Hello Again
Recently I've noticed a somewhat inexplicable (at least on timing) pivot beneath the market. It's almost as if some economically sensitive parts of the market are doubting that they should be pricing in a recession. It has seemed like the money flows that move the market are shifting from recession to recovery. This has been more so the case in US exposed sectors. It also feels like we're seeing a shift in trajectory of some sectors and economic priorities.
Is it done? Well that's the million if not billion dollar question. I don't know. I believe there are some things with very optimistic prices other things have a long way to go to reach historical average valuations... That's all within what I'd call cyclicals, not even AI related stocks. Cruise lines at these prices are extremely confusing. I'd contemplate a short position there to reduce the 'cyclical' factor of my portfolio but... With the market acting mechanically on narrative of cyclical recovery into a heavily shorted sector... I mean that's how value investors (and people who ignore market mechanics) die. Mostly I like some cyclical areas.
Lumber
Many commodity producers remain below book, including a number who more often than not fare well within their field. I think some are past the cyclical trough in margins and are likely into early stages of what's effectively 'next cycle.' things that went into the cost curve and had supply come out. One that I've spoken about here is lumber for instance. It's particularly interesting because the US homebuilders (a different type of cycle) have been telling the story of a recovery for a while as the market kept talking crash. From here, I believe if their starts volumes increase it should disproportionately help the lumber recovery. I'm not in the 2021 $1000 lumber camp at this point but in 2018 the group had +20% ROEs and traded at 2x book... Vs now 0.7-0.9x book... Whatever the market decides, breakeven is roughly $500 so time above is some decent cashflow, we don't seem to be pricing in a ton. It's interesting (disclosure long). I still think incremental demand should be strong while most of the market is more locked in place with their old mortgages as that doesn't help/matter to those looking for a first time home. Family formation is actually stronger in the 'good times' periods that would coincide with higher rates. Either way there was a lengthy stretch where building was depressed and I believe some higher level/catch up is necessary.
Auto Parts
Auto parts is another cyclical that I remain long and optimistic about. They're historically cheap because economic sensitivity... As best I can tell. If the structural earnings recovery & growth doesn't revalue them higher, I hope they're able to buy shares off the unappreciative shareholders to compound at +20% most years. Less of a clear catalyst there for what would make the market revalue but history suggests it should happen eventually. Stocks with those kinds of track records don't trade that cheaply forever. Yes, I know someone out there is rolling their eyes at the thought of this value moron talking about cheap cyclicals. You might me right... But I'm talking (or trying to talk at least) about the assets from a full cycle earnings power perspective. Sub book vs 1.5-2x book average. It's not flashy but if it works as historically it's probably a double+ on a decent company. One which can hopefully add value to move the target further forward along the way. It's the type of thing that feels like it deserves more than the decent allocation I've given it because the risk reward feels like it makes a lot of sense. While people would rightly point out that autos are interest sensitive, I find it interesting that the last time we had sustained higher rates (the 90s) auto parts companies were absolutely rocking. perhaps it was the strong economy, perhaps the high cost of capital just increased the required returns to make investments acting as an artificial moat. It's not my thesis, just something I found interesting and counter to conventional thinking (or this market's assumptions at least).
The point of most of these is that things have long histories of being less dramatic than people expect. It makes investment interesting when the market basically assumes trouble. When there's upside in continued difficulty it's easier to be patient enough to stick through the potentially not ideal but survivable situation.
Real Estate
Personally, I'm well versed in entering the pain trade. It's probably where I've entered the most asymmetric investments historically. I have benefitted from the fact that I don't have to report my performance to anyone in this way. Being rate-exposed has been painful. Unfortunately, at this point most of my favorite sectors value-wise are places negatively impacted by the same hike-resumption environment.
I think some of the fear in the real estate is misplaced. People frequently discuss cap rates as negatively impacted by rates. What gets lost in that discussion is the rising rents, replacement costs and economic values of prime locations in decent economic environments. The last time we had a rate hikes cycle, real estate values rose substantially... In the 70s too. Further still people seem concerned about interest rates and leverage profiles. On some assets that could be an eventual issue. On the sector from a very broad perspective... The math if actually done on the leverage is closer to a shrug.
