Market Perspective

Next Man Up

After a selection process that was literally like none other, President Trump has officially nominated Jerome Powell to be the next Chair of the Federal Reserve. Mr. Powell, a lawyer by training, has been a member of the Board of Governors (BOG) of the Federal Reserve since 2012 and will ultimately be confirmed even if the Senate hearings get contentious (think rules based vs. discretionary monetary policy). Mr. Powell has proven himself to be a centrist, voting with the consensus at every policy meeting during his tenure on the BOG. As such, we expect a Jay Powell led Fed to remain patient, and continue down the path of gradual interest rate hikes.

A

Where he differs from Chair Yellen is on the regulatory front. We expect him to be more willing to relax financial regulations that have become overly burdensome. If regulation can be relaxed without jeopardizing the core principle of the financial reforms put in place after the 2008 financial crisis, we expect him to pursue such policies. Additionally, we are curious to learn if he will be marginally more sensitive to the role that ultralow interest rates have played in recent asset price inflation. A chair who is more in tune with growing financial imbalances would be a welcome shift from our perspective. Simply put, Mr. Powell’s likely course of action fits nicely with the current administration’s agenda and is largely a continuation of the Yellen/Bernanke Fed.

A

This nomination came as no surprise to investors as markets were little changed after the announcement and volatility fell (yes, it had room to fall further). Looking forward we expect the future path of interest rates to be little changed under a Powell Fed, thus equity markets can breathe a collective sigh of relief. We continue to believe that one of the biggest risks for equity markets is a rapid and aggressive tightening cycle. Without a dramatic shift in the inflation outlook we expect no such outcome with Powell at the helm. With that said, we have argued in previous editions that anecdotal evidence suggests inflation pressures are bubbling beneath the surface which begs the question, how far behind the curve is a Powell Fed willing to fall?

A

After weeks of trial balloons and market jitters, the most striking part of yesterday’s announcement is the general complacency that has penetrated every corner of financial markets. From a policy perspective, steady as she goes is usually a good thing as it means less uncertainty. However, in this situation, steady as she goes means mounting financial imbalances, a trend that is unsustainable. Eventually this docile financial environment will become unruly and intraday volatility will reign supreme. But pay no attention, that is business for another day. For now, all we can do is quote a famous American cult film, “Party on Wayne.”

Performa Market Perspective

It has been almost 100 years since the U.S. mainland witnessed a total solar eclipse. As we approach the August 21st phenomenon, towns and cities across America that are lucky enough to be in the “path of totality” are girding for the influx of eclipse watchers.

A

On that Monday in late August, the moon will completely block the sun, leaving viewers to admire the sun’s previously invisible (to the naked eye) sparkling corona. The path of totality slices diagonally across the U.S. from Oregon to South Carolina and suffices as a solid starting point for any model that tried to predict the outcome of the 2016 U.S. presidential election.

A

As excited Americans finalize their travels plans, this summer’s total solar eclipse is a reminder that while events, experiences, and outcomes can feel intensely unique and impactful, it is easy to misinterpret cause and effect. As we sift through the daily barrage of financial information and data, we too need to routinely step back, take a breath, and ask ourselves, are fundamentals and data changing prevailing market trends and sentiment or are investors backing into theories based on price movements?

A

Investment Solutions For Captives Just the other day, our Charleston office ordered special eclipse viewing glasses so everyone can look directly at the eclipse without damaging their retinas. Along that narrative, it feels to us that many investors must be looking at the current investment landscape similarly – viewing the markets with a special type of lense that blocks out any negatives and highlights the beauty of an always rising equity market. Alas, the reality is that after an almost decade long expansion, we have a few concerns when we examine today’s landscape. Namely, record levels of consumer debt, muted productivity, an aging population, underfunded pensions, and political uncertainty. Non-financial corporate debt is at record highs as leverage metrics have increased dramatically. Moreover, external factors such as Brexit and other potential geo-political events pose additional risks.

