SINGAPORE (Mar 6): The US bond market rallied strongly even as fear over the coronavirus outbreak is driving the stock market’s steep selloff. Treasury yields are falling to record-low levels on the back of investor flight to safety.
Yield on the 10-year Treasury, which is used as a benchmark for a wide range of lending rates, including for mortgages, auto, credit card and student loans, fell below 1%, for the first time ever. This time last year, yields were hovering around 2.7%, before the US Federal Reserve cut rates three times (totalling 0.75%) in 2H2019.
Last week, we wrote about how the Fed and Trump administration will do everything possible to extend the lifespan of what is now the longest economic expansion in the country’s history.
There are precedents. The Fed has lowered rates and/or added liquidity to the financial system in response to every sign of concern and/or panic in the market since the global financial crisis (GFC). Given the anticipated economic impact from the viral outbreak, why would this time be different?
True enough, the Fed slashed rates by 50 basis points on March 3, an emergency cut in between pre-scheduled policy meetings. Stocks, however, ended the day sharply lower after a brief rally immediately following the announcement.
This raises the question of whether markets are nearing immunity to monetary stimulus. We suspect not — it was more likely the realisation that a rate cut is no panacea, especially for a viral outbreak. It may even have, unintentionally, conveyed the perception of a panicky Fed. That said, we do believe that lower interest rates will be positive for the US housing sector.
Historically, falling bond yields and an inversion of the Treasury yield curve are seen to be red flags for an imminent recession. However, in the current environment, we believe it is a reflection of excessive liquidity and the market’s betting that the Fed will loosen even further. Indeed, corporate credit spread over Treasuries, though rising slightly in recent days, remained low by historical yardsticks.
The US consumer confidence index for February remained robust. The job market was strong, with the last three-month job addition averaging 211,000, and unemployment low at 3.6%. Wage growth remained positive.
Falling interest rates is pushing down the cost of debt servicing and putting more money in consumers’ pockets. Household debt service as a percentage of personal disposable income is at a record low. Thirty-year fixed mortgage rates — now hovering around 3.6% — are near the lowest levels in 50 years.
All of the above are underpinning strength in the US housing market. The NAHB/Wells Fargo Housing Market Index, a widely watched index for single-family housing market outlook, improved from 56 in December 2018 to 74 in February 2020 (see Chart 1). Readings above 50 indicate improving confidence.
Millennials are driving the demand for homeownership. Survey after survey in the US and Europe have shown that the young still want to own their homes. The sharing economy works for offices and cars, not so well for homes and life partners. Decision-making is more emotional than rational.
The home construction sector appears poised for a boom. Supply of new homes has been constrained by rising raw material and labour costs over the past decade, as evidenced by falling inventory (now at the lowest level since 1999) and the rising average age of homes — currently around 39 to 40 years, compared with 28 to 30 in 2008.
The latest batch of data indicates that homebuilding starts and permits are at the highest levels since 2007 (see Charts 2 and 3). This bodes well for building material and homebuilder stocks. The rising age of homes, coupled with savings from refinancing, should also boost home improvement activities.
Of course, all of the above are historical statistics. The outlook could change, for instance, if the coronavirus outbreak morphs into a full-blown pandemic. The longer the crisis drags on, the bigger the impact on businesses, which could, in turn, start to hurt employment and wage prospects. Like we said before, buying a home is a long-term commitment, built on consumer confidence.
We bought into housing-related stocks as early as April 2019 — Builders FirstSource at US$14.40 and Home Depot at US$197.20. The stocks rallied to record highs of US$28.43 and US$247.36 respectively before giving up some of these gains in the current stock market selloff.
Meanwhile, we acquired BMC Stock Holdings last November for US$28.22. The stock rose as high as US$31.67 before falling back to US$25.64 currently. On Jan 7, we added Lennar Corp to our portfolio at US$58.12 a share. Its shares were trading as high as US$71.38 just two weeks ago.
The stock market selloff over coronavirus fears is not unwarranted. Share prices are adjusting to the expected hit on earnings for companies across a wide swathe of the global economy. The question is to what degree. Right now, no one knows. Hence, it is impossible to predict how the market will trade in the coming days. But we remain upbeat that this too shall, ultimately, pass.
Lennar Corp
Lennar is one of the largest homebuilders in the US, with a current market cap of US$20.3 billion ($28.1 billion). The company’s scale and emphasis on technological advances have helped strengthen its competitive advantage, as reflected in its strong margins.
Its focus is on mid-tier and affordable homes, demand for which will be driven, primarily, by first-time buyers. While the average selling prices are lower, this market segment has proven to be quite profitable.
Lennar handily beat market expectations in its latest 4Q2019 earnings results, released in early January, underpinned by higher sales and improved operating margins. New home orders rose 23% y-o-y while deliveries were up 16% y-o-y.
Management expects operating cash flow to increase from US$1.6 billion in 2019 to US$2.0 billion in 2020 — and has indicated plans to increase dividends and pursue more aggressive share buybacks, in addition to paring down debts. Lennar has the lowest leverage among all US publicly traded homebuilders.
Looking ahead, the company is continuing with plans for a more “land light” strategy — such as contract building of homes in bulk for third parties — which reduces impairment risks and improves cash flow.
Home Depot
Home Depot is the largest home improvement retailer in the US, with a market cap of nearly US$263 billion. Like Lennar, the company too reported solid results for its fiscal year 2019 and provided upbeat guidance for fiscal 2020.
Comparable sales in the latest quarter were up 5.2% y-o-y, boosting comparable sales for FY2019 to 3.5% y-o-y, and 3.8% in the US. Earnings per diluted share grew from US$9.73 in FY2018 to US$10.25 in FY2019, a 5.3% increase.
In line with the stronger earnings and confidence in the business moving forward, Home Depot raised quarterly dividend by 10% to US$1.50 a share. This means the company has now increased dividends for 11 consecutive years.
The company’s multi-year investment programme has proved to be successful so far. Investments in enhanced signage and the front-end part of its stores have improved customer experience and productivity, which led to market share gains. The focus on digital platforms, as part of its multi-channel retail strategy, saw online sales growing 21.4% in the last fiscal year.
Looking ahead, management expects another strong y-o-y performance in FY2020. Total sales growth is guided to be between 3.5% and 4.0% while diluted earnings per share are forecast to rise 2.0%.
Home Depot is looking to open six new stores and margins should stabilise to around 14.0%, up from 13.2% in the latest quarter. Operating cash flow is estimated at US$13.5 billion, of which US$2.8 billion will be reinvested into the business. On top of dividends, the company plans for additional share buyback of at least US$5 billion.
The Global Portfolio recouped some lost ground for the week ended Thursday, up 1.1%, faring better than the benchmark index’s 0.6% decline. Some of the big losers were BMC (-7.3%), The Boeing Co (-7.4%) and The Walt Disney Co (-3.4%). On the other hand, Builders FirstSource (+10.2%), Adobe (+3.6%) and Apple (+3.4%) were among our top gainers for the week.
Last week’s gains lifted total returns for the Global Portfolio to 18.5% since inception. This portfolio is still outperforming the MSCI World Net Return Index, which is up 11.1% over the same period.
Tong Kooi Ong is the chairman of The Edge Media Group, which owns The Edge Singapore.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
