Agency mortgage REITs were bruised by the debt ceiling battle, but are poised to outperform as the markets’ focus on Congress subsides.
Thanks to Washington’s debt ceiling follies, agency mortgage REITs significantly underperformed the S&P 500 on a price return basis over the last two weeks of July (-5% vs. -1.8%). As noted in our U.S. Investment Strategy service’s June 6 Special Report recommending agency MREITs, they are highly leveraged entities sensitive to disruptions in the availability or cost of funding. Although by all first-hand accounts, the group faced no increase in margin requirements ("haircuts") and only a modest uptick in borrowing costs ("repo rates") that barely impacted its profit margins, investors were quick to sell on market chatter of the possibility of higher haircuts and repo rates. As the concerns fade, the market should recognize that the group’s decline occurred even as the macro backdrop supporting it improved. Amidst the accumulation of data suggesting that the economy is slowing, market consensus now expects that the first Fed rate hike will not occur until 2013. The Special Report demonstrated that fed funds rate expectations have been the best predictor of group performance and its relative prospects may further benefit from a weak backdrop given the Treasury’s explicit guarantee of its portfolio assets. Bottom line: We reiterate our recommendation to own the agency MREITs, which we continue to expect will outperform the broad equity market through the end of the year.
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