With cracks in the key auto and real estate sectors just beginning to appear as the Federal Reserve continues to hike interest rates aggressively, we agree with Ray Dalio’s thesis that conditions for the economy will do so likely to deteriorate significantly in the coming years. Because these sectors make up a significant percentage of the S&P 500 (NYSEARCA: SPY) in and of themselves and generally reflecting the broader economy, a dip in either or both would likely spell trouble for the SPY in the coming months and years. In this article, we will examine these risks in more depth while sharing our approach to current economic conditions.
Macroeconomic outlook by Ray Dalio
Yesterday billionaire Ray Dalio said we are “starting to see all the classic early signs” of a recession. After another significant rate hike (75 basis points) by the Federal Reserve and a very hawkish outlook for further rate hikes, which made it clear that the Federal Reserve’s top priority is to fight inflation, Ray Dalio made it clear in an interview as a result there will be economic pain:
We are currently very close to a year of 0% growth. I think it’s going to get worse in 2023 and then 2024, which has electoral implications…
What [the Federal Reserve] doing will balance it out. They will tighten monetary policy and take away credit until the economic pain is greater than that inflation pain.
In particular, he highlighted the housing and auto sectors as those beginning to face severe headwinds from rising interest rates. This is mainly because many homes and cars with debt are bought on fairly generous financing terms. The reason why financing is generally fairly easy to come by is because these loans are collateralised by the underlying asset (i.e. the home or car in question) which can be relatively easily resold at market value by the lender should the borrower defaults on her loan.
Our macroeconomic outlook
In the immediate aftermath of the COVID-19 outbreak, interest rates fell to all-time lows as the Federal Reserve struggled to stimulate economic activity and stave off a recession. In addition, the federal government distributed thousands of dollars to every American taxpayer to further stimulate the economy and help ease economic hardships many were suffering as a result of the COVID-19 lockdowns and reduced consumer activity due to health concerns. This combination of extremely cheap financing and extra money in consumers’ pockets resulted in very strong demand for vehicles and homes.
As a result, real estate (HOMZ) and automotive (CARZ) stocks significantly outperformed the SPY following the COVID-19 crash:
However, now that interest rates are spiking and economic growth is faltering in 2022, these sectors are undergoing a sharp reversal and have underperformed the SPY year-to-date:
Real estate (excluding engineering and construction companies or mortgage lenders) currently makes up 2.84% of the index, while auto stocks — led by mega cap Tesla (TSLA) as well as Detroit titans like General Motors (GM) and Ford (F) — join in several other auto parts makers and car dealers accounted for 3.84% of the index. That’s not even counting chip manufacturers like NVIDIA (NVDA), who would significantly increase that percentage if they were counted. With almost 7% of the index consisting only of auto and real estate stocks, their future outlook is not irrelevant to the index’s overall performance.
Unfortunately, the prospects are not that great. As noted, both sectors appear to be in a Fed-fuelled bubble that is now being burst by a sharp reversal in the very policies that originally inflated them. However, there is the potential for significant additional economic carnage beyond deflation of the bubble itself. This is because the rapid fall and then dramatic rise in interest rates in such a short period of time has misrepresented the true conditions of the economy to entrepreneurs and executives, causing them to reallocate capital—possibly large—to higher risk. longer-term investments (i.e., speculative high-growth and underperforming technology companies, as typified by the ARK Innovation ETF (ARKK) mania). There has also been an incentive for individuals to buy homes and vehicles with cheap debt that they can no longer afford at current interest rates. This is likely to result in a massive and sudden drop in demand and, should unemployment rise, an increase in auto loans and even mortgage defaults. All of this will cause inventories to rise and potentially drive prices down sharply.
We are already seeing single family home prices in the United States peaking and even beginning to decline. Demand has evaporated and the home stock is starting to rise as homes stay on the market longer. This effect has spilled over into the mortgage industry, which is also grappling with dwindling demand after booming in 2021.
Even more chilling is the fact that the Federal Reserve appears poised to slash house prices, with Chairman Jerome Powell stating:
What we need in the longer term is better matching of supply and demand so house prices rise at a reasonable level and at a reasonable pace and people can afford houses again. And I think we – well we probably in the housing market have to go through a correction to get back there.
The Federal Reserve also has the firepower to do this. As the Mises Institute reported earlier this year:
Runaway house price inflation continues to shape the US market. House prices across the country rose by an average of 15.8% year-on-year in October 2021. US house prices are well above their 2006 bubble peak and remain above the bubble peak even after adjusting for CPI inflation… Incredibly, in this situation the Federal Reserve continues to buy mortgages. It buys many of them and continues to be the price-determining marginal buyer or big bid in the mortgage market, expanding its mortgage portfolio with one hand and printing money with the other… The Federal Reserve now has $2.6 trillion in mortgages on its balance sheet. This means that about 24% of all outstanding home mortgages in this entire large country are held by the central bank, which has thereby earned the remarkable status of being by far the largest savings and lending institution in the world.
Given that the Federal Reserve owns nearly a quarter of all mortgages in the United States, by selling them or simply letting them expire naturally, it can drive mortgage rates significantly higher. Meanwhile, rising interest rates are also likely to hurt demand for vehicles, particularly new vehicle demand, since the high prices that new vehicles fetch typically require buyer financing.
While these headwinds bode ill for the economy, a separate question is whether the SPY is cheap enough to buy right now. Well, based on data compiled by Current Market Valuation, the stock market as a whole appears to be fairly valued at the moment. The Yield Curve, Buffett Indicator, and P/E Ratio models all imply that the market is overvalued, while the Interest Rates, Margin Debt, and S&P 500 Mean Reversion models all imply that the market is fairly valued.
However, given the bearish macro outlook, it seems like prudence would advise caution at current levels and wait for some safety margin before buying the SPY now.
Moreover, as Ray Dalio reiterated in his last interview, “cash is still a garbage asset” because the real interest rate (the nominal interest rate minus the inflation rate) remains negative.
Bonds are probably the worst investment of all in a rising interest rate environment because their value is directly and almost completely correlated with interest rates.
So where to invest? Floating rate securities — if they can be bought at a good price — aren’t a bad choice. However – again – in the current environment, the interest rate often lags behind the inflation rate, unless you take a reasonable risk. There are some BDCs that have investment grade balance sheets and fairly conservatively positioned investment portfolios that are almost entirely allocated to floating rate debt, along with excellent underwriting performance, and are notably trading at significant discounts to NAV. However, their loans are still riskier, so they could struggle during an economic downturn.
Another approach is to bet that a recession will force the Federal Reserve to reverse course and cut interest rates shortly, causing regulated utilities (XLU) and other recession-resistant high-yield companies like triple net lease REITs ( VNQ) and MLPs (AMLP) are creating ) attractive buys, especially while their share prices are being suppressed. This is the approach we prefer at High Yield Investor, although we also buy some assets with exposure to floating rates, as well as other niche low-value assets.
Ultimately, we believe SPY is not yet cheap enough to warrant direct investment, but we believe there are opportunities in the market today. For this reason, we believe it is prudent for investors to be honest with themselves about their risk tolerance, volatility and time horizon and choose their positions accordingly.