At first glance, it seems the markets answer that question with a resounding "no." This seems to us to be little more than a knee-jerk worry. While no one will claim the economy is steaming along, it certainly isn't teetering on the brink of recession either. Our view is that we are entering a period of transition, moving from Fed support to self support. A look back shows that periods of falling equity prices and rising bond yields are not uncommon during policy shifts by the Fed. The most recent example of this is the summer of 2003, post tech bubble burst. That year the S&P 500 rose 15% in the first half of the year and then dropped 5% over the summer. In addition, the 10-year Treasuries shot to 4.6% from 3.1%. Following this, the S&P resumed climbing in late September and finished the year up better than 25%.
Obviously, 2013 is not 2003 and a global financial meltdown is not a bursting tech bubble, so what we as investors need to do is assess whether we are entering a summer of buying opportunities and whether or not the economy can prosper without Fed support. The current concern is less about equities than it is about interest rates and whether or not rising rates will snuff out the recovery. History shows that equities prosper during times of rising rates because higher borrowing costs reflect a stronger economy, and when we think about rates we think about housing. The housing sector was a major drag on the recovery for several years, but has clearly found its bottom and has been trending positively for a while now. We believe that among other readings, the continued elevated readings on housing affordability strongly suggest that the housing recovery still has legs.
The recent backup in mortgage yields - from 3.4% in late April to 4.46% as of this week for the the 30-year fixed - has caused concern, but we do not believe that a 100 basis point rise in rates will meaningfully impact the demand recovery because housing affordability remains high relative to its historical numbers and will likely remain that way at least until the Fed meaningfully lifts short-term rates, and let's be clear that tapering a bond buying program is not explicitly raising short-term rates. It should be noted that this rate increase is being accompanied by rising job and income prospects, which will partially offset the higher financing costs. Thus we believe that the current state of rates will not overtly step on the current housing recovery.
As a side note, for those of you who are unfamiliar with the housing affordability metric, it is determined by income, home prices and mortgage rates. When the index is 100 it means that the median family income qualifies for an 80% mortgage on the median priced single family home. This metric became widely used in 1971, and from that time to 2003, just before the housing bubble began, the affordability index averaged 115.0. A higher reading indicates better affordability.
The affordability index peaked in January of 2013 at 210.7, and was down to 183.1 in April. Rising home prices are the primary reason that the affordability index dropped over the first four months of the year. If we assume a 5% drop in May, the same rate as April, and another 10% in June due to price increases and mortgage rate increases, that brings us to a reading of around 156. This is still 36% above the pre-bubble long-term average. That means housing remains quite affordable and we can withstand more rate increases before the housing recovery is meaningfully impacted.
While next week is a holiday week, there are several key pieces of data: manufacturing data on Monday and employment data on Friday.
Enjoy your weekend!