Q2 2023 Commentary from Andorra
“I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.”
-- Warren Buffet
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Overview
We have entered a period of sustained higher interest rates. Some of the immediate results we have seen from this are a slowing housing market and stress in the banking sector. The housing market softness has been transmitted quickly as prospective buyers must re-budget around higher mortgage payments, which directly impacts how much house they can afford. Other sectors of the economy may have a more muted or longer lead-times to feel the impact of higher rates. But it should be noted that big-ticket items like boats, motorhomes, and other discretionary purchases have slowed in recent months.
Gauging how much the current slowdown is due to post-pandemic hangover and how much is directly tied to higher interest rates is difficult. Boat and RV manufacturers booked their most productive year in 2021. 2022 was their third best year on record, but 2023 is shaping up for a potential 50% decline in production numbers versus 2022. Industry watchers are blaming decreased production on high interest rates, bloated inventories, and slow sales. Many are forecasting a recovery in 2024 but that is predicated on interest rates coming back down, which may take longer than many currently expect.
Coupled with higher interest rates, the economy is also trying to absorb persistently high inflation. To some extent a higher cost of money (interest rates) and higher cost of goods (inflation) has generally led to a slowing economy. The Federal Reserve (the Fed) is of course hoping for a “soft landing” from their interest rate increases. But as we have seen post-COVID, the Fed was soundly wrong about how massive stimulus and zero interest rates would impact the economy (massive inflation has ensued).
Now, rapid increases in interest rates are a wildcard and where impacts will be hardest felt. Banks have already failed, and we are seeing substantial stress in the commercial real estate market. As mentioned, big-ticket items are beginning to see substantial slowing. So, as we continue in an uncertain environment with Russia and now adding the Middle East, we do expect inflation to stay somewhat elevated and rates to stay higher for longer. The big question is what the outcome will be.
Economic Commentary
Until recently, the US economy has proven to be very resilient in the face of higher interest rates. The issue now is, how long is the lag before higher rates severely impact the economy or will the Fed really engineer a “soft landing.” Discretionary big-ticket items like boats, RVs, furniture, and appliances can be leading indicators of where the economy is headed and where it is slowing. Weakness across all of these areas are being noted from manufacturers to retailers. Milton Friedman said monetary policy acts with long and variable lags. We are already seeing the effects of tighter monetary and fiscal policy, but this may only cut the froth off of the economy and put us back to somewhat “normal” pre-pandemic levels.
As the preceding chart clearly indicates, rates have again moved to new highs. It is estimated that the average U.S. household has about $8,000 in credit card debt. While 2020-2021 saw a decline in overall debt levels, 2023 is shaping up for a new record-high of over one trillion in revolving debt. This, coupled with the ending of various stimulus programs, a re-starting of student loan debt repayments, and a generally high level of inflation, could be a persistent headwind for economic growth. These factors, along with a general cooling of the economy may mean we have seen a peak in interest rates. Hopefully this is true, as the housing industry has seen affordability indexes and transaction levels indicating we are in for tough times ahead. Slowing sales alone don’t spell imminent trouble for the economy, but as so many jobs are tied to the housing market a slowdown has a knock-on effect in furniture, appliances, home services, relocation, and other related markets.
In the face of higher interest rates and a slowing housing market, the employment landscape continues to stay very tight. Only recently, the JOLTS report (Job Openings and Labor Turnover Survey) and unemployment rate has started to show softness from historical records. Even with less potential job openings, the unemployment rate continues to stay extremely low but is back up to almost 4%. This compares with a record low of 3.4% in January (the lowest in 54 years). It is expected that these factors may allow the Fed to stop raising rates and adopt a “wait and see” approach going forward.
Outlook
In relation to where markets are currently at (primarily the stock market), we have sold off only briefly with the market entering “correction” territory in October. Preceding this in the first half of 2023 the bond market posted some of the worst returns in modern history. We have since bounced off these lows in both the bond and equity markets largely due to weak economic reports which have been interpreted as rates may come down in the near future. But the interesting thing is, the Fed and European Central Bankers continue to communicate they will continue to keep interest rates higher for longer.
There has been no indication that interest rates will decline meaningfully when the economy slows. Higher rates are intended to cool the economy and their actions have been working. Further, there is no indication that the economy is falling off a cliff which might necessitate a rate cut. So, we are left with an economy that is softening (which at some point will impact corporate earnings) and is trying to absorb substantially higher interest rates. Why does this matter? It appears that the Fed’s actions are working but remember the Fed’s primary focus isn’t asset price levels; so let’s touch on interest rates and their impact on asset prices.
Ray Dalio has recently been credited with stating, “It all comes down to interest rates. As an investor, all you're doing is putting up a lump-sum payment for a future cash flow.” Dalio certainly isn’t the first person to relay this concept as it is a universal truth of finance. Higher rates are impacting all businesses that either must obtain capital or their business is valued off of a present value of future cash-flows. This is why commercial real estate has been especially hit so hard as both of these factors impact the present value of the business or associated property. Couple these factors with a slowing economy, and it is widely believed this is what has so many in the investment management industry so concerned. We have witnessed the fastest and largest jump in interest rates in the past 50 years. It would seem that US equity markets have been largely immune from the rapid rise in rates.
In the chart above we can see that for the last 25 years equity prices have been correlated to a decline in interest rates. Interest rates have steadily fallen for the past two decades and stock prices have moved up as the “cost” of money has moved down (and the economy has remained relatively strong). The rise in interest rates has made one thing certain, that bond yields are now somewhat attractive. Interest rates were so low that bonds were no competition for stocks. But, within the equity market small and mid-cap stocks have sold off, much more so than large-cap stocks. This is an area that is showing some opportunity as valuations have come down substantially. So, as interest rates will likely stay “higher for longer;” short term bonds, opportunistic bonds funds uncorrelated to treasury markets, and small-cap stocks should provide an opportunity for investors going forward.