It’s no secret that the major catalyst for this “Great Recession” was the highly leveraged consumer who mortgaged their future with cheap credit on the back of inflated housing prices. That may risk oversimplifying the problems we are facing and, indeed, the ensuing collapse of credit markets and the dismantling of the banking system created much greater threats to our economy. The general population may never understand how perilously close we were to a calamity worse than the Great Depression, due to a widespread failure of the banking system. As it is, the only evidence of support for the U.S. economy today is coming from massive infusions of liquidity by the Federal Reserve and the supposed ability of the U.S. Government to finance a growing budget deficit; both very controversial actions. The markets have responded to this support and are currently trying to discount an uncertain future. Right now you can find equally compelling arguments for an extremely wide array of potential outcomes. We seem to be riding on a “razor’s edge” of confidence that keeps us on guard and focused on capital preservation and balance in the portfolios. We are much better off than just a few months ago and that alone can inspire markets to move higher if risk appetite increases. However, we still need to keep a grip on reality and weigh the fundamentals.
From a macro-economic perspective, there are three areas that are of particular importance when reading the roadmap to recovery.
1.) The housing market
2.) The health of the largest component of U.S. GDP – the consumer
3.) The prospect for inflation.
While we look at each individual investment in our portfolios based on its own merit, our asset allocation and willingness to take risk largely rests on these big picture factors.
Housing
Figure 1. (Click on chart to enlarge)
Figure 2. (Click on chart to enlarge)
These charts point to some very important progress in the housing market. The first thing to recognize is the improvement in housing supply. Figure 2 shows a massive contraction in building activity represented by building permits, while figure 1 shows a recent downtick in housing inventory (the green line). This is tremendous progress towards flushing out extra supply. If you look very closely at the last data point on each chart you will even see microscopic improvements in demand. Housing permits just moved slightly higher and houses sold (the blue bars in figure 1) have recently moved up. So the housing market may well be improving and that has very significant implications for stability in the banking system. That is undeniably the market at work and certainly a good sign.
Natural rates of supply and demand are highly correlated to population growth but they were most recently skewed by the proliferation of cheap mortgage credit. Since 1960, average building permits have run close to 1.5 million per year. In the period from February 2003 to August 2006, the heart of the housing bubble, average annual permits were running just over 2 million units. In 2005, permits were running close to a 2.2 million annualized rate every month. Given the below average numbers of the last 2 years, the average annual permit rate from February 2003 until now is just over 1.6 million, signaling a reversion to the mean and a more normal environment.
Lingering concerns remain from foreclosure rates that are resulting from what may be the highest rate of unemployment we’ve seen in the last 30 years (currently at 9.5% and rising). The Mortgage Bankers Association recently reported that 1 in 8 of the nation’s home mortgages
The Consumer
The state of the housing market provides a good lead-in to discussing the state of the consumer. First, let’s take a look at mortgage debt relative to household real estate values.
Figure 3
What’s important in figure 3 is the skyrocketing loan-to-value ratio (the red line) over the last 3 years. Home mortgage debt has remained close to $10.4 Trillion while housing values have plummeted almost $4 Trillion since 2006. The only ways for loan-to-value to improve is for debt levels to go down or housing values to move up. Even though supply/demand has improved, a meaningful rise in the value of real estate is very limited in the near term, given tight credit and unemployment. Debt levels can only effectively be reduced by asset liquidation or aggressive savings toward future debt reduction. Neither of these support rising real estate values and are likely be dilutive to future household income and equity. Certainly it is helpful that mortgage debt has stopped growing. Refinancing has been very strong as rates are managed lower by the Federal Reserve and lending is subsidized by the government through Fannie Mae and Freddie Mac. We are clearly fighting fire with fire as such policies significantly contributed to the housing bubble in the first place.
Figure 4. (Click on chart to enlarge)
Figure 5. (Click on chart to enlarge)
That leads us to household income statements and the ability of consumers to continue driving the economy higher. As identified in figure 4, U.S. households are well on their way to a higher savings rate. In an environment of high unemployment, record levels of household debt service (18% of personal disposable income), and tight credit, there is virtually no choice but to save. While saving has healthy long-term implications, it makes for very difficult economic growth in the near-term. Add to this that average weekly hours worked, as reported by the U.S. Department of Labor, are at the lowest levels since 1964 (when the data was first compiled) and you can understand how personal income statements are pinched. How does this relate to economic growth? Figure 5 shows that consumption is at record levels near 73% of GDP. However, with consumption coming under pressure because of significantly higher savings rates, it’s easy to see the why GDP growth may be limited over the next several years. In other words, increased saving naturally results in lower consumption, which could keep the economy stagnant for years to come.
