Q3 2023 Outlook:
The Coming Infrastructure Boom
From 2008 until recently, investors had to take on outsized risks to get any real return. Cash paid nothing. Corporate yields were anemic and sovereign yields were worse.
For those stuck in the 60/40 world, equities were the only choice. TINA, meaning “there is no alternative1” became a popular acronym. In other words, stocks were the best of the worst. Investors were forced to buy equities to have any chance of sufficient returns.
But not anymore. Fed rates haven’t been this high since 2007. And now it’s equity earnings yields that look weak.
Cash may be a good trade but what is a good allocation? We are no longer in TINAs world. The bottom line for investors: there are plenty of alternatives to choose from.
After a summary of Q2 market activity, we discuss why inflation is going to be sticky and what investors can do about it.
Rate Compression of Yields Across Assets
Source: U.S. Department of Treasury, Federal Reserve, S&P Global.
After a summary of Q2 market activity, we discuss why inflation is going to be sticky and what investors can do about it.
1H 2023 Market and Economic Summary
U.S. Economic Performance: Trending Favorably
- Inflation is currently running at 3.0% annually after peaking at 9.0% in June 2022
- Real GDP2 = The Conference Board estimates this at 1.0% FY 2023 (vs 2.1% 2022 actual)
- The unemployment rate remains low, at 3.6% in June, matching pre-pandemic levels.
- The debt ceiling drama was not a crowd pleaser. The plot is trite, the ending cliché, yet the stakes are too high to skip it. The denouement: no debt ceiling until January 2025 and no plan to reduce soaring interest payments.
- Debt projections are grim. The U.S. must sell a staggering $2 trillion of treasuries annually for the next decade. QT will not continue; the Fed will have to purchase trillions of those treasuries, according to the CBO.
Monetary Policy Overview
A hawkish pause. After 10 consecutive rate hikes, the Fed paused in June. However, the Fed retains a hawkish tone and messaged two more rate increases this year.
A summary of the Fed’s actions in 2023:
- Powell doesn’t see inflation returning to 2% until 2025 and reiterates that the Fed will be restrictive for as long as it takes.
- All 23 banks passed the latest Federal Reserve Board stress test. The test imagined unemployment surging to 10% with CRE declining 40%. The passing grade allows banks to change their buyback plans and dividend policy.
Credit Market Performance:
- Hail SOFR and farewell to LIBOR, which officially ceased publishing on June 30. SOFR has big shoes to fill.
- Investment grade bond yields are near 20-year highs (excluding around the 2008 turmoil). Driven by their insurance connections, private credit managers are starting to muscle into the IG world, says the Financial Times.
- Fitch Ratings has increased its default rate estimates for 2023. Default rates will be 4.5%-5.0% in High Yield and 4.0-4.5% in Leveraged Loans.
U.S. and Global Market Summary:
- Look at Tim Cook! Apple stock reached new highs and became the first $3 trillion market cap company.
- Mega caps surged, propelling equities to a strong 1H. Markets shrugged off banking turmoil, rising interest rates, and recession fears.
- The Nasdaq had its best start to the year since 1983, surging 32%
- Move over NFTs and crypto, AI is having a moment, sending chip makers and software companies stocks to new heights.
Consumers persist, but so does inflation, as student loan repayments are looming. Investors are focused on finding relatively stable yield with low correlation to the equities market, as P/Es remain elevated and recession fears linger.
I. The Consumer Remains Strong, but Student Loan Repayments Are a Wildcard.
Fears of a near-term recession are present but receding. Unemployment is low and the consumer is undaunted. But will the consumer keep spending? The data says “yes.”
Credit card delinquency rates are increasing, but remain below pre-COVID levels:
Credit Card Delinquency Rates
Source: Federal Reserve Bank of St. Louis. Shaded areas indicate U.S. recessions.
And although credit card balances are up,
Consumer Credit Card Balances
Source: Federal Reserve Bank of St. Louis.
the denominator is too. As a percent of income, consumers are still in better shape than they were pre-COVID:
Household Debt Service Payments as a % of Income
Source: Federal Reserve Bank of St. Louis. Shaded areas indicate U.S. recessions.
