VNQ - Buffett Says Rising Interest Rates Are Gravity To Asset Prices - Our Picks

2023-10-03 07:05:00 ET

Summary

• Mr. Buffett shares his wisdom on how interest rates impact stock valuations.
• We look at the forces driving the recent rise in long-term interest rates and their impact on several key sectors.
• We also share our long-term outlook for interest rates and some of our top picks of the moment.

Warren Buffett of Berkshire Hathaway ( BRK.A )( BRK.B ) once stated that:

Interest rates are to asset prices like gravity is to the apple. They power everything in the economic universe.

Given that long-term interest rates have been rapidly rising lately, this statement is particularly noteworthy:

In this article, we will explore the dynamic between rapidly rising interest rates and asset valuations, discuss the reasons for the recent rapid rise in long-term interest rates, share our outlook for long-term interest rates, and then discuss some of our top high-yield opportunities in the Real Estate Investment Trust ((REIT)) ( VNQ ) and utility ( XLU ) sectors.

The Gravitational Forces of Interest Rates

Just as gravity pulls mass towards the center of the earth, so rising interest rates pull down asset prices and economic dynamics. This is because:

1. Rising interest rates increase the discount rate used in discounted cash flow valuation calculations, thereby reducing the intrinsic value of cash-flowing assets such as stocks ( SPY ), rental properties, and private equity investments.
2. Rising interest rates reduce the value of commodities like gold ( GLD ), silver ( SLV ), and Bitcoin ( BTC-USD ) given that the opportunity cost of storing wealth in assets that do not generate cash flow increases as interest rates rise.
3. Rising rates reduce the relative value of fixed-income products like bonds ( BND ), preferred equity ( PFFA ), and many bond-like equity investments such as utilities, REITs, and renewable yield companies since their yields are compared to the increasing risk-free rate. As a result, the market reprices the yields on these assets higher, thereby pushing down their trading price.

Why Long-Term Interest Rates Are Rising So Rapidly

The recent rapid rise in interest rates in the U.S. can be attributed to a significant shift in the market's perception of the economic landscape. In the years since the 2008 financial crisis, the Federal Reserve's accommodative monetary policies aimed to combat disinflationary pressures and stimulate economic growth.

However, the recent surge in 10-year Treasury yields to 16-year highs indicates a fundamental change is taking place. Investors now appear to believe that the U.S. economy is entering a "high-pressure equilibrium" phase characterized by persistently higher inflation rates, low unemployment, and positive economic growth. This change suggests that rather than struggling to raise inflation rates, the challenge may be to contain them. Such a shift carries profound implications for various sectors, particularly those which have grown accustomed to historically low interest rates over the past decade. It could also prompt the Federal Reserve to continue raising rates to counteract inflation, potentially leading to disruptions in the financial system.

Moreover, this implies that the era of zero interest rates has come to an end, leaving investors grappling with uncertainties about the future economic trajectory and monetary policy. With the federal government issuing massive quantities of treasury bills into the market to fund its runaway spending practices, the Communist Chinese Party dumping its massive stockpile of treasuries in order to sanction-proof its economy, and the Federal Reserve shrinking its own balance sheet of treasuries, there are massive supply drivers and shrinking demand for U.S. government debt. As a result, the private debt markets are also getting squeezed, leading to a massive supply-demand imbalance that is pushing long-term interest rates dramatically higher.

Our Outlook For Long-Term Interest Rates

While this appears to be a very dire situation for interest rates and prominent business leaders like JPMorgan Chase's ( JPM ) CEO Jamie Dimon warning of interest rates soaring still higher to 7% levels, we take a more moderate view of where interest rates are headed.

It appears clear by now that the Federal Reserve is at least near the end of its hiking cycle, and likely finished with it. The two most important inflation metrics - core CPI and core PCE - have fallen dramatically over the past year, and over the past three months have been running at very moderate levels:

Moreover, the lag effect of shelter on the core CPI metric has not been fully manifested in the numbers yet. When it does, core CPI should plunge even lower. On top of that, artificial intelligence - which should have tremendous deflationary impacts on the economy - has yet to truly impact the economy in a meaningful enough manner to suppress inflation. However, developments in this space are accelerating rapidly and their impact should be felt soon, providing further relief from inflation. Once the lagging shelter component of core CPI appears fully in the numbers and artificial intelligence's impacts are more fully felt in the broader economy in the coming months, the Fed will likely move to cut interest rates if it hasn't already by then.

Moreover, recession warning signs are flashing , and if/when an economic downturn manifests itself, we expect the Federal Reserve to accelerate its rate cuts. Long-term interest rates should follow soon, especially if the Federal Reserve pivots away from shrinking its balance sheet and resumes purchases of long-term U.S. Treasuries which should help solve the current supply-demand imbalance.

What if a recession never manifests itself? We still think that rates are headed lower. First of all, the inflation battle seems to be won already, with or without a recession, as stated previously. The Fed is simply waiting to make sure that inflation does not catch a second wind. Moreover, the federal government's massive debt burden and runaway deficit spending are not sustainable at today's interest rates, much less 7% interest rates. Finally, the U.S. economy has trillions of dollars in debt maturing in the coming years. Given that much of this debt was originally underwritten at far lower interest rates than today's levels, having to refinance this debt at rates that are 2-4x higher than the debt was originally underwritten for could cause a massive and sudden collapse of the economy. To preserve the solvency of the U.S. government and its economy, the Federal Reserve will have to cut interest rates fairly soon, even if inflation is not fully back to its 2% target yet.

REIT Opportunities

Thanks to sky-high interest rates, REITs - long a favored choice for income-seeking investors - have sold off with a vengeance:

This is because - when long-term interest rates surge - the relative attractiveness of REIT dividend yields declines in comparison to the rising yields of risk-free government bonds. As the yields on these bonds rise, driven by surging interest rates, the yield spread between REITs and bonds narrows, driving capital out of REITs and into bonds, pushing REIT prices lower.

Given that we do not think interest rates will remain at higher levels for the long term, we think that now is a great time to load up on REITs. One of our favorite picks of the moment is NNN REIT ( NNN ). Between its 6.4% dividend yield, impressive quarter century plus dividend growth streak, BBB+ credit rating, steady organic growth from contractual rent hikes, conservative payout ratio, and well-diversified and recession-resistant triple net lease retail portfolio, NNN is a great pick for an economic downturn and falling interest rates. Given that the stock price has plummeted to levels not seen since the 2020 COVID-19 crash, now is a great time to load up on this high quality, proven long-term wealth compounder before interest rates decline again:

Utility Opportunities

Utilities are another sector susceptible to the gravitational forces of interest rates. They have traditionally been considered a haven of stability and income given that they provide essential and recession-resistant services such as electricity, natural gas, and water, enjoy regulatory protections in many cases, and typically payout attractive dividend yields.

However, as interest rates rise, utilities tend to suffer immensely. This is because the sector is highly capital-intensive, requiring substantial investments in infrastructure and maintenance. As a result, when long-term interest rates climb, the cost of financing these capital expenditures increases. This, in turn, squeezes the profit margins of utility companies, making it challenging to maintain their dividend payments at current levels.

Furthermore, higher interest rates tend to reduce the attractiveness of utility stocks in their popular portfolio role as bond substitutes. Investors seeking safety and income may find rising bond yields to be a more compelling alternative to utilities, especially if they are struggling with shrinking profit margins and growth rates due to a rising cost of capital. This is precisely what is happening to the sector right now, with the sector plunging 11.20% lower in just the past five trading days, led lower by one of the most popular and successful utility companies out there NextEra Energy ( NEE ):

As a result, there are plenty of great buying opportunities in the sector right now. One that we like particularly well is ATCO ( ACLLF ). It possesses a very strong balance sheet, has a very low payout ratio, and has been run very conservatively. It boasts a dividend growth streak of over a quarter century and now offers a dividend yield of nearly 6%. It is in great shape to weather a recession, operates primarily in energy-rich Alberta which has likely been benefiting from the recent surge in oil prices, and should experience considerable upside if/when interest rates fall. The company trades at a discount to the value of its underlying Canadian Utilities ( CDUAF ) holdings and also has several exciting growth businesses in addition, including a ports business and a structures & logistics business.

Investor Takeaway

Warren Buffett's analogy likening interest rates to gravity holds profound implications for investors, especially those with portfolios heavily weighted in REITs and utilities. Given that we hold significant exposure to utilities in particular in our portfolio, it has been a rough week for us.

However, our passive income stream has not suffered and some of our other holdings are holding up quite well. While the current market dynamic looks ugly in our brokerage account, we are able to keep calm, make opportunistic buys at yields that are far higher than we would have been able to achieve otherwise and let the dividends flow while we wait for interest rates to calm down over time.

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