Important to understand in all this is that there is a level of production the U.S. economy has to maintain in order to meet the basic needs of a productive and growing population. Lower capacity utilization rates and drastic cutbacks in capital spending have reduced manufacturing inventories by almost 10% from year ago levels while sales have decreased 18%. The decline in sales has recently begun to moderate and may support some GDP growth from inventory restocking. As far as predictions go for the recession ending this year, much of it will be tied to this natural process. For example, Intel Corporation recently excited the markets when they claimed higher sales and margins largely due to inventory restocking by their OEM customers. As we hear this from more businesses, it will be received as relatively good news and indicates we are not going over the cliff as we were in the 1st quarter. But that is about all it indicates at this point.
Our economy still faces a gap in potential growth as it begins to rely less on a “borrow, import, and spend” model and shifts towards one of “invest, innovate, and export”. Important to note, export oriented economies such as China, face almost the exact opposite challenge, as they will encourage less saving and more consumption. As we see aggressive infrastructure spending and stockpiling of industrial commodities by the Chinese, arguably a significant factor in recent global economic stability, we will learn about their economic viability, as their largest customer (the U.S. consumer) embarks on a fundamental shift in saving behavior.
In all, consumers and households have very difficult issues to confront as the excesses of the past 20 years are corrected. We expect this sector to emerge healthier and more resilient after several more years of adjustment. We also need to monitor how significant headwinds from government policy in the private sector and the prospect of higher taxes will affect future rates of unemployment and income.
Inflation
Possibly the most debated issue among economists today is whether we are headed for inflation or deflation. Milton Friedman is famous for declaring that inflation is always and everywhere a monetary phenomenon. This is a simple concept and given the record increases we’ve seen in money supply it would mean we already have inflation.
Figure 6. (Click on chart to enlarge)
The above chart was originally used in a blog piece written back in November 2008 (click on the link to read that post) and depicts what is called the monetary base. It is often referred to as the Federal Reserve’s balance sheet and reveals the magnitude of the increase in the supply of money. Where is all this money going? The Fed has initiated several unprecedented programs to support liquidity and credit in the economy. For the first time in its history, it is literally functioning today as the lender of last resort to the short-term commercial paper and asset-backed lending markets, as well as backstopping money market mutual funds. It is even buying mortgage debt and U.S Government bonds to keep interest rates low. Without this continuing support, we believe that our economy would have collapsed into a serious depression.
Friedman’s theory may have already proven true, as we do have rampant inflation manifesting in the price of U.S. Treasury bonds, where yields are frustratingly low. In fact, Warren Buffet, in his annual letter to shareholders, stated that the Treasury bond bubble may prove to be just as extraordinary as the dot com and housing bubbles. Consider that while the monetary base has increased, it is only acting as life support and has not encouraged meaningful increases in bank lending or private investment. Money has continued to filter down into excess banking reserves held at the Fed, short-term treasuries, and FDIC insured bank accounts, as consumers, businesses, and banks look to hold cash to stabilize balance sheet capital. The Fed is in the money market every day and Fed Chairman Ben Bernanke has expressed confidence that by targeting only what the credit market needs, they can unwind their balance sheet very quickly, if and when private capital comes back to the market. The problem is that large parts of the credit market, such as asset-backed securitizations, have essentially disappeared and banks are still quite risk averse when deploying capital, so it may be quite some time before private capital reappears in sufficient quantities to make a difference.
Unless liquidity provided by the Fed finds its way into the economy and grows via the multiplier effect of bank lending and investment, we will not see any meaningful rate of inflation in consumer goods or wages. With capacity utilization rates low (68% vs. average 80% since 1980) and unemployment rising, there is very little pricing pressure. Also consider that, according to Federal Reserve data, aggregate debt of the U.S. economy is roughly $56 Trillion, which includes approximately $12 Trillion of U.S. Government debt. As you can see in figure 7 below, that is approaching four times the level of U.S. GDP. By way of comparison, that ratio was only 2 to 1 in 1985. If confidence wanes and deleveraging continues, inflation in the general economy will not develop any time soon. This is where the government stimulus is intended to pick up the slack, why its effectiveness is being debated, and an additional stimulus plan seems likely. We need money in the economy to move toward productive investments and expenditures. If it only transfers to social and corporate welfare (bailouts) and then lays idle in bank accounts and Treasury bonds, we lose the efficient allocation of capital. In this way, some inflation in goods and services will be a welcome sign, indicating the movement of money deeper into the economy. It is only after evidence of a significant economic rebound that we can begin to fret about potential runaway inflation in consumer prices.