A

Additionally, investors have enjoyed years of excessively easy monetary policy, and the multiyear long grab for yield has multiple markets looking frothy, or in some cases, overvalued. This list should be long enough to cause even the most optimistic of investors pause – but that certainly is not the case today.

A

In this Market Perspective, we further examine current market dynamics and explore whether it is finally time to plan ahead for the next economic downturn?

A

Since the American Civil War, there have only been two economic expansions longer than the current one. For some, the duration of the current expansion alone is enough to spark concern. However, we caution against this view since imbalances and shocks are the greatest factors in spurring recessions, not length. Just as some people may believe that a total solar eclipse portends a negative life event, there are plenty who argue that since the economy has been growing for so long, a recession must be around the corner. Both opinions miss the point. In the case of eclipses foreshadowing a negative life event, the more likely explanation is a well-documented cognitive theory called confirmation bias. More specifically, the human brain associates two events, and then assigns some sort of causality between them. If one believes that a total solar eclipse is a precursor to something bad happening, then when their cat dies a month later, clearly the total solar eclipse was the triggering factor. The confirmation bias here is that business cycles have ends and therefore the duration of the cycle portends the end. Under the rules of logic, there is certainly something missing. When this business cycle ends it will go down as one of the longest on record, but it’s not going to end because it was too long.

A

So where are we in the business cycle? What is the state of the U.S. economy? Are there imbalances? Should we be worried about recession?

A

To start, looking at economic fundamentals and financial data, we do not think there is a high probability that the U.S. economy is in imminent danger of falling into recession over the next 12 months. To provide a framework, we list some key financial and economic indicators in the table below for three time periods: June 2006, June 2008, and June 2017. These dates represent the U.S. economy prior to the 2008 credit crisis, during the crisis, and the current environment.

A

At the moment, equity markets remain a source of wealth; the yield curve has flattened (but nowhere near inverting); the labor market is solid; and, gas is cheap. On the corporate front, both the manufacturing and non-manufacturing sectors are reporting growth. While the excitement over fiscal stimulus and tax reform promised after the 2016 election has turned to frustration and a bit of disappointment, the general tone on earnings calls continues to be cautiously optimistic. This is not exactly what we’d expect to be hearing from companies if their leaders were worried about the economy falling out of bed tomorrow. So if a recession is not around the corner, what part of the cycle are we in?

A

Given this profile, where is there value in commercial real estate? Lending directly to a well-seasoned property operator with a recognized niche can still be an interesting investment for a long-term investor. Borrowing rates are still within the lower end of the historical range and the relative value over other fixed income instruments remains. Most fixed income investors, however, are not equipped to own loans outright and cannot lock up their clients’ capital.

A

Clearly we passed the mid-point of the current economic expansion. U.S. auto sales peaked in December of 2016 at 18.29 million units before falling 10% and stabilizing during the first half of 2017. Additionally, the labor market has fully recovered from 2008, and we are four rate hikes into the first stage of the current monetary policy tightening cycle.

A

In summary, we’re definitely not at the beginning of the cycle, we’re past midway, but a recession is not imminent. This puts the current expansion around the 7th inning, with plenty of ballgame left. As the expansion continues to unfold we will continue to monitor labor market data closely, as we feel it has done the best job describing the true underlying momentum of the U.S. economy during this expansion.

A

As we have previously stated, one of our main theses about the current economic cycle is that it can be viewed in slow motion – extraordinary monetary policy accommodation has distorted the cycle to approximately double the historical normal length. Under this methodology, halfway through 2017 represents the 8th anniversary which points to a third to a quarter of the cycle left (i.e. 2019-2021 when the exhaustion finally tips the economy).

