The following paragraph is a refresher on our macro analysis framework from a prior post:
We divide the economy into four components: consumer, corporate, real estate, and government. We evaluate each component along several factors including, but not limited to, liquidity, leverage, and sentiment. Each factor is evaluated on both an absolute and trend basis to determine the fundamental outlook for each component. This helps to determine our overall macro view, which states our 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 we have mentioned in prior postings, the current overall global economic data is weak, and the trend is still negative. Several of the leading indicators we look at, including the JPMorgan Global Manufacturing PMI, the New Orders Components, and the OECD Composite of Leading Indicators, suggest that there is more weakness to come.
The U.S. continues to appear better than other developed markets, but the weakness that started to appear in global data 12-18 months ago is having a larger impact on U.S. data.
Our overall macro view is that global growth is continuing to decline, and the leading indicators suggest a bottom in economic data has not been reached. Current Global and U.S. GDP expectations for 2019 have been lowered compared to 2018 and the original estimates for 2019. It is not clear that the U.S. will definitively enter a recession in 2019, as some of the coincident and lagging indicators such as employment and GDP growth are still positive. At this time, our base case is that the Fed will need to change their policy stance and begin to cut rates in 2019. We believe that the longer they wait, the likelihood that the U.S. will enter a recession will increase. This conclusion lines up with prior periods after the FOMC stopped increasing the Fed Funds Rate. Since 1971, the FOMC has started to lower the Fed Funds Rate within five months of their last rate hike, on average. In 2001 and 2007, the FOMC waited eight and fifteen months, respectively, before they started to lower rates, which are the longest periods on record. The last rate hike of this cycle was in December of 2018. History would suggest that if the FOMC waits past the July meeting to start lowering interest rates, the downside to the economy and financial markets may increase.
In terms of the four components, we currently still prefer the consumer and commercial real estate over the corporate and the government sector. Since our last macro update, the corporate sector has deteriorated more as the recent weakness in corporate profits has been a headwind to fundamentals. The consumer still looks healthy overall, but we are starting to see signs of weakness in some areas.
Overall, consumer balance sheets still look healthy, owed in large part to a healthy residential mortgage market. Delinquency rates have started to increase for auto loans and credit cards, which may be attributable to the recent increase in their respective interest rates.
Employment data continues to be positive, despite some slower growth in private payrolls within the last few months. Wage growth is still positive but has been growing at a slower rate. We have also seen a spending slowdown in certain markets, like autos, housing, and retail sales. We believe this may be contributing to the lower consumption portion of GDP.
The fundamentals of the commercial real estate market continue to be healthy and there are few signs of balance sheet issues in terms of the amount of debt, maturity profile, interest costs, or coverage ratios. Below is an update on some key balance sheet metrics of the REIT market.
Recently, there has been a steady decline in volume, especially in the office sector. Real Capital Analytics noted that CBD (central business district) volume declined 40% year-over-year in April and the year-to-date volume declined 24%, however overall commercial real estate volume is down less than office volume. A large portion of the decline in volume is being driven by the lack of entity or full company acquisitions. The recent strong performance of the REIT industry has caused their stock to no longer trade at a discount, making them less attractive takeover targets. There have, however, been some large private market portfolio transactions taking place.
Price appreciation remains positive but has been slowing down. This appears to be normal as the cycle ages and prices have reached record highs. Return dispersion remains elevated and the retail sector continues to struggle while industrial continues to lead. This differentiation is a healthy sign that investors are appropriately assessing the potential risk-return across the real estate market with some evidence that well-located retail locations have been successfully repurposed. Development activity continues to remain balanced and there are few signs of oversupply.
Leverage in the corporate sector continues to move higher, as non-financial business debt to GDP reached a new high and remains our major concern.
The recent corporate profits slowdown has caused leverage ratios to increase and interest coverage ratios to decline. They remain at levels that do not suggest immediate risks, but they are trending in the wrong direction. If the economy continues to track along the negative trajectory that we noted above, this will likely have a negative impact on corporate profits and cashflows. Declining profits combined with high levels of leverage will put the corporate sector in a vulnerable state. Sustained weakness in the corporate sector could lead to an increase in unemployment, negatively impacting consumers, and eventually impacting the commercial real estate market through higher vacancy rates.
Measures of business confidence have come off their recent highs. This could be a temporary setback based on lack of direction around trade policy or a reflection of weaker global growth. Either way, business confidence has historically had a high correlation with capital investment which has a high correlation with profits and employment. We will continue to monitor developments in the corporate space, as they tend to lead the other components.
The U.S. Federal Government budget deficit continues to increase and is now over 4.5% of GDP. Historically, it is unusual to see the budget deficit increasing during a time in which GDP growth is positive and the economy is accelerating. The CBO is projecting the deficit will continue to increase, which will lead to an increase in Treasury issuance. This may cause a capital reallocation as the buyer base for Treasuries has become increasingly more domestically-oriented (which is explained in our prior post). The fastest growing portions of the federal budget are defense and interest costs, which seem unlikely to change given the current geopolitical environment and the increasing amount of outstanding debt.
From a longer-term perspective, we expect fiscal stimulus to be a larger focus in the next recovery cycle as monetary stimulus will likely have less of an impact. This is based on current low interest rates and a large central bank balance sheet.
In summary, we will continue to maintain our reduced level of market risk and likely look to further lower the risk profile of our portfolios should economic data continue to weaken from current levels. However, if the FOMC were to dramatically switch its policy stance in the next 30-60 days and economic data began to stabilize, we would likely return to a more normalized portfolio positioning.
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.