September 7, 2021 | If we told you that a group of banks and REITs outperformed fintech stocks during the first nine months of 2021, what would you say? But hold that thought.
Leen's Lodge September 4, 2021
In this issue of The Institutional Risk Analyst, we ponder the remains of 2021 after several days of fishing at Leen's Lodge in Down East, Maine. Some people believe that the Federal Open Market Committee is in a hurry to end bond purchases and raise interest rates, others seem inclined the opposite direction. But fact is, stocks and housing prices in the US are racing ahead at double digits, faster than in the 2000s, raising an ugly but entirely appropriate comparison regarding inflation and asset prices.
Speaking of assets, we’ll be presenting some of the top-performing US banks in the next issue of The Institutional Risk Analyst for subscribers to our Premium Service. The performance of the bank group in 2021 is striking, especially since the fundamentals of most banks have weakened since Q1 of this year. As we approach the end of the third quarter of 2021, lower revenues, earnings and NIM seem to have finally caught the reluctant attention of Buy Side managers. As a result, stocks have been griding sideways since May, when talk within the FOMC of tapering asset purchases disturbed giddy market participants.
If we told you that a group of banks and REITs actually outperformed the fintech sector this year, would you believe it? Notice that Western Alliance Bancorp (NYSE:WAL), which we profiled earlier this year (“Western Alliance + AmeriHome = Big Possibilities”), has outperformed Square Inc. (NYSE:SQ) and other fintech plays in terms of total return. Indeed, the one-year total return calculated by Bloomberg for WAL was twice that of SQ, which ranks #9 on the list. You still think that’s air you are breathing?
While home prices are indeed continuing to gallop along at double digit annual rates, the volumes in the mortgage lending space continue to slow. This presents the FOMC with yet another dilemma since any increase in interest rates is likely to slow lending volumes even more. Meanwhile, as we approach the end of Q3, banks are positioning for yet another weak quarter in terms of loan growth, a key indicator of the direction of current and prospective earnings.
Looking at the FRED chart above showing the 10-year Treasury note and the 30-year mortgage series from Freddie Mac, the former has essentially been shuffling sideways for the past year. This stable rate environment, however, has been positive for REITs, which have seen total returns over the past year in high double digits or about half the rate of return of banks. We own Annaly (NYSE:NLY) common BTW.
Names such as Redwood Trust (NYSE:RWT), Chimera Investment (NYSE:CM) and MFA Financial (NYSE:MFA) have led the REIT group, which tends to cater to a retail, income oriented investor base. The average dividend yield for the REIT group is just 9%, according to KBW, roughly half of the level of two years ago. This is one reason why the scarcity of risk-free collateral engineered by the FOMC is the dominant market factor.
Giant REIT New Residential (NYSE:NRZ) is the laggard in the group with “only” a 48% total return over the past year. Once again, the FOMC proves that pigs can indeed fly and even soar given enough inflation. Angel Oak Mortgage (NASDAQ:AOMR), which floated its shares in June on the sea of liquidity provided by the FOMC, is another laggard in the REIT group that may eventually regret its public debut.
While there remains considerable uncertainty as to the timing of any change in FOMC policy, we remain skeptical that the Fed can change any aspect of policy without provoking a market event. The excessive upside moves in valuations for stocks and housing assets, for example, suggest that a correction is not only likely but entirely necessary.
To get from here to there in terms of returning markets to "normal" may require navigating some very rough water. Keep in mind that despite the big gains of the past year, most if not all of the resi REITs are trading at or below book value. Banks, on the other hand, are trading near multi-year highs even as fundamental languish.
Dick Bove confirms our recent trashing of Bank of America (NYSE:BAC): "Revenues are meaningfully below where they were in 2009. Moreover, they are basically showing no growth in the past few years. They are erratic and in a downward trend." Ditto. Yet, thanks to the FOMC's excessive stimulus, BAC was one of the best performing bank stocks in the past year.
The timing and direction of any rate change is going to hinge on changes to the Fed’s purchases of Treasury bills for the system open market account or SOMA, perhaps the most significant acronym in finance today. Strategist Ethan Heisler at KBRA puts the situation succinctly in his excellent monthly slide deck:
“Given that the bulk of the Treasurys the Fed holds in its SOMA portfolio is concentrated in the front end of the yield curve (see Slide 6), bank treasurers could theoretically anticipate upward pressure on short-term yields in 2022 when it begins to taper. On the other hand, this month’s refunding announcement by the Treasury hints at bill-issuance reductions during auctions in the fall that may offset the upward pressure on yields by reducing supply.”
Since the FOMC is currently the largest purchaser of both Treasury paper and MBS, the timing of any change in purchases for SOMA will obviously impact valuations across the interest rate complex, particularly for banks and REITs. Any increase in yields on the 10-year Treasury, for example, likely will be negative for mortgage lenders, which may be the worst performing sub-sector for financials in 2021. It seems increasingly apparent that the FOMC cannot make any change in policy without provoking a catastrophic sell-off in equities and the dollar.
One former Goldman Sachs bond trader opined last week:
“Judy Shelton's commentary, "Congress Needs to Rein In a Too-Powerful Federal Reserve," has the correct motive but understates the seriousness of the mess the Fed has created. They have driven asset prices to absurd levels, and have made Americans owners of homes they will be walking away from down the road. The Federal Reserve cannot stop their purchases and money creation. The whole financial system would implode. Why do you think the Chinese are getting out of Treasury paper? They see it coming. The dollar will eventually leave its Fed induced heights.”
So the good news is that banks and REITs have outperformed fintech leaders over the past nine months. The bad news is that the FOMC has so distorted financial markets in the quest for the socialist utopia of “full employment” that any change in policy is likely to provoke an investor tantrum. The most recent weak jobs data gives markets a bit more room for exhuberance, but any sign of policy change by the FOMC could provoke a massive selloff in global equities as asset prices and fundamentals become reacquianted.
More than ever before, the FOMC is the prisoner of history to paraphrase Jim Grant. Or to recall the wisdom of Professor Ed Kane from our discussion about COVID and monetary policy this past February (“Ed Kane on Inflation & Disruption”):
“Many seem to be hoping that things will go back to the way things were, back to ‘normal.’ But I am always reminded of the concept of ‘hysteresis’ which basically says we may travel up one path in response to outside forces, but when these outside pressures subside, we should not expect that we will return to the same ways of doing things. We have to recognize that hysteresis is a general phenomenon. Investors, in particular, must ask what kind of paths will unfold if and when we establish herd immunity, and accept that the good old days cannot completely return.”