A

However, this analysis does not take into account certain factors particular to this expansion nor do external shocks feed into the model. How does one reconcile a still expanding economy with the laundry list of concerns that we highlighted earlier? The amount of debt in today’s system is frightening. Corporations have taken advantage of the low interest rate environment, refinanced, increased leverage, and showered shareholders with increasing payouts to both make them happy in a low yielding environment as well as make earnings growth look solid (even though it is superficial). Similarly, consumers have begun to lever up as total consumer debt, as a percent of gross domestic product, has reached fresh all-time highs with student loans becoming a serious hindrance to future growth.

A

Additionally, economies are always susceptible to negative growth shocks. China remains a source of considerable uncertainty and is playing an increasingly important role in the global economy. Thus, any unexpected negative news out of China will have bigger implications as it ripples through the rest of the world, as seen during the late summer of 2015. Meanwhile, geo-political shocks stemming from a Brexit breakdown, ISIS, North Korea or other such events could be equally detrimental to growth trends and are even harder to predict.

A

These risks and imbalances are real, potent, and should not be ignored even though investors currently see nothing through their eclipse glasses. This is evidenced by the sizeable drop in global asset volatility and a remarkable run of risk asset price gains without any meaningful pauses. Perhaps once those glasses are removed, the markets will become fixated on negative news, data, and/or events that typically have influence on investor sentiment.

A

The objective for us is to be able to recognize misplaced confirmation bias and see through the noise. In other words, while a market pullback is certainly in order, that does not mean it is the beginning of the end. This economic cycle is far from over, but it is essential to pay attention to the sign posts up ahead that will assist us in guiding our client portfolios through the remainder of this expansion and the next recessionary period. While August 21st represents the first total eclipse viewable from coast to coast since 1918, few realize that total solar eclipses occur fairly regularly over the rest of the globe. An increasingly connected global economy can both hinder and help the speed of localized economic cycles. As the U.S. enters a sensitive part of the business cycle, it is increasingly important to evaluate each emerging trend and new piece of market data in this global context. Being too narrowly focused and reactionary to each individual piece of incoming data can be detrimental to portfolios and performance over the long run.

A

Cognizant of today’s risks and imbalances, yet humble enough to know that unforeseen shocks can destroy even the best analysis, we maintain a defensive position within client portfolios. It is not time to pack up shop and insulate portfolios for the next economic downturn. However, given the current landscape, we feel it is prudent to dial back exposures. The current goal is to capture a good portion of the potential available remaining upside, while making sure that no harm is done should the cycle end sooner than expected or a Black Swan event derail global growth and markets.

Commercial Real Estate as the Next Shoe to Drop, What are you Yellen?!

The U.S. commercial real estate market accounts for over $2 trillion of associated debt with 23% of that found within Commercial Mortgage Backed Securities (CMBS). We have long been participants in the CMBS sector as it often provides both diversification within the broad fixed income market as well as compelling relative value versus other sub-sectors. Despite the clear benefits, we must be diligent when analyzing potential CMBS holdings as they are slightly less liquid than corporate bonds and while they may look homogeneous on the outside, the securitized deals themselves have unique collateral as well as structural differences.

A

We are highlighting the CMBS sector since it has come under a bit of scrutiny this year and we believe some opportunities may arise in the near term.

Taking A Look In The Review Mirror

A

Looking back to the Great Recession, the consensus view was that CMBS would suffer a similar fate as the sub-prime and residential mortgage (RMBS) market, an implosion that brought down Bear Stearns and Lehman Brothers. While there were some similarities, namely overvalued properties and overleveraged owners, CMBS was not the next shoe to drop as some had speculated. Sure commercial property values had soared from 2001 to 2007 and property prices fell hard in the aftermath of 2008, but it was not Armageddon as fewer than expected forced sellers came into the market.

A

Unlike single family homes, commercial real estate produces rental income. Since leases are usually long-term commitments, owners have a built-in cushion that buys them time during periods of market stress. It takes a significant loss of tenants in a short period of time to bring a commercial mortgage underwater. Despite the extreme financial stress associated with the Great Recession, this did not broadly occur post-2008.

