December 2018 Retail Sales - Big Miss or Fake News: Delayed due to a lapse in federal funding from December 22nd, 2018 to January 25th, 2019, December 2018’s retail sales report was released by the U.S. Census Bureau on February 14th and was met with a mix of negative and confused reactions. The report for December 2018 pegged consumer spending as having fallen 1.2% from the previous month (November 2018). Total sales rose 2.3% from the same period in the previous year and for 2018, as a whole, sales were up 5% compared to 2017. It was the 1.2% month-over-month drop that headlines have zeroed in on. The Wall Street Journal touted the decline as being “the biggest monthly drop since September 2009” and going as far to say “the performance was so poor that some analysts questioned the report’s accuracy.” To make matters even more confusing, U.S. hiring numbers were strong for the December time period which means that the state of U.S. households should have been relatively strong. Also giving analysts pause about December’s report was the performance, or the reported lack thereof, of online retailers. Online sales reportedly fell 3.9% from November which makes it the largest month-over-month decline since November 2008. This is in stark contrast of reports from companies like Amazon who saw 2018 4th quarter revenue up 20% from the previous year.
Our Takeaways: There seem to be a lot of pieces in the December 2018 report that do not correspond with other data points and sources. Most notably, and as we highlighted in January’s letter, company financial reports/press releases and private industry reports (such as Mastercard’s annual holiday spending report) pointed in near unison to very solid sales numbers and growth for the whole holiday season - both November and December. There did appear to be lag at the beginning of December which was largely attributed to a heavier spending cycle around Thanksgiving and a longer-than-normal period between Thanksgiving and Christmas. This lag, however, was overcome by robust spending closer to Christmas day according to company and industry data. Further muddying the waters was the supposed dismal performance of online sales. As mentioned above, online sales fell 3.9% month-over-month, but were up 8.4% year-over-year for the whole quarter. Yet, this is in contrast to 20% difference for Amazon in Q4 2018 vs. Q4 2017. To put why this number is so important into perspective, Amazon alone accounts for 49 cents out of every dollar spent online, meaning that Amazon accounted for 117% of the Q4 2018 growth in online sales. Put another way, the other 51% of online retailers (by sales volume) must have seen a decline in Q4 sales from last year to make the Census Bureau’s report accurate. Now, it is entirely possible that this is a case of a few, highly publicized retailers doing very well during this past holiday season which is throwing noise into an otherwise unremarkable report for the state of the U.S. consumer, but it would stand to reason that it is equally likely the report just got it wrong.
2019 Housing Market Start and Homebuilder Sentiment: 2019 proved to have a rocky start to the year for the housing and homebuilder markets. Affordability has been a big issue for the last few years, ostensibly pricing many would be homebuyers out of the market. Furthermore, late 2018 saw material increases in financing costs, pricing even more would be buyers out of the market. These factors came together at the beginning of this year reflecting broad based negativity in major home appliance shipments, home builder sentiment, new housing starts, existing home sales, and jobless claim for major “bubble” markets such as Seattle. However, in a matter of weeks it appears things are beginning to turn around. The NAHB (National Association of Home Builders) Market Index took a significant upward run between February and March pointing to highetend optimism among NAHB’s membership. Wall Street also appears to approve of this newfound optimism. Shares of home builder stocks have outperformed the S&P 500 by 8% since the end of January with individual names such as William Lyon Homes posting outperformance of over 25% above the market.
Our Takeaways: That data seems to be sending a fairly strong signal that there was some substantial slowing in the housing market sometime in the fourth quarter of 2018. This is likely due to the 20 basis point run up in interest rates for home mortgages going into the fourth quarter which was subsequently eased by the fall in rates that started in the middle of the fourth quarter. This has resulted in mortgage application volumes that are at multi-year record rates for this time of year, which is in turn likely what is fueling the home builder optimism. It is possible this recent flurry is due in part to FOMO (fear of missing out) on behalf of some consumers who saw their plans to build or buy priced out by rate rises last year. Now that rates have declined again, they are trying to get projects going and rates locked in before they have a chance to go up again. Wall Street is clearly putting a heavy emphasis on mortgage rates when assigning values to home builder companies and the housing market as a whole. We expect this trend to continue until there are exogenous shocks that disrupt the economic drivers behind the current dynamics.
Loan Service Boom: Loan service rights, which are the rights to collect interest, principal, and escrow payments from a borrower, are a transferable aspect of most loan agreements in the U.S. home mortgage market. It has been a sparsely looked at or talked about area until recently, but last year sales of such rights jumped 14% from the previous year. This increase included a 27% boost in the fourth quarter compared to the fourth quarter a year prior totaling $183 billion worth of mortgage servicing rights exchanged. One explanation for this trend put forth in a recent Wall Street Journal article is that “[since] many of the sellers are independent mortgage lenders that don’t have deposits to fund themselves or other lines of business… Stronger players - both banks and nonbanks - have been picking up servicing rights from weaker lenders who need to raise cash.” As interest rates have risen and the rate of refinances and purchases has declined, the trend has likely been further exacerbated.
