2/19/2020
IV. 2019 Annual Letter excerpt - Macroeconomic overview:
Despite the S&P 500’s +31% total return in 2019 (which clients should consider in the context of the S&P’s -4% total return for 2018), Long Game Financial’s (“LGF”) macroeconomic outlook has remained unchanged since 2018: we continue to be optimistic about the US economy because the US consumer is financially strong relative to history, we believe there is significant room for the US housing market to expand due to insufficient home supply in many parts of the country, and we remain concerned about the long-term sustainability of China’s economic growth model.
We will start with China: although LGF primarily invests domestically we do believe that it is incumbent upon all investors, regardless of domicile, to attempt to identify imbalances in the global economy that could affect the financial results of the companies they own locally—and, as noted in last year’s letter, we believe China should concern all investors greatly because of the sizeable effect that country has on commodity prices and interest rates.
Over the past two decades China has been the marginal consumer of the world’s industrial commodities, and in recent years its borrowing-and-spending-driven growth has comprised roughly 30% of global economic growth and 50% of global investment. Because of this, LGF believes that owners of stocks that benefit from higher commodity prices and higher short-term interest rates are implicitly betting on China’s continued economic expansion, often unknowingly. While we are hesitant to bet against China (as Keynes said, “the market can stay irrational longer than you can stay solvent”), we also believe it is foolish to bet on China—so we continue to do neither by actively deciding to maintain de minimis look-through exposure to commodities and higher interest rates for the foreseeable future.
Chinese economic concern notwithstanding, it is likewise important to emphasize the US’s relative economic independence: the US net exports oil and agricultural commodities, net imports finished goods from China (that is, many US businesses do not depend on China as an end-market), and the US’s domestic demand for housing—arguably the number one driver of the US economy—is mostly independent from the global macroeconomy. Therefore, while a hypothetical decline in China’s economic growth would be economically negative for aspects of the US economy, any resulting downward pressure on industrial commodities and/or interest rates would be an offsetting positive for the US.
Meanwhile, the statistically-long US economic expansion, which started in summer 2009, continues to chug along and we see few reasons for medium-term pessimism despite the stock market’s persistent fixation on (and sometimes jarring price volatility as a result of…) one sensationalized risk or another (see “China Trade War”). Amidst the din we note that (1) the US consumer is wealthier than ever right now (with significant room to increase their personal borrowings relative to historical baselines), (2) new home construction per capita remains muted by historical standards, and (3) unemployment, long-term interest rates, and inflation expectations remain at or near their historical lows.
The remainder of this letter walks through LGF’s updated macroeconomic graphs, which we introduced in our 2018 annual letter. We believe these graphs suggest that the US economy is currently healthy with meaningful, latent drivers of expansion.
1) Per the Federal Reserve, US consumers are wealthier than ever.
US household and non-profit net worth in third quarter 2019 reached an all-time high of $114 trillion. This is a nearly $45 trillion increase from the third quarter 2007 peak of $69.5 trillion.
US household debt service relative to disposable income was 9.7% as of 2019Q3. This is the lowest reading for this metric since at least 1980 (the beginning of the St. Louis Federal Reserve’s data) and represents a marked decline from the >13% high prior to the 2007 recession.
Record high net worth and record low debt service relative to disposable income indicate Americans have the ability to increase their borrowing and spending.
Increased borrowing-and-spending occurred during the end of the last two US economic expansions, but we have not yet observed meaningful borrowing-and-spending during our current economic expansion.
As one example, the Urban Institute reports that cash-out mortgage refi volume is currently a fraction of what is was prior to the last recession despite record home equity:
2) Home prices are cyclically high but low interest rates help affordability and in our view the data do not suggest a surplus of housing.
…new home construction remains relatively muted: home permits per capita, despite recovering from the post-financial crisis trough, remain in-line with troughs reached during prior recessions in the 1970s, 1980s, and 1990s (that is, the red line below).
In our view, these data at least suggest that we should not be too concerned about a supply glut depressing real estate prices. This is relevant because (1) real estate is an important driver of employment and (2) real estate and stocks drive most of the variability in consumer wealth.
3) Unemployment is at a cyclical low, which tends to be concerning—but in our view US leading indicators are neutral-to-positive currently.
Unemployment, broadly calculated, is at a cyclical low.
The KC Fed Labor Market Conditions Index continues to suggest above-average labor market conditions.
Temp employment, a historically useful leading indicator, continues to be at a historically high level of over 3MM although it is also no longer growing.
The yield on 10-year treasuries minus the yield on 2-year treasuries remains historically low and went negative only briefly in third quarter 2019 (as one might expect, this was widely publicized in financial publications at that time). The slope of the yield curve is a widely discussed leading indicator because recessions have historically followed yield curve inversions.
4) US debt markets are currently open for business.
Bank lending standards tightened slightly in 2019 after loosening in 2017 and 2018 but in LGF’s view they remain loose relative to history.
The riskiest subset of below-investment grade corporate bonds remain within their post-2009 trading range.
5) US oil production hit a new all-time high.
US crude oil production reached a new all-time high in 2019. This is relevant because declines in crude oil typically lead to lower gasoline prices and thus increase disposable income for consumers.
Increased disposable income is important because consumption constitutes over 2/3 of US GDP (that is, it is difficult for the US economy and the US consumer to decouple).
6) Market-based measures of forward inflation expectations remain muted.
Ten-year breakeven inflation—a forward-looking, market-based measure of inflation expectations—remains low and rangebound. This is important because muted inflation is ideal for most investments.
7) We do not consider the stock market richly valued, especially considering today’s historically-low long-term interest rates.
Ten-year US treasury bonds currently yield approximately 1.6%, which is effectively an all-time low. A historically low 10-year yield is notable because all else equal, lower long-term interest rates reduce discount rates and therefore increase asset prices.
On 2/3/2019 the S&P 500 traded at 19x next-twelve month adjusted earnings (a 5.3% earnings yield), which LGF considers reasonable considering today’s historically-low interest rates and the current state of the US housing market and US consumer.
Although 19x is a historically high multiple for the S&P 500 in absolute terms, absolute multiples mean little; multiples always require context to be meaningful. In specific, we must gauge the S&P 500’s multiple relative to (1) the 10-year treasury yield (a measure of investors’ opportunity cost…all else equal, a lower 10-year yield means higher multiples) and (2) with some view of the extent to which the S&P 500’s cyclical components may be over-earning or under-earning (all else equal, “under-earning” cyclicals have temporarily higher multiples and “over-earning” cyclicals have temporarily lower multiples).
With these critical consideration in mind, in LGF’s judgment the S&P 500’s 19x earnings multiple falls within a realistic range because (1) the spread between the S&P 500’s earnings yield (the yellow line below) and the 10-year treasury yield is roughly at its post-financial crisis average and (2) in LGF’s view, once again, the data suggest that there is significant room for the US housing market to expand, especially in light of today’s historically wealthy US consumer.
© 2020 Long Game Financial, LLC