A

With that being said, CMBS prices performed worse than the underlying properties during the financial crisis because it was the only part of the market banks could try to use as a hedge. Prices for valuing holdings can be quite different than prices of actual transactions – especially if no one is buying commercial properties or trading many CMBS bonds in the shadows of a crisis. Valuations eventually realigned, however, and both the real estate and CMBS markets recovered within a few years at a faster rate than residential property prices.

A

Additionally, rock bottom interest rates provided multiple opportunities to refinance commercial mortgages, giving property owners another way to make it through to better times. In turn, all the positive cash flow generation attracted a broader buyer base hunting for yield.

A

The upshot is that commercial property, on average, is now worth more than twice its value from the lows – a star performer in the land of physical assets.

Today – Prices Are Running Hot

A

Janet Yellen, Chair of the Federal Reserve, voiced her concerns about rising commercial property prices during her visit to Capitol Hill last month. The CMBS market shuddered slightly in response. What Chair Yellen did not mention was the Fed’s own culpability for fueling over-heated prices in many markets. By leaving interest rates low for so long the Fed crowded investors out of traditional markets and sent them on a hunt for yield. Capital eventually found its way to the commercial property market and prices have increased. While commercial property prices look to be a little frothy, we see a few reasons why this trend will likely slow.

A

Property valuations and total debt are at all-time highs. There is also the dual threat of rising interest rates and higher spreads resulting from tightening lending standards and new rules for securitizations. This makes refinancing less attractive and should reduce the velocity of property price gains going forward.

A

The retail sector of the economy also factors into our view that average property values have peaked. The continued maturation of internet-based shopping continues to cannibalize physical store sales and has led to chain store difficulties across the country. In turn, shopping malls and other retail related properties are suffering. Retail based properties are a large sub-group within the commercial real estate market and, by extension, some CMBS deals. It will take time to reposition malls and other retail oriented space. Life style projects are the theme du jour, but it will take time to know if this is the wave of the future, a fad or just wishful thinking.

A

Given this profile, where is there value in commercial real estate? Lending directly to a well-seasoned property operator with a recognized niche can still be an interesting investment for a long-term investor. Borrowing rates are still within the lower end of the historical range and the relative value over other fixed income instruments remains. Most fixed income investors, however, are not equipped to own loans outright and cannot lock up their clients’ capital.

A

At Performa, we still favor investing within the CMBS sector. Maturing CMBS deals have outstripped new transactions, creating negative supply and a favorable technical landscape. This has been countered by lower CMBS bond trading liquidity due to the increased bank/broker-dealer regulatory capital requirements. Periodic supply/demand imbalances can create wide divergences from fair value, which creates pockets of opportunity at certain times and good exit points at others.

The Year Ahead

A

As weaker hands fold in response to negative headlines, we actually see some potential to add CMBS exposure at more attractive levels in 2017. Below we discuss several factors that will allow us to pick and choose deliberately.

Factor 1: Sometimes Older Is Better

A

We like to graze in the more mature, lush pastures. The CMBS market’s best years in terms of new issuance and its worst in terms of underwriting, since the market went mainstream in the early/middle 1990’s, was 2005 to 2008. Many of these deals have loans with balloon payments coming due in the next 24 months. The wall of maturities is not as dire as feared as elevated property values and interest rates that are still historically low will allow for successful refinancing. However, some of the delinquency numbers in these transactions are scaring off buyers – even before they look under the hood of a 1 to 2-year bond.

A

While 60-day delinquencies in pre-2009 deals are over 15% (scary to some), the loan balances are smaller after a decade or more of principal payments. So, the outright number of delinquent borrowers has not increased substantially, but their properties represent a growing percentage of a shrinking pool of loans (Source: Credit Suisse). The average CMBS deal has experienced only a 5.4% loss, (slightly higher for the later 2006-2008 deals according to Credit Suisse).

A

Even with large delinquencies, older CMBS deals provide more collateral protection today than at new issuance since they have been deleveraging. Avoiding deals with properties that face potential refinancing trouble still leaves us with a large enough buying universe for short-term, high quality bonds with attractive absolute yields.

Factor 2: Retail – Keeping The Tourists At Bay

A

The negative headlines from the retail sector keep coming, helping to create potential buying opportunities, as others leave the market. In the first two months of 2017 both JC Penney and Sears announced a combined 270 store closings and employee layoffs. Investors who only dabble in CMBS are shying away from new transactions with significant retail industry exposure. New, diversified CMBS deals average between 20%-30% of retail-based collateral.

A

While the overall decline in retail store space must be monitored, not all strip and shopping malls are the same nor will all of them board up. The property type, owner’s track record and location are important differentiators as well as the mix of non-clothing and big box retailer tenants (food and service industry). For CMBS buyers, there are structural components within CMBS deals that protect investors beyond good property analysis, primarily in the form of overcollateralization, which protects bondholders at the higher end of the cash flow waterfall. In other words, the lower rated bonds within a CMBS deal support senior, higher rated bonds.

A

These deal enhancers allow us to focus on the highest quality portion of the market that offer the first claim of cashflows and around 30% additional protection from the features above even when real estate prices may not move much higher or, in a worst-case scenario, start to fall.

A

Using an example of the latest CMBS deal in the market, 100% of properties would have to default on their loans and be sold in foreclosure at a 30% loss before the senior (AAA rated) bond took a hit to its principal. Isolating just the retail loans, and defaulting of the entire 23% of retail property loans in that transaction, even with a complete loss in a liquidation, an investor would not lose one dollar in the highest rated bond principal. Are these draconian loss scenarios possible? Perhaps, but the pre-2009 CMBS deals offer some clues.

A

2008 vintage CMBS deals are the worst on record, with collateral losses averaging 11% of the original pool balance. For new deals, this still leaves around a 20% cushion for the senior bonds, which continues to grow back over time. In order to take broad senior losses, the market would need a recession event that tripled those experienced in 2008 and an acceleration in the timing of the losses. We view such an event as quite unlikely.

Factor 3: Relative Value

A

Finally, there is the relative value proposition. We have historically compared AAA rated CMBS bonds to their single A rated, Corporate bond counterparts. The chart below illustrates the correlation between them over the past six years with CMBS looking slightly on the rich side.

A

That said, the credit quality of the CMBS bonds are materially higher and the give up in yield is around 20 basis points per year. Looking at previous market pull backs, CMBS tends to dislocate briefly from its Corporate cousin – something we will continue to monitor.

A

It is fair to expect current unease in the retail space to be followed by an uptick in delinquencies. As these loans are worked out it is also our expectation that certain cross over buyers will pull back from the market and demand will wane. The decreased appetite for CMBS will result in wider spreads versus Corporate debt, which should create an opportunity that savvy investors will look to exploit.

Tying It All Together

A

Ultimately, we view the commercial real estate market as one that carries potentially significant risks, and with it, the opportunity to generate strong risk adjusted returns under certain circumstances. We do not view the sector as the next catalyst for a market meltdown. The securitized market will certainly see pockets of stress, highlighted by the retail sector, but supply in the overall market has remained largely constrained leading to favorable sup- ply/demand technical factors. Away from securitization in the whole loan market, we are more concerned about the amount of existing debt and how the current business cycle may impact the value of current transactions in the future. That said, much of the debt outstanding is in the strong hands of investors with longer term investment horizons which should be able to withstand short to mid-term price volatility.

A

At Performa, we view CMBS as a valuable subsector within our overall Structured Product allocation. We have recently maintained a position between 5-15% within Fixed Income portfolios depending on market conditions, and concentrate on high quality structures (generally rated AA/Aa2 and above), that can offer interesting return profiles while also buffering from potential broader losses in the CMBS space. As bottom up investors with substantial experience over different market cycles, we are able to take advantage of attractive buying opportunities when the sector gets oversold.

A

So Janet… Please stop Yellen!