In the past year, the word “tapering” inspired moments of panic in global financial markets. Tapering refers to the U.S. Federal Reserve’s gradual retreat from the Quantitative Easing (“QE”) programs pursued by Fed Governor Ben Bernanke in the immediate aftermath of the Global Financial Crisis. Reduced reliance on QE is at the heart of the Fed’s “return to normalcy”, and, over time, seems likely to result in higher interest rates. This has serious implications not only for the U.S. treasury market, but for virtually all asset classes globally.
At the end of 2013, we learned that Janet Yellen, often portrayed as a philosophical fellow traveler of Ben Bernanke, would inherit Bernanke’s post as Federal Reserve Governor. The Fed also had announced plans for modest monthly reductions in QE through 2014. Whereas earlier in the year the market was prone to wild swings on the basis of “will they or won’t they” speculation about the prospects of Fed tapering, actual news that the Fed would, in fact, taper according to a pre-announced schedule received a favorable welcome from investors worldwide.
If it seems as if this note is headed toward prognostication about what the Fed will do, rest assured, you are still reading something written by Third Avenue. We are ultimately agnostic about the direction of future Fed policy, because predicting macroeconomic events is notoriously difficult and nearly impossible to get right on a consistent basis. One could reason, for example, that rising rates would force equities to sell off and lower levels of liquidity. Conversely, one could reason that investors may view Fed tapering as a sign that the Central Bank believes the worst economic conditions are behind us. Both conclusions indeed seem entirely plausible; however, if the historical track record of market prognosticators is any guide, both of these predictions should be taken with a grain of salt.
Maintaining our focus on fundamental value
Third Avenue’s portfolios are comprised of companies that exhibit financial strength and were purchased at meaningful discounts to our conservative estimate of intrinsic value. Purchasing companies with strong balance sheets and high quality assets means that we believe will provide some protection from rising interest rates. Because of their strong balance sheets, our portfolio companies do not need to access capital markets in order to expand or run their businesses. While some CFOs will undoubtedly worry about the rising cost of debt issuance, the CFOs of our companies will likely be directing the spending of cash already on hand.
Take White Mountains Insurance Group, for example, a company with ample liquidity. While rivals may be hurt by rising rates, White Mountains will likely remain unscathed and, most importantly, able to use its cash and equity to purchase rivals at bargain prices. Indeed, this is a strategy White Mountains’ management team has successfully executed for over a decade.
Bank of New York Mellon operates a large money market fund business that, in the Zero Interest Rate Policy environment had contributed nothing to the bottom line as the bank has rebated fees to fund holders who would otherwise wind up with a negative return. Should interest rates rise, BNY will be able to end its fee rebates, restarting a revenue stream that has been dormant since 2008. Key Corp. and Comerica, two regional banks that have performed well, could also benefit from rising rates as net interest margins improve.
We believe that the Fed’s actions, as they unfold, will continue to present unique opportunities in 2014 and that ultimately Tapering will prove to help some companies and their stocks even as others are hurt.