Our Takeaways: This trend seems to be in line with several other overall trends in the banking industry. As mentioned above, the rate of refinances and purchases has declined as rates have risen. In addition, being later in the cycle has led to a depleted stock of interested (or eligible) refinancers or purchasers. In other words, everyone who was looking to, or was able to, refinance their current home or purchase a new one has already done so. Banks, as a whole, have also recovered substantially since the financial crisis in 2008, but - as a result of the new regulation enacted after the crisis - there are several narrow “buckets” (defined as ranges of total capital) that are ideal for banks to operate in. Under the new regulatory requirements, banks have to meet different standards based upon their size; so as a bank grows, it becomes more profitable relative to their regulatory requirements until they reach the next size bracket and the regulatory requirement costs go up exponentially. This has created a market dynamic whereby banks have to scale exponentially via acquisition rather than linearly through natural growth. This trend of purchasing servicing rights is similar in the sense that smaller players are forced to either sell off assets (the servicing rights), be bought out, or face the prospect of being forced out a business when the market dries up completely during the next downturn. So, while this is a relatively new trend, these do appear to be very late cycle type activities on behalf of larger banks and non-banks, and therefore will be another data point to monitor and assess the overall strength of the housing and lending markets.
Electric Vehicle Metals: Two interesting things are occurring to metals used in lithium-ion batteries which could have long term consequences on the production feasibility of electric vehicles (EVs). First, prices of cobalt and lithium have experienced dramatic price declines. This in turn, has caused disruption to the mining operations for these metals since returns are much lower than originally projected when production began. Moreover, it appears much of these price declines are a result of overproduction. Miners saw an opportunity with the metals as the hype around battery technology (specifically for EVs) began to heat up and they jumped at the chance to begin extracting more of these metals. The second interesting item is causing prices of a third metal, graphite, to move in the opposite direction. Batteries account for about 30% of global graphite demand and China produces 70% of the global supply of the metal. However, the central government has recently been cracking down on production operations due to an intensified focus on environmental concerns. It turns out that the extraction of graphite can have extremely negative consequences to the surrounding environment. A recent Axios article cited an instance where “discharged pollutants from a graphite-producing plant prevented a local Chinese river from freezing in the winter, potentially disrupting the local ecosystem.”
Our Takeaways: This is a small example of the uphill battle EVs are having, and will continue to have, as a viable business product. Technological advancements and consumer reception aside, one of the most cost intensive part of EVs are the batteries. If supply chains cannot be reliably and cost effectively established due to something as simple as price stability around input commodities, then that could significantly impact the speed and amount of future investment, and thus, development of that critical infrastructure. Without the supply chain infrastructure in place, mass scale production of EVs at prices that would make them as available to consumers as their gas consuming counterparts will significantly impact their long term ability to capture a portion of the self-transportation market. Assuming public opinions over come and technological challenges can be overcome, this may be the single biggest threat to the EV industry.
4th Quarter GDP Report / 2018 Full Year GDP Growth: After a delay due to the government shutdown, U.S. GDP data for Q4 2018 and full year 2018 has been released. The fourth quarter showed 2.6% quarter-over-quarter growth which was 40 basis points higher than the 2.2% growth rate that had been anticipated. Many market participants believed that the government shutdown was going to have a larger effect than what ultimately proved to be the case. The two biggest contributing factors were consumer spending and business investment which gives some positive indicators about U.S. consumers and businesses. Year-over-year GDP growth for 2018 came in just below the White House’s anticipated number of 3% at 2.9%. This continues a recent upward trend in annual growth rates.
Our Takeaways: As noted above, business investment was a significant factor in the Q4 GDP number. This is positive because business investment is critical for the long term growth and success of companies. It has been widely reported that many companies have chosen to spend their excess cash from higher profits and tax breaks on share buybacks. This is an all but wholly unproductive use of capital, particularly at the current market’s high prices. Warren Buffet noted in his most recent letter to shareholders that Berkshire Hathaway’s companies invested a record $14.5 billion back into plant, equipment, and other fixed assets last year. He also mentioned that if the current tax treatment of accelerated depreciation of capital assets continues, then they will aggressively continue to spend on these assets because the rate of depreciation allowed for tax purposes does not even come close to the real rate of decline in the value of these types of assets bring to companies. Quoting from his letter: “Berkshire’s $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those “maintenance” capital expenditures, we spend large sums in pursuit of growth.” Switching gears, another interesting data point from the quarterly GDP report was consumer spending in Q4 relative to inventory spending in Q3. In a previous letter, we mentioned that the Q3 inventory build up many businesses were engaged in to get ahead of likely tariffs around the holiday season was a gamble on the strength of the consumer. While it was not by a wide margin, there does appear to be a miss between how much businesses spent to build up inventories and how much consumers spent buying those inventories, so we will continue to monitor those metrics to see what, if any, fallout arises from that course of action.
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