During every cycle, different components of the economy evolve in their own unique manner. We divide the economy into four components; consumer, corporate, real estate, and government and evaluate them along several factors including, but not limited to, liquidity, leverage, and sentiment. Each factor is evaluated on an absolute and a trend basis to determine the fundamental outlook for each component. This helps to determine our overall macro view, which informs our overall risk tolerance and direction. The outlook at the individual component level helps determine what areas we want to take more or less risk. Below is a summary of our recent macro discussion.
As mentioned in prior postings, the overall global economic data is weak and the trend is still negative, as measured by the Global Manufacturing PMI surveys and the Citi Economic Surprise Index.
The U.S. continues to be one of the stronger economies globally on an absolute basis, but the trends have started to decline.
Our overall macro view continues to be one of the slower global growths during 2019, slower U.S. growth but no recession, and little risk of accelerating inflation. This leads us to be inclined to reduce our overall level of market risk but not one of full-on defensive positioning.
In terms of the four components, the consumer and commercial real estate markets appear to have the healthiest current fundamentals and better trend data than corporations and the government sector. The consumer sector has experienced the strongest balance sheet repair of the four components this cycle, due mostly to a reduction in mortgage debt.
Consumers have also benefited from a strong labor market and wages are starting to increase at some of the fastest rates this cycle.
Low interest rates have also led to some of the lowest debt service and financial obligations ratios in history.
The biggest potential weaknesses we are monitoring in the consumer space are the impacts of higher rates on consumer loans like credit cards and autos, the continued growth in student loans, a potential peak in consumer confidence, and the dependence on financial assets as a percentage of total net worth.
The commercial real estate market is another area that has seen continued fundamental improvement driven by balance sheet repair. Using REITs as a proxy, overall debt levels, interest costs, weighted average maturities, and coverage ratios are near record positive levels.
Going forward, we believe fundamentals will likely improve at a slowing rate as cap rates are very low, NOI growth is slowing, and some sectors are experiencing negative secular headwinds (like retail). However, we think this return dispersion reflects a healthy market signal that investors are being more selective in how they assess different property types, which creates a more stable overall market environment.
The corporate sector has seen an increase in overall debt levels this cycle.
While low interest rates have helped make leverage and coverage ratios look healthy, if the economy continues to weaken, earnings/cash flow decline, and borrowing costs increase, these fundamental indicators can deteriorate quickly.
Some indicators of business confidence have also started to decline.
The U.S. Government has likely seen the largest decline in terms of overall debt levels and fundamental financial health, which has the weakest trend data.
The budget deficit has started to widen at an accelerating rate and is projected to continue to do so for several years.
This can likely get worse as these projections do not include a recession, interest outlays continue to increase even with low interest rates, and long-term potential growth in the U.S. continues to decline.
In summary, we will be looking to reduce our overall level of market risk (lowering the beta at the security and industry level, shortening the maturity profile, moving up in credit quality, and increasing interest rate exposure) and shifting the mix of our risk allocation to more consumer and real estate areas and reducing corporate exposure.
Next week, we will be discussing some trends in corporate credit markets.
Rank Dawson, CFA
Vice President, Strategic Planning
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.