40% leverage and 5-6% cap rates while you can fix 6+ year debt at 5.25% or lower for longer term. There's a monumental difference between a 40% levered 10-15 year amortization debt load with laddered maturities and a 20+ year amortization individual mortgage jumping 40% all of a sudden when it comes to interest service. I mean a RE developer spoke about accessing 10 year debt near 4% too.. that's less than most cap rates and we'll below what's available for consumer mortgages. I wouldn't go overboard on pushing all expirees to the same time but if you're concerned about RE that can tap fixed rate capital below 5% for 10 years you basically cover the whole amortization period while gathering the cash you sit on and earnings +5% on shorter term cash... It doesn't sound tremendously concerning. They could essentially flip their balance sheets to be net beneficiaries of higher rates while reducing risk. I've basically come to the point where I've decided that what I think should be done doesn't matter... the central banks are intent on being a danger to everyone so protection from the 'risk' that they could be incompetent morons who are willing to blindly wreck the world must be considered. If rates go down they'd get a valuation bump and have plenty of capital and access to more. If rates go higher you make more on the cash & probably higher NOIs plus gain flexibility to deploy cash at higher rates of return.
That ~4% 10 year debt is probably a blessing for the country of the market priced a flat yield curve more in line with 'higher for longer' we could easily start facing other problems.
This slide from one of Canada's largest REITs basically explains it. For all the expensive living, high rent etc, their yield on cost is under 5%. If bonds or cap rates were pushed above 5% for duration you'd make less money adding supply than sitting in cash or buying existing assets. That would further shut down very much needed rental development. As is, most non-pre-sold development is rapidly slowing. According to central bankers that's the way to cool rent inflation... Incase you were wondering what caused my lack of faith in central bank logic.
Meanwhile... And this is the weird part... A bunch of these things have long term rental contracts often with rents well below market that roll into NOI growth. More economic growth or inflation doesn't hurt them in the long term. So, while I look cautiously at the potential for further cap rate raises, I think that with proper maturity management plenty of REITs are actually looking at some of this market backwards. Leverage is normally a structured bet on improvement or value creation. Here the market jumped straight to the concern that things keep going so well that it would be expensive to repeat the same bet.
As you can see, rising real estate prices have been a lowering rates phenomenon for 40 years... Before that they were a rising rates phenomenon. :)
Oddly, for REITs in the last rate hiking cycle they were compounding in the high 20% total returns.
Whatever the rhyme or reason or market thinking it's another area where I think you're able to pick up discounted assets. It wouldn't surprise me to see tactical deleveraging in response to higher debt service costs and perhaps different investor yield expectations. The fear is really that central banks are completely incompetent and hike into a declining economy. That's why I look at inverting the rate exposure on the balance sheet to any degree that flexibility allows. If they're going to further invert the yield curve...
Also I mean, let's say you're a company with access to long term debt near or sub 5, I may sell assets to de-risk but I'm not paying off the debt. I'm setting up maturities at better terms with my newfound flexibility and making the spread sitting on cash until something changes. If you can develop for a ~5% yield, your floor is somewhat hedged grab increased debt at 4.5, on assets that pay for themselves sit on excess cash at 5.5 or 6 or whatever stupid level they decide. Make the spread, benefit from the rent growth lunatics can cause & once they figure it out and put rates where it makes sense to develop you have cash (when you ironically don't need it). Point being fresh rates are the floor & as long as an eye is kept on debt roll/pay down schedule there's an intrinsic & logical hedge available here. There's always a spread somewhere, in a healthy market the spread rewards usefulness most (developing a new building) in a well supplied market it might be on buying a asset at a higher yield... On a demented market it's being useless/wasteful and accumulating cash... But that's where we are.
I hate suggesting this strategy of grabbing term in debt because I believe it *should* be perfectly wrong. Rates should have peaked and in terms of what's best for growth of humanity and what's best for most people, should come down. Not only that, I think inflation is falling and will normalize without further hikes. What should happen and what will happen don't necessarily have any relationship with each other. Protection and ability to survive stupidity is more important.
Hate For Housing
It's amazing how much hate the Canadian housing market has. Plenty of renters are downright angry or gloating about rate hike putting homeowners underwater. I don't know what they think will happen when housing starts continue to decline due to lack of profitability. I don't think affordability will get better on that trajectory. I don't think rents will get much lower either. We lost 14000 construction workers last month which is a repeat of the April losses. Step one Price down. Step two Supply down. Step Three Price up... but with less people being able to afford it due to less supply. I for one would prefer the price to fall because we get supply for everyone than the price to rise because no one can rationalize building... but what do I know. Months if not years ago I was being vocal about the fact that rate increases make affordability worse... they did... when they moderated and we priced in cuts it started getting a bit better only for hikes to reverse that. That's without getting into supply destruction. Worse is coming on this trajectory.
Oil
I keep hearing that crude is underpriced, lack of investment higher cost, no profit at $70 etc.
