It’s starting to feel like Fall has finally arrived here in Northeast Florida. Football is well underway, playoff baseball is in full swing, and the Florida-Georgia game is right around the corner. Pumpkin spiced lattes are everywhere we turn. The temperature has even dipped below 80 degrees.
And of course, there is Halloween.
We don’t think of ourselves as doom-and-gloom permabears. However, capital preservation is our highest priority and we probably tend to skew towards being more risk-averse than many of our peers. So, in the spirit of Halloween, we thought we could have a little fun and share the top-5 things that are keeping us up at night.
#5 - Consumer Spending Slowdown? – With personal consumption expenditures accounting for nearly 70% of GDP, the US is a consumer-driven economy. Pandemic savings and government stimulus were an enormous tailwind to the consumer in the post-covid boom. However, excess savings are starting to burn off as Americans are faced with higher prices, tightening credit and the resumption of student loan payments. Although the degree to which savings have been depleted is debated, there are some signs that consumers are under more strain. Take, for example, the 10-year high in credit card delinquencies in the context of an almost 10-year low in personal savings:
Our take: To be fair, there are also metrics like rising wages and strong employment that suggest consumer spending can remain robust. This mixed bag at a macro level is similar to what we have observed at the company level. Some businesses – like Walgreens, Target and Dollar General – have called out a challenging macro environment pressuring their customer base. Others – like Costco, Home Depot and Walmart – have cited a more resilient consumer.
We tend to gravitate to those consumer businesses that have the balance sheet and operating history to prove they can weather economic cycles, and generally remain underweight businesses that are reliant on larger ticket discretionary items.
#4 - Credit Spreads Widen – The surging interest rates at the long end of the curve have grabbed plenty of headlines over the last month and led to a selloff in the equity market. The short-end of the curve has had the same result, albeit with less drama. A determined Fed has continued to hike short-term rates higher, which is the primary driver for the interest rates on bank loans. Investors have been forced to grapple with how to handicap prices of debt-laden companies for the stress of higher interest rates.
One fact that seems to grab less attention today is that these rate increases have taken place in an environment where credit spreads remain relatively benign. As measured by the spread between the yield-to-worst of the ICE BoA US High Yield Index and the 10-Year Treasury Yield, the current spread of 4.5% is below the 4.7% average from the last 20 years. In the face of what many believe is a slowing economy at risk of a hard landing, spreads are arguably not adequately pricing this risk. And while the blow from treasury rates alone has been a tough pill for the market to swallow, a one-two punch of treasuries and corporate spreads is potentially frightening.
Conventional wisdom would suggest that both of these happening simultaneously is unlikely. If investors are worried about an impending recession and send corporate spreads higher, then treasuries are likely to catch a safety bid and provide some cushion as bond markets adjust. So the thinking goes, anyway.
Our take: We don’t necessarily bank on this negative correlation holding up and keep in mind Mark Twain’s quip that “It’s not what you don’t know that kills you, it’s what you know for sure that just ain’t so.” This means that we’re stress testing our holdings under severe financial conditions. And from a portfolio management perspective, it means prioritizing equities with excellent balance sheets and credits with reasonable capital structures that are not reliant on the capital markets staying open to stay alive.
#3 - The Credit Cycle – One of the most frequently debated issues in financial media today is whether the US economy can pull off a soft landing. The mixed signals in the market have given bulls and bears ample data points to bolster their arguments. As we have written before, we don’t have a strong view one way or another. However, one of the strongest pieces of evidence that we see against the soft-landing camp is the history of credit cycles.
While we prefer to approach investing from a bottoms-up perspective, we are believers in market cycles and try to be mindful about the phase of a cycle when we construct portfolios. In our view, Fed hiking cycles – which encourage or discourage borrowing – are one of the best and simplest proxies for a credit cycle. We are now over 18 months into what has been one of the fastest hiking cycles in history. History suggests that a recession will be tough to avoid. Since WWII, most agree that there have been three soft landings (the mid-60s, early-80s and mid-90s) in 12 tightening cycles; a 25% “success” rate. A recent article from PIMCO analyzed 140 hiking cycles in developed markets over 70 years and similarly found that recessions follow a hiking cycle 75% of the time, and over 90% of the time when the hiking cycle began with elevated inflation[1]. History is not on a bull’s side.
Our take: We find market history to be a useful guidepost, but we don’t pin our analysis to historical analogs. In the current market environment, we’ve erred on the side of caution and constructed portfolios of companies that have the balance sheet and operating model to withstand a hard landing. But this does not mean that we’re betting on a recession: simply that we’re adjusting our positioning based on our risk-adjusted opportunity set.
