.8%). Annualized means that the growth rate for the second quarter was extrapolated to estimate what the growth rate would be for an entire year (i.e. multiplied by 4 but it is a little more complicated than that). The third quarter is expected to be much stronger, with professional estimates ranging from about 2.3% to 3.8% (Blue Chip Consensus Survey). Also last week, Fed Chair Janet Yellen gave a speech in Jackson Hole, Wyoming, that to me sounded somewhat lacking in conviction about the timing of the next rate hike. Futures markets are expecting the federal funds rate (which the fed targets) to be little changed in September to about 42 basis points from today’s 40 basis points.
You can calculate this for yourself, and I promise you that it is kind of fun and that it will definitely increase your financial confidence. Just Google “CME 30-day fed futures” (that’s for Chicago Mercantile Exchange,) and you can see the price of federal funds futures contracts each month for the next 3 years. Banks and fixed-income (bond) managers use futures contracts (a single contract is $5 million) to manage or hedge their short-term interest rate exposure. A futures contract allows one party (e.g. a baker) to lock in the price of something (e.g. wheat) for a fee (futures contract), transferring the risk (e.g. higher future wheat prices) to another party. The fed funds rate that is implied by the futures contract is equal to 100 minus the contract price (Journal of Economics and Finance Education). For example, the September contract price is 99.58, and 100 minus 99.58 is 0.42. That’s what the market expects the federal funds rate to be on average for the month of September: 0.42% or 42 basis points. Since that’s about what it is today, the market is pricing in no hike for September. Calculating probabilities is a little bit more involved but it too is not very complicated. Futures markets are not perfect forecasters by any means (there is a lot of peer-reviewed research on this subject), but they are a great anchor or starting point for making forecasts of everything from short-term interest rates to gold and silver prices.
A big event this week has to do with the fact that the Global Industrial Classification System or “GICS,” developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poor’s, is breaking out Real Estate Investment Trusts or “REITS” into their own sector. Prior to this decision REITS were part of the Financials sector, which includes banks, insurance companies, etc., and the Financials sector was one of ten broad economic sectors (e.g. Energy, Healthcare, etc.). Now there will be eleven sectors. REITS typically invest in real estate properties and trade on major exchanges. That means that they are both more liquid and more diversified than investments in specific pieces of real estate, like a house or an office building. REITs are defined legally and so have their own unique characteristics, like being required to pay 90% of the income they earn out to their shareholders. Currently they comprise about 3% of the S&P 500, roughly on par with the Utilities, Materials, and Telecom Sectors. Some REITs are very specialized, focusing on specific areas like hospitals, hotels, shopping malls, apartment complexes, etc. Breaking out REITs makes sense to us at STMM, and we have generally evaluated them independently from the other financials.
Finally, speaking of real estate, the Economist magazine last week had an article pointing out that the largest asset class in the world is the US housing market (your house, my house, etc.), with an estimated value of $26 trillion. That’s larger than the entire US stock market (assuming the S&P 1500), which I calculate to be about $23.5 trillion (sum of S&P 1500 small, mid, and large cap stocks). That’s fascinating! By contrast, total US government debt outstanding, for example, is a little over $18 trillion (according to TreasuryDirect). In fact, when addressing the nation’s debt burdens, it is an incomplete conversation if some recognition of the value of the nation’s assets isn’t considered as well. I’ll elaborate on the nation’s debt situation later on in this election cycle (as I’m sure it’ll be at the top of the headlines soon), but for now consider that the net worth of households and non-profits in the US, that’s assets (own) minus liabilities (owe), was about $88.1 trillion in the first quarter of 2016 (Federal Reserve Board of Governors).
Posted on Mon, August 29, 2016
by Danny Aleman