I also keep hearing that offshore break-even are $40 and that seems to go with drill baby drill among offshore companies. The Canadian oil companies keep talking about ability to make good profit at lower prices while the Saudis seem content subsidizing the market. $70 is plenty for most of the world to grow but iffy for the marginal producer's full cycle returns. IMO the bear case is that $70 looks like good money in many places and the bull case is we need all the $70 oil we can get later. I don't believe we need sustained $90+ oil. I think in a reasonable environment $80 is more than adequate for all relevant parties... That said, the market is rarely so civil. I'm not a believer in $100+ oil. I mean if you look at the technological advancement since 2007 era... we've grown drilling productivity by something like 20% CAGR. There are resource quality offsets but I don't think we're near a place where sustained higher prices are needed. Looking at the cycle of equity prices leads me to similar conclusions. $75-$80 is my rough idea of right price. $60 to $90 wouldn't make me surprised. I do find in interesting how much the WCS spread has fallen.
Gasoline
Gasoline has remained, largely through elevated crack spread, significantly (unhelpfully) inflated. It would be a breath of fresh air if the futures got this right. Many perceptions of inflation are linked to gasoline plus if you're looking for short term CPI relief that could be where it pops up. The futures suggesting a ~20% decline in gasoline prices would certainly be a useful data point in suggesting that inflation is back at target quicker to avoid further damage.
This has been delayed enough that I really wouldn't count on it to be accurate.
Uranium
It amazes me how long a sector can go without me feeling like I have much new to say. The price is still below where I feel it must eventually go. The investment possibilities remain a different question altogether. Most, obviously don't trade strictly on uranium price or fundamentals. It leaves a huge basket of things that I don't know what to make of. I will say that we have seen a different psychology from what some early bulls hoped for. There was hope that companies would wait for a good price to move forward. What we've seen is companies rush forward with a minimum price. It doesn't change the end S/D math but it does change the irr hopes. There has been some positive demand developments but the big one (China) simply hasn't been progressing at the pace hoped years ago that would be required to make this an explosive bull market. It's been more nuanced than I or many bulls from years ago thought. There are some names within the space I find appealing and many more I have no interest in today given the other opportunities in the market in less risky companies. The uranium I own I sometimes question why... and other times think I should add more.
Data
Inflation has continued to decline but particularly in the US, the economic data has been improving.
In the US, data has probably been the strongest. It looks like the economy may be reaccelerating. GDP revisions are upward and payrolls look very strong. Housing hasn't been getting weaker since last year despite the continued hikes. This despite record profit spread between the 30 year treasury and 30 year mortgage rates further tightening the funding in that market. Builders are stepping in to offer their product with more reasonable funding to great effect. May had very strong starts and new home sales data. If that's a trend, I like the outlook in lumber.
In Canada the only data still looking very strong is the population numbers. Ironically... The weakest of data (in May at least) was housing starts. We're at like 1 housing start per 6 new inhabitants (trailing)... It's almost like as profit margins shrink you get less housing starts or something. The interesting thing is for a decade now people have been indoctrinated with the belief that low rates caused prices to increase yet if you look at 100+ years of history, it doesn't seem to suggest that. Anyway, housing starts are now down by ~33% YoY and back to pre pandemic pace. The most recent number was before the June rate hike (also before some positive US housing data).
Canada has now seen back to back months of declines in full time employment. A few months ago, out main transports suggested volumes were consistent with a mild recession. These points are wild to me considering we're running at something like a 2.5% population growth. Adding a million people a year and the economy is still losing jobs and volumes declining. I don't know if the recent improvement in the US will drag us out of this slump or not. Either way, the BoC seems absolutely oblivious to this entire paragraph as they just restarted raising rates in June. They want more suffering so we may well get that.
In connection with the railroads saying in may that they're seeing a mild recession amidst 2.5% population growth, wages have now been flat since March posting declines in may and June from their April peak. Unemployment is 5.4% up from a cyclical low of 4.9% (5% two months ago). We are certainly in a per capita recession... not that that means anything. The economists who at the same time 'we need more hikes' & predict 20k jobs per month and call 60K a big beat while 250K population growth per quarter should (at average employment rate) mean 55k jobs per month are truly infuriating. 292k from last Q at a 62.2% employment rate would be 60.5K per month... so the last 3 months average of 28k is... not great.
Counterintuitively the CAD has been strengthening despite the weaker data. Probably the surprise hike. Ideally this helps trade prices and reduces inflation perceptions. We're trailing the US in many things but we are likely to be dragged around by their data on a muted and lagged degree.
I think the Canadian economy is in conflict between the mortgage holders (almost all of which have rates that will reset in 5 years or less at any given time) and the human QE of immigrants supporting the pending suffering. Unfortunately, whichever way you cut it I think we're going to see an increase of homelessness. You have one hand fighting the other and the net policy looks incompetent and disgusting. The interest payments are off the charts because the debt load is so much higher than in the past. The shock of it all is pretty ridiculous because there's not really time to adapt and recognize what's happening to try to stem the bleeding before the next assault. They aren't even giving the time necessary to see that inflation was already falling because they literally keep adding to it. Every month from August to February ~0.1% inflation worth of Mortgage interest cost (CORE) inflation will roll off (except if rates are sent higher first). I think the bigger risk is political response and to living standards of the average Canadian rather than 1% above target inflation being potentially sticky or having a few more tech workers. The market will figure it out... But probably not in the way that some are thinking.
