Macroeconomics can be a funny thing. From an investor’s perspective, it can feel like economics are all about butterfly effects; where one tiny change in one market can have a ripple effect causing massive changes throughout other markets.
A good example of this effect happened earlier this week when Bloomberg reported that the European Central Bank is planning to trim its quantitative easing program. Currently, the ECB buys 80 billion euros a month worth of bonds issued by corporations and public institutions (mostly European countries), but the rumor from Bloomberg says the ECB will cut that buying by 10 billion euros per month very soon. There was a devastating impact on REITs; solid reliable firms like HCP, Inc. (HCP) and Realty Income (O) lost over 2% in a day.
Meanwhile, the finance sector (XLF) saw a boost, gaining 0.4% by the end of the day. European banks got the biggest boost, with Royal Bank of Scotland (RBS) and beleaguered Deutsche Bank (DB) climbing the most.
The fall in REITs and the rise in financial stocks come from the same source: the ECB. But there’s an oddity here. For one, RBS focuses on UK investing and reports income in pounds, which weakened significantly as Theresa May announced a plan to initiate Brexit early next year. Deutsche Bank is a separate can of worms, struggling in the face of potential fines from U.S. regulators and a lack of profitability. And, of course, XLF tracks the U.S. financial industry whose exposure to Europe is quite limited.
To make matters more confusing, the REITs that fell yesterday have next to no exposure to Europe at all—O and HCP focus on properties in America. So why is there a direct correlation, and impact, between ECB bond buying, U.S. REITs, and British and European banks?
The answer lies in liquidity and interest rates. The ECB’s bond buying program has helped keep funds in the bond market. That higher demand has helped companies issue debt and find buyers for that debt. This is good for REITs, because they use debt in the form of bonds to finance investment and expansion. If the ECB pulls back on buying bonds, it could make it harder for REITs to sell bonds in the market.
But even more importantly: it could also be a sign of Central Bank interest in raising interest rates. Worries about the Federal Reserve rising its Fed funds rate target have fallen by the wayside; the ECB’s move to cut on its bond-buying activity would indicate central bankers are getting confident in global growth, which could in turn mean Janet Yellen is getting ready to raise rates too. That will make bond yields go up, making it again more expensive for REITs to borrow. As they pay more interest rates on debt, their profit margins decline. Hence the fall on Tuesday.
So what about banks? They went up for the same reason: expectations of higher interest rates. High interest rates are very good for banks, because banks effectively make a profit by lending out at rates that are close to the rates set by central bankers. If the Fed raises interest rates by 0.25%, for instance, banks will see their profit margins inch up a bit as well.
This is a particular issue in the Eurozone, where negative interest rates have plagued banks in recent months. Negative interest rates mean that banks need to pay a fee for the funds they have in their reserves. Banks have not found it easy to pass on those costs to customers, meaning traditional retail banking as an industry has become wildly unprofitable in Europe. This is partly why DB has suffered a huge loss in the last few quarters, and why shares are down 50% over the last few months.
So, we see, the ECB rumors have changed the story for investors. Now there’s an expectation of rising interest rates, and that will have the opposite impact on REITs and financials. Thus the decline in one and the rise in the other, even when the shares aren’t directly exposed to the ECB or even the European economies.
This butterfly effect is the systemic risk of investing. It is a very real risk, and it is why investors always need to stay aware of what is happening both in the fundamentals in the companies they invest in, and in the world as a whole.