The Standard & Poor’s Homebuilders exchange-traded fund (ETF), XHB, has increased by more than 30% in 2023 and 40% over the last 12 months. A number of homebuilder stocks such as PulteGroup (NYSE: PHM) and renowned value investor David Einhorn’s Green Brick Partners (NYSE: GRBK) have substantially outperformed even this lofty benchmark. Building supply stocks such as Installed Building Products (NYSE: IBP) have also performed strongly, outpacing even the rapid climb in technology stocks.
This might seem surprising given the incredible demand for housing and renovation activity during the pandemic, and the dramatic rise in interest rates over the past 18 months. The cost of money has risen at the fastest pace on record and the interest rate on new and variable rate mortgages has nearly tripled. Shouldn’t higher interest rates make servicing a housing loan more expensive, reduce the demand for housing and renovating, resulting in lower prices and less homebuilding activity and therefore lower share prices for homebuilders and building products companies? Well actually, it depends.
Second-Level Thinking
Iconic fixed income investor and co-chairman of Oaktree Capital (now a part of Brookfield Asset Management following the merger in 2019), Howard Marks, highlighted the challenges of drawing direct cause-and-effect relationships in chapter 2 of his book “The Most Important Thing” (the book comes highly recommended, but for those who prefer more digestible content freely available on the internet, the majority of Marks’ teachings can be found in his “memos to clients” at no cost on the Oaktree Capital Management website. While they’re all valuable, the 2015 memo “It’s Not Easy” is the most applicable to this discussion).
Two of Marks’ most poignant examples of second-level thinking were:
“First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”
“First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall far less than people expect, and the pleasant surprise will lift the stock; buy.”
Demand AND Supply
There’s no doubt that higher interest rates impact buyers’ ability to service larger loans. Ceteris paribus (all else being equal), this would lead to lower demand and lower prices for homes. Not all things are equal though, and this is only half of the equation. We know from microeconomics that the price and quantity demanded of a product or service depends on both the demand and its supply.
This is important because one difference between the United States and countries like Australia, Canada and the United Kingdom, is that buyers are able to obtain fixed-rate mortgages. Incredibly, these can be for up to 30 years! Understandably, there was a huge refinancing boom over the last few years as homeowners locked in incredibly low mortgage rates–a decision that will likely be one of the best of their financial lives.
Homeowner Mortgage Rates in the U.S. by Interest Rate
Source: Bloomberg
The only downside of locking in an extremely attractive interest rate for the next 30 years comes around if someone wants to move house. There needs to be quite a compelling reason to relocate when the average mortgage rate is now more than double what you signed on for 2 years ago–a very high-paying job or moving in with a partner, for example.
The outcome of this has been that less people are moving than ever before. This actually follows a bit of a long-term trend, and is a consistent theme in Australia as well: people are staying in their homes longer. To put some numbers on it, at its 2022 Investor Day, REA (owner of leading property website realestate.com.au) showed that the average property owner stayed in a home for 10.6 years, up 27% (or 2.3 years) from the 8.3 years 10 years ago. There’s a number of reasons for this change (including less desire to relocate for job opportunities), but no doubt the substantial amounts homeowners have spent renovating and furnishing their homes just the way they like it has a big impact.
Source: REA 2022 Investor Day
Other influences on why housing supply is limited include strong levels of immigration, short-term rentals (such as AirBNB), and smaller household sizes brought about by fewer children per family, higher divorce rates and work-from-home arrangements (that have encouraged larger homes with better amenities such as heating/cooling). The Reserve Bank of Australia (RBA) estimated that the number of people living in each home fell from an average of 2.55 in late 2020 to 2.48 by mid 2022. While this might seem like a small change, in just 2 years this meant an extra 275,000 homes would be needed to house the existing population.
The trend is no different in the U.S., where the average household size was 2.5 in 2022, down from 2.55 in 2012 (you may notice a slight bump during the Global Financial Crisis, when the challenging economic conditions forced young people to move back in with their parents and homeowners and renters to take on extra housemates). Multiply this by the size of the U.S. population, and you can guess the results. According to CNN, the US housing market has a shortage of 6.5 million homes.
Average Number of People per Household in the United States (1960-2022)
Source: Statista
The number of new homes being built is not putting a dent in this shortage. There has also been a dramatic level of underbuilding since the Global Financial Crisis–essentially as an overreaction to the extreme level of overbuilding prior to the crisis, which caused the huge bust. Locally, we have also seen a devastating impact from the supply chain challenges during the pandemic. A whopping 1,872 home builders declared bankruptcy in the 2023 financial year (up until May 14, according to the Australian Securities and Investments Commission). This is the largest number of insolvencies on record, and includes the likes of industry giant Porter Davis Homes, which went into administration in March with over 1,500 homes under construction at the time. In fact, since 2021, builders working on around 5,200 homes worth approximately $2.2 billion are estimated to have entered bankruptcy.
It’s Not Easy, But It Is Rewarding
It’s important to keep your investments simple and easy to understand. However, inexperienced investors can often draw false conclusions using first-level thinking–particularly about economic forces. This is why we have highlighted several times the success famous investors (including Peter Lynch) have had ignoring macroeconomic factors. As Howard Marks points out, it’s also essential to consider how the uncertainty and risk relates to the price of an investment. There’s no doubt that this is the most challenging part. As Berkshire Hathaway co-chairman Charlie Munger once said: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” But that’s also what makes it so interesting, and what gives investors the great opportunities for outsized returns.
This week’s reading and viewing list covers Ray Dalio’s old shop Bridgewater talking about disequilibrium, Seth Klarman on market inefficiencies, a guide to the modern monetary system, how to achieve scale and so much more..
Australia’s unemployment rate has defied the doom and gloom predictions, falling to 3.6% in May from 3.7% in the prior month. Around 61,700 jobs were added across the country, most of which were full-time roles. The number of employed in Australia reached 14 million for the first time, and the participation rate also increased to 66.9% (meaning more people were looking for work).
While the numbers were boosted by a small decrease in employment during the preceding Easter period (when employment fell more than it usually does), the numbers provide another indicator that the economy continues to “run hot.” This is backed by still-high levels of inflation, with the consumer price index (CPI) recording 6.8% in April, up from 6.3% in March. Higher rents, increased travel costs as consumers and businesses increase their travel plans in a restriction-free world, and a rise in petrol prices following the end of the reduced fuel excise levy were the primary factors. Yesterday did see a lower than expected inflation print coming in at 5.6% for the year to the end of May 2023.
For the first time, the Reserve Bank of Australia (RBA) has openly admitted that it wants to see the unemployment rate rise in order to curb inflationary pressures. The RBA’s deputy governor, Michele Bullock, drew some criticism for these comments–which some may view as ironic at a business event in Newcastle entitled “Achieving Full Employment.” It’s never easy seeing job losses, and they can have a severe impact on people’s financial, physical and mental health – an important point that American politician Nancy Pelosi put forth strongly when the Chair of the United States Federal Reserve testified about recent rate increases in the U.S.
It’s important to keep in mind, though, that inflation impacts everyone in society (to varying degrees), while the impact of job losses is more directed to those who become unemployed (typically 3-5% of the population during steep recessions). Inflation also has very real and detrimental effects, particularly those with lