Waves and Tides, Ocean Liners and Motor Boats
Dear Fellow Shareholders:
As my June report noted, I could have repurposed my March commentary with a June date. For my September comments, I could easily recycle my June comments (which closely echoed March) with a September date. More simply put, not much has changed. The U.S. continues in a slow expansion producing full employment without inflation (which usually accompanies full employment). This is a rare but happy economic state.
Yes, headlines are ever negative, implying big changes just ahead. But to date in our current expansion, they amount to the boy who cried “Wolf.” Headlines provoke episodic adrenaline rushes, but paying too much attention to headlines can lead to unneeded, even unwarranted portfolio changes. The analogy of waves and tides can provide perspective. Headlines are like waves which ebb and flow on the ocean’s surface, but the real story is the tide beneath the surface. If the tide is rising, the waves will move closer and closer to the shore. If the tide is receding, the waves will also recede.
For the past decade, the fate of the economy has been determined by a rising tide. To be sure, some waves have given the impression that the tide is receding. But the reality is that the tide has been ever-rising. Daily headline waves may suggest a change in tidal direction, but so far the tide has continued rising.
I believe that one of three events will eventually change the tidal direction of the U.S. economy: excessive private debt, excessive spending in cyclical industries, or rising inflation.
Hyman Minsky explained that excessive private debt develops in three phases. In the initial phase, both lenders and borrowers are cautious. Debt is only undertaken when cash flows from the debt-financed project are sufficient to pay both the interest on the loan and to repay the principal. More aggressive lenders and borrowers mark the second stage. In this stage, cash flows from the debt-financed project are only sufficient to pay the interest; both lender and borrower count on capital appreciation of the project to repay the loan principal. In the final phase, each party relies on a rise in the value of the debt-financed project to service the debt, as the cash flows from the project aren’t even sufficient to pay the interest on the loan.
The ’08 Global Financial Crisis (GFC) presents a recent example of how this plays out. In the years leading up to the GFC, aggressive lenders enabled aggressive borrowers to borrow far beyond their ability to service home loans. They both counted on the continuing rise in home prices to enable the refinancing of the loan. When home prices stopped rising, worried lenders demanded loan repayment. The only way for that to happen was for the borrowers to sell the home. But too often the home could not be sold for more than the value of the loan. The loan was underwater. This caused both lenders and borrowers to panic. More lenders wanted repayment and more borrowers tried to sell their homes. Ultimately this led to a collapse in home prices.
During the current expansion, rising private debt has not been an issue. It is apparent that both borrowers and lenders bear scars from the GFC. Anxious lenders remain reluctant to lend, and traumatized borrowers remain reluctant to borrow.
Excessive spending in cyclical industries (e.g. airlines, autos, construction) is often most visible in real estate. The Texas oil bust in the ‘80s left 200,000 vacant homes in Houston. In turn, this led to bank failures resulting from overly aggressive lending. Over the years, Miami has experienced a series of condo booms culminating in vacant, partly-completed projects. The GFC left tracts of unfinished housing developments across the country. As noted in the above paragraphs on private debt, excessive spending on cyclical projects depends on overly aggressive lenders who provide the funding for the ill-conceived borrowing. It is likely that residual angst from the GFC is reigning in cyclical industry spending in the same way that it is subduing private debt.
The lack of inflation in the current business cycle has puzzled observers. Most expansions feature some type of over-investment financed by aggressive lenders, which usually brings rising interest rates and rising inflation. In this cycle, the Federal Reserve (Fed) has tried to get inflation to rise to 2%. Yet inflation has remained stubbornly low. One reason is that both lenders and borrowers remain cautious, as they did for years following the Great Depression. This caution has led to investment levels insufficient to spark inflation, which is not necessarily bad. In fact, the lower level of investment appears adequate to meet the needs of the economy. Employment is at near-record lows, and inflation is contained. Instead of being designed to dampen an overheated economy, the recent rate cuts by the Fed are intended to keep our current expansion going.
Demographics are also playing a role in low inflation. When the population is predominantly young, there is ample demand for many kinds of goods, most notably housing. But when a population ages, spending tends to dry up. Most of the desired goods have already been purchased, and homes are often sold in favor of simpler apartment living. Saving takes the place of spending. Inflation has a hard time igniting in an environment where the demand for goods is weak while the supply of savings is strong. Japan has led the way in demonstrating the tendency of prices to decline as the population ages, and Europe is following the path laid out by Japan. While the median age is not increasing as rapidly as Japan and Europe, the U.S. is moving in that same direction.
Low inflation and low interest rates tend to go hand in hand. One reason for this is that a large component of interest rates is the inflation rate. For example, during President Jimmy Carter’s term, interest rates were in double digit territory driven by an inflation rate of 13%. Our current interest rate is, in part, driven by our low inflation rate. Low rates invoke two different responses. Some respond by borrowing aggressively to invest in projects made viable by the low rates, or they seek to invest in riskier but higher yielding projects. Others pull in their horns and save more to offset the low rates. If the majority decide to save more, the Fed’s attempt to stimulate the economy via low rates will fail. It will be tantamount to pushing on a string — lower and lower rates bringing ever more saving instead of being the spark to get the economy moving.
While the three economic causes of recession are benign, non-economic political factors could lead to a market setback, if not a recession. Tariff wars have already slowed economies around the globe. The end of such wars has been promised many times, but, as with Charlie Brown’s elusive kick, Lucy keeps moving the football. Brexit is already affecting European trade and threatens an even more severe impact. Conflict with Iran brings the threat of a hot war. Who knows what the riots in Hong Kong might bring?
It is not yet time to ride through the streets like Paul Revere shouting: “A recession is coming! A recession is coming!” But sooner or later a recession will come. When that happens, stocks will decline. That doesn’t mean we should abandon ship. I like the analogy of a speedboat versus an ocean liner to describe our approach. Once an ocean liner is moving in one direction, it is a lengthy process to get it moving in another. On the other hand, a speedboat is nimble enough to freely change directions.
We are investing in companies which are “speedboats.” They have the ability to navigate in a way that liners do not. Though they may not have the ability to sidestep a recession, they usually exit a recession in a better competitive position than they entered. They may have been able to make a favorable acquisition. They may have been able to hire some good people who were let go. They may have been able to negotiate favorable terms with stressed suppliers. And so on.
While speedboats don’t want a recession, neither do they fear one.
I want to thank you again for having the confidence to invest your money alongside of ours. While we won’t hit every pitch, we hope to hit enough to make your investment grow over time.
This letter is for informational purposes only and does not constitute investment advice or a recommendation of any particular security, strategy, or investment product. The expressed views and opinions presented are for informational purposes only, are based on current market conditions, and are subject to change without notice. Although information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge, Seven Canyons Advisors cannot and does not guarantee the accuracy, validity, timeliness, or completeness of such information and statistics made available to you for any particular purpose. Past performance is not indicative of future results.
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