APRIL/MAY 2014
MARKET AND ECONOMIC CONDITIONS
By Adam B. Landau
Permit Capital Advisors, LLC
It has been almost two years since European Central Bank president Mario Draghi channeled Malcom X and his “by any means necessary” declaration (with an original nod to Jean-Paul Sartre) with his announcement that he would do “whatever it takes” to save the euro. We believe Draghi’s intervention represented a turning point in the Eurozone’s battle to maintain its common currency, as evidenced by the extent to which borrowing costs of the peripheral countries have since fallen. While there are still significant underlying economic and political problems that rest outside of ECB control, the hemorrhaging has been halted. Interestingly the more acute issues have moved to the core of the continent, as problems in Italy and France continue to fester, with both countries facing double-digit unemployment and triple-digit debt-to-GDP levels. The good news is that both countries have recently appointed promising new prime ministers with liberal economic views.
Regardless of these political developments, the region is still certainly vulnerable to a significant external shock. This could be delivered by further movement of Russian forces into Eastern Ukraine, and the resulting economic sanctions that the EU would be forced to impose. While we don’t ignore these risks, we also make an attempt to keep them from taking a stranglehold on our investment decisions. We have seen the damage done in recent years to investors who got bogged down in macroeconomic and geopolitical concerns – as fear of not only the euro crisis, but also the fiscal cliff, debt ceiling, Chinese growth, and assorted other issues have kept many retail and institutional portfolios severely underinvested relative to their strategic targets.
Howard Marks, Chairman of Oaktree Capital Management who is known in the investment community for “memos to Oaktree clients”, recently wrote in one of his missives about the difficulties that accompany an investment strategy crafted in the face of fear. Marks stated that, “Most great investments begin in discomfort. The things that most people feel good about – investments where the underlying premise is widely accepted, the recent performance has been positive and the outlook is rosy – are unlikely to be available at bargain prices. Rather, bargains are usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late.” Where supported by fundamentals, we like finding such investment opportunities, and recognize that this strategy is built for long-term success rather than quarterly victories defined by low tracking error. Today, we believe that investing in Europe has become a more attractive relative proposition based in part on both ongoing investor skepticism, and continued momentum with respect to economic growth.
On our shores, the recovery has been steady, slow, and atypical in its composition. There is some evidence for the belief that the pace of growth could pick up over the second quarter, and second half of this year. The whisper number among strategists is that 2Q GDP in the U.S. could be 3.5%. The private sector has delivered 3.4% annual growth since 2009 , and a slowing of public-sector retrenchment should allow overall growth to gravitate towards this figure. We are already seeing the fiscal drag easing faster than expected. It is happening around the world, but the biggest change is in the U.S., where the impact of last year’s tax hikes and across-the-board spending cuts, or “sequester”, has largely passed. This is seen in CBO data that estimates that the deficit in this country will fall by around 1% of GDP in 2014 after declining by 3% of GDP in 2013. By next year the reduction in the deficit will be negligible. Further, labor market conditions appear to be strengthening, as evidenced by data that goes beyond the payroll numbers. In recent months, temporary employment has started to increase at a faster pace, which has a history of leading to bigger bumps in the number of permanent hires. Importantly, the employment-to-population ratio (the proportion of the civilian non-institutional population aged 16 years and over that is employed) continues to rise, indicating that more people are finding jobs. The figure now sits at the highest level since July 2009.
One caveat to the optimistic projections of growth going forward is that it will likely have to take place without much of a contribution from housing. The housing recovery has stalled, at least temporarily, due primarily to two issues: the effects of the severe winter weather and last year’s rise in mortgage rates from 3.5%-3.75% to roughly 4.3% today. In March, single-family new home sales fell by 14.5% for the month, and 13.3% against March 2013 figures. Low inventory is another problem, as roughly half of homeowners that normally would be selling, are not putting their homes on the market, stating that they’re not in a “financial position to sell their homes” right now. The explanations vary: 19% say low equity in their home, 16% say they are locked into low mortgage rates they don’t want to give up, and 14% bought their homes less than seven years ago and deem that it is too soon to sell. However, this is not as significant of a hurdle as it once was, as residential investment currently accounts for 3.1% of GDP, which is less than half its peak of 6.6% in 2006. A 7.9% annualized fall in residential investment in the fourth quarter of 2013 subtracted 0.3 percentage points from GDP growth, and estimates suggest that the impact will be flat in the first half of this year.
While the for-sale housing market is experiencing fits and spurts, the rental market and other pockets of the commercial real estate market remain robust. There is access to an abundance of debt for developers with strong track records, and there is capital looking for yield. The value found in opportunities varies widely from market to market, but where properly identified and researched, it can play an important role in a diversified portfolio. While cap rates are not generally high, the safety of yields and level of prospective returns are attractive where teams with proven management capabilities can add acquisition and operational value. One of the most attractive aspects of real estate investments in today’s world is that they have historically exhibited low correlations to both equities and bonds over longer time horizons. Their performance is more likely to be driven by GDP growth, as well as supply and demand dynamics in specific markets. We believe that a portfolio of commercial real estate, ideally diversified across property types (multi- family housing, retail, office, industrial), can provide both current cash flow as well as future growth. Particularly in the secondary markets of the Mid-Atlantic region, where undermanaged properties and inefficient capital structures can be a catalyst to immediate value creation.
About Adam Landau
Adam Landau is Chief Executive Officer and Chief Investment Officer of Permit Capital Advisors, LLC. He has 15 years of experience evaluating investment managers, developing asset allocation strategies, and coordinating the process by which the two disciplines are merged. Visit http://www.permitcapital.com to see how Adam and Permit Capital Advisors, LLC can