#2 - Frozen Housing Market – For those of you who have tried to buy a house recently (or who have friends or family that have), we’re guessing you’re aware of the struggle it can be. Prices are high, inventory is low, and financing is expensive. The ultra-low rates that most homeowners locked in during the post-covid boom has created a reluctance to trade out of a cheap mortgage, thus exacerbating the supply shortage and keeping prices high. One of our favorite measures of residential housing value is to compare sales price to median income. The trend in this metric over the last half century is remarkable:
Note that the data above uses year-end values and doesn’t incorporate the last few quarters of data that show a slight reversal as home prices slid from their peak. But the broader point remains: housing is very expensive (approximately 2 standard deviations higher than the avg of the last 50 years by this measure). While the secular price growth made sense in the context of declining rates, current mortgage rates – hovering at 8% for a 30-year – are the highest they’ve been in 23 years. The last time rates were that high, the price-to-income ratio was about 25% lower.
A couple days ago, there was a headline in the Wall Street Journal titled, “There’s Never Been a Worse Time to Buy Instead of Rent,” which highlighted the chasm between home prices and rental rates. We’re not big on predictions, but we think it’s unlikely that this relationship lasts. And the two ways that it comes unglued are each arguably negative for asset prices:
i. Rental Rates Increase – Housing accounts for about 1/3rd of the CPI Index. To the extent that property owners push through rent increases to keep up with housing values, it likely puts further pressure on inflation measures, makes the Federal Reserve less likely to pivot dovish, and keeps a lid on asset prices.
ii. Home Prices Decline – A compelling case could be made that a reduction in home prices would be a good thing for the economy. However, it’s hard to ignore that this would be a reversal of what powered the market in the post-GFC period: loose monetary policy pushed real estate and financial asset prices higher, creating a wealth effect for the homeowner class of the economy that spurred consumption spending. As the perverse logic went, “bad news is good news.” For those that believe the economy is still overly dependent on asset prices, home price declines could be seen as a negative.
Our take: We should mention that we’re certainly not expecting some 2008-level event to repeat in the housing market. Our house view is more constructive (puns intended). While we wouldn’t argue that prices can remain this high, we believe the fundamentals of this housing cycle are far stronger than 15 years ago. We see a shortage of supply, rather than leveraged speculation, as a key driver of price activity.
#1 - Geopolitical Tension – This is fresh in our minds as we turn on the news and see horrific scenes from the conflict in Israel and Gaza. We are hopeful cooler heads prevail and that fighting does not escalate and spread. Tensions with China, particularly related to semiconductors and other critical technology, also seem to be rising. And then there is the Ukrainian defense against the Russian invasion, which the Biden administration has pledged to support. It seems reasonable to suggest that geopolitical conflict between global powers is higher than it’s been in some time.
We’d be out of our depth to offer insightful commentary on these issues. But we would suggest that the market has perhaps underestimated these risks. It may surprise you to hear that the S&P 500 closed higher on the market days following the initial news of Russia’s invasion of Ukraine (2/25/22) and the Hamas attacks on Israel (10/9/23). As we write this, the price of Brent Oil is within $3 per barrel of the level immediately before the Israeli conflict, which seems notable given that around 20% of global oil production passes through the Strait of Hormuz. Finally, the three stocks in the ‘Magnificent Seven’ that disclose revenue from China - Apple, Tesla and Nvidia – are up 34%, 76% and 199% YTD, and rely on China for ~20% of their revenue on average.
Our take: We’re not suggesting that US companies are facing an impending threat to their business models from overseas conflict. However, we could envision some of the second-order effects of this conflict (wider budget deficits, higher energy prices, greater restrictions on foreign trade, etc.) weighing on corporate profits and asset prices.
We hope you don’t come away from this thinking we are sitting in a bunker waiting for the market to crash. There are always risks to be concerned about, and we are reminded of the old adage that markets climb a wall of worry (the last decade is a great example!).
In fact, we view the volatility and fear we’ve seen creeping into markets recently – due to some of the reasons discussed above – as a great opportunity, as they are more likely to produce dislocations from long-term fundamental value. Here at Intrepid, we’re dusting off our Halloween baskets and preparing to separate the tricks from the treats. We hope you have a nice holiday.
[1] https://www.pimco.com/en-us/insights/blog/fed-seems-confident-in-soft-landing-but-we-see-risks/