A recent Supreme Court ruling restarts student loans. The situation is in flux; however, repayments are expected to resume later this year. Morgan Stanley says:
- 1/3 can repay with no problems
- 1/3 will have to adjust their spending in other areas
- 1/3 “won’t be able to make payments at all.”
II. Due to Housing Costs, Inflation Won’t Recede Anytime Soon
Inflation has already declined from a 9% annual rate one year ago to 3% today, still higher than the Fed’s stated target of 2%. How long will it take to cut inflation down to size? Powell thinks it will take until 2025.
The Fed’s rate increases are a blunt instrument, not a scalpel. Higher interest rates indirectly fight inflation by changing behavior. Good medicine tastes bitter, and curing inflation is no exception. It’s only when interest rates are high enough to reduce demand (hopefully without causing a recession) that the dose is potent enough to work.
Returning to 2% inflation will be a challenge, mostly because of housing. Housing is typically a household’s largest expense. It accounts for over 1/3 of CPI, more than double the next largest category.
CPI Categories by Weight
Source: Bureau of Labor Statistics, 2023.
Rent increases have slowed but housing costs are still elevated. Partially this is because housing inventory is still 50% below pre-COVID levels:
Active Home Listings in the U.S.
Source: Federal Reserve Bank of St. Louis. Shaded areas indicate U.S. recessions
Available homes are quickly snatched up:
Median Days on Market for New U.S. Home Listings
Source: Federal Reserve Bank of St. Louis. Shaded areas indicate U.S. recessions.
Until housing pressures relax, inflation will remain elevated.
III. The Housing Market: Still Strong for Builders and Renters, but Expensive for Owners
Housing pressures have benefited homebuilders and renters. The S&P Homebuilders Select Industry Index is up nearly 30% this year. Tight housing supply and low affordability remain the hallmarks of the space, leading to the increasing popularity of single family rentals (SFR).
Investors are noticing. New inventory is coming online with more build to rent (BTR) housing projects. BTR is still a small share of the housing market but growing rapidly. For investors, BTR offers efficiency of scale and cost advantages that piece-meal acquisition lacks. The homes are new, requiring less maintenance; they are often concentrated in one location, making servicing and administration more efficient.
The SFR market keeps expanding, offering ways to diversify through geography and housing type. Investors see SFR as a potential way to mitigate inflation, allow for possible capital appreciation, and generate income.
IV. The Coming Infrastructure Boom
Like private credit, infrastructure investing is having a moment. Institutional investors are shifting from higher risk PE and VC funds to the presumed stability of infrastructure. 2022’s exceptional fund raise for infrastructure will be deployed primarily for digital and energy projects. Institutional investors like the long-term nature of the asset class, which has a low correlation to equities. Plus, it can help hit certain ESG targets. Retail investors are also waking up to the potential of infrastructure.
The U.S. will need more than $3 trillion of infrastructure investment over the next decade. The Infrastructure Investment and Jobs Act (IIJA) and the Inflation Reduction Act (IRA), will allocate large amounts of capital to transportation, energy, and other infrastructure projects.
The core attributes of infrastructure investment are what makes it desirable for institutional investors: typically essential assets, with predictable cash flows and inelastic demand. No matter what happens with the broader economy, we will all continue to use electricity, drive, and use our phones. Plus, the asset class can also act as an inflation hedge.
Conclusion
“Central bankers, who resort to printing money, manipulating interest rates and fuelling asset price bubbles, exude a similar air of infallibility. They fail to heed Cantillon’s warning that it’s all very well to embark on a grand monetary experiment, but there is no painless exit.”
- Edward Chancellor, “The Price of Time: The Real Story of Interest”
The effects of low interest rates are starting to reverse, as inflation, and higher rates look like they are here to stay. As higher rates become structural, the malinvestment that accompanied ultra-low interest rates will unwind. Investors should act accordingly, exploring options outside the paradigm of 60/40. In the new world of higher interest rates and sticky inflation, it pays to have investment alternatives.