In the meantime, the reset of rates will continue to put the incremental financially marginal Canadian in a position where they lose their house... And the non marginal to ship large payments to rich old GIC holders. The loss of productivity on this capital will likely be a negative to the economy and destructive to some people's lives. This differs from the US where most rates are fixed for 30 years at the time of purchase so rate hikes don't change the conditions of past deals. (Before you ask we just generally don't have the same options available)
Rates
What I think should happen and what I believe is likely are two different questions. Ignoring that I think rates are already higher than they need to be, I think the data has given cover to CBs for more stupidity. By this point I think it should be clear that interest rates don't do what some people thought. Places that didn't hike have seen inflation implode... But no one is talking about that. In Canada 1/4 of our core inflation is Mortgage Interest Cost... Few care about that. Capital and supply is now more expensive... nobody cares. Anything bought with financing is being inflated in CPI. Acceleration interest payments are stimulating the US economy and we're just gonna pretend that's not happening. But let's just keep pretending that raising rates is the only magic in the universe capable of bringing down inflation. The reality is I think inflation is probably running 2s which basically already disproved the 'sticky' fears and shouldn't be a reason to take rates higher. That said, we have 1 more month of helpful base effects here in Canada which should take inflation to 3.0 or 2.9 from 3.4... we then get effectively a season of negative base effects where inflation is likely to rise. (Before you tell me that 3 and rising is too high, I'd highlight that 3 is actually 2 + Mortgage Interest Cost and by rising I mean by 0.5 excluding Mortgage Interest Cost.) I have 0 faith in those at the helm to be any more prescient than the moronic hot takes one might hear on twitter... I really have no idea what they might do with that.
The US Might actually be a beneficiary of higher rates. I was cautious about this theory and don't know how fully sold on it I am... BUT. The US has $32 trillion in debt most of which is short term T bills. as that rolls over it's now $1.5 Trillion of unfunded interest payments being shipped out to the holders of US debt. US debt is an ASSET as well as a liability. The owners of those assets are getting paid more as the US treasury goes further into the red. IE new money being pumped into the economy. That should at least offset some of the theoretical slowing hikes are supposed to cause. I'm pretty surprised that the US is just paying out 2x their military budget in interest or 1/3 of their tax revenues and we're just acting like that's normal. It could be rather terrifying if it turns out to be the case that debt payments are accelerating the economy (if that proves to be inflationary)... but not bearish stocks.
We actually had 3% inflation back in 2018... We didn't freak out about it then and it naturally fell back down... with interest rates at roughly 1.5%-1.75%.
'Missed it by That Much'
It's pretty unfortunate... Being me at least... I've been calling for inflation to come down with or without rate hikes... It mostly has (and looking at how inflation has collapsed the places that didn't increase rates, I think there's more undiscussed validity there). I've been saying Canada should scrape by because of our immense population growth. Population has boomed and Canada has miraculously muddled along despite every rate reason not to. Despite being ok with those points my expression of these ideas have been junk. I failed to consider that the BoC would want to kill us for no reason. We could have had a very soft landing if we stopped rates a long time ago. Maybe we still can, maybe not. Maybe a soft landing is still a miserable outcome because the average Canadian suffers.
Conclusion
It's difficult to plan your investment when you're having to base decisions on the market's response to irrationality. The market tries to fix problems while forces act to make them worse. There are tremendous risks in both directions... Will they kill the economy? Will the create more inflation? I don't know how much of each we get. What I have noticed is that most of the time people only discuss half the equation... the half that the market believed for a long time. "Interest rate hikes slow the economy and kill inflation," or "When rates do X, this market does Y." Often, when you follow the logic, there is none & the historical reference is based on a time where there was a bunch more going on. The economy & the market work things out. Supply is a big part of the equation. Profit and cost of production matter. Often relying on what 'people say' misses a lot of the other side. In physics you learn every action has an equal and opposite reaction. Economists seem to ignore that. It's becoming evident how dangerous that is. My response is caution. Spread factor exposures, company risk profiles, sectors etc out to avoid being at the mercy of poor policy.
I'm critical of much of this stuff because I fear the consequences. I believe there is something deeply wrong with the premise of how things are being done. Tons of potential is possible for making it better but immense destruction is possible from making it worse too. I hope we don't go that direction but believe we're concerningly close.
Enough rambling for today, catch you next time.