Figure 7. (Click on chart to enlarge)
Investment Implications
When considering everything discussed above, it is reasonable to question whether or not the extreme conditions we are witnessing should portend greater challenges ahead. Are we really at a breaking point that marks a turn in the global economy and the balance of power? Are we over or underestimating the potential for debt induced price deflation to accelerate? Is debt at four times GDP unsustainable? Certainly at two times GDP it may have looked just as troublesome. Is consumer spending at 73% of GDP necessarily too high? Couldn't consumption continue to increase as it has in the past? Are dramatic declines in U.S. equities and housing prices sufficient to provide reasonable future returns? The list goes on and we continue to ask ourselves these questions when formulating investment decisions.
In all, the state of the housing market and consumer, when combined with inflation expectations, signals that a significant and healthy correction is running its course, while risk aversion remains very high. We believe the markets have discounted many of the economic challenges we face and could potentially move higher if more positive news develops. At the same time, we do not like the condition our economy is in to handle any external shocks (of course we are talking mainly about ever present geopolitical threats). Households are still over-burdened with debt, government policies are casting a long shadow on consumer and investor confidence, while monetary policy has introduced unprecedented risks. There is little value in trying to speculate and predict specific outcomes of the Great Recession. There are simply too many variables to allow for bold predictions, and investors shouldn’t feel anxious to chase returns. There is a growing belief that “it’s different this time” and that we are likely to continue feeling the ramifications of “The Great Recession” for a generation to come.
Given this, our focus at FalkerInvestments is on the objectives of our individual clients and the investment returns required to meet current and future financial needs. The majority of our clients are invested in our model portfolio, which achieves what we think is an appropriate balance of risk and return for long-term compound growth. Within that portfolio, our strategy over the next 6-12 months is to remain balanced with EVA-producing, dividend-paying stocks representing 55-65%, investment-grade bonds 20-30%, and the remainder in the US Treasury Money Market Fund.
We also manage dedicated bond portfolios for some of our clients, in which we hold significant investment-grade fixed income holdings that provide relative stability and modest returns to support their lifestyle. We do not encourage them to look for returns in excess of what they need and can reasonably achieve. We are investing those assets across the yield curve while keeping enough liquidity to invest if rates move higher.
Equities have recovered from declines that occurred earlier in the year and have reversed a small percentage of 2008’s decline. On the whole we see our stocks being close to fair value, given the state of earnings projections, while remaining intact to produce solid returns on capital going forward. We have not attempted to “catch bottoms” or take incalculable risks to ride recent momentum in the markets. We have and will continue to take advantage of the current market rebound to trim positions, where warranted, while maintaining an active list of dividend-paying reinvestment opportunities.
Our bond allocation has done very well and we are actively looking for 6-8% long-term returns in investment-grade bonds, as they become available. In our model portfolio, the maturity schedule is currently under three years with an average yield-to maturity around 8%. The short-term nature of our bond holdings provides us with reinvestment opportunities, should rates move higher from rising expectations of inflation.
It is important to note that cash should not burn a hole in our pockets in times like this. Remember that we are only a few short months removed from what was a potentially devastating collapse in the banking system. Investing is dynamic and, while earning any yield seems desirable over no yield, it is important to consider the value of liquidity and stability that a core cash position provides. Just as banks are sitting on excess reserves to protect capital while waiting for better lending opportunities, the access to stable and liquid cash serves as an effective lever for us to quickly respond to investment opportunities. Our portfolios are designed with a cash component in mind , which is factored into our expectations for return. It has served as an extremely useful asset over the last 12 months by providing reassuring stability in difficult times, while also allowing us to move quickly on specific bond investments. Finding meaningfully better short-term yields today requires losing significant flexibility and certainty of return, the two things cash is meant to provide. If we see any very short-term bond opportunities that strike the right balance, we will pursue them with a percentage of cash that we would otherwise expect to hold in treasury funds during that time period.
So that covers how the macro-economic view is influencing our thinking. Hopefully you’ve made it through without too much head-bobbing. As always, we appreciate your comments or questions. We really are fortunate to communicate with a wide array of very intelligent, informed clients and friends, who provide useful inputs to our thinking.
Peter Falker
July 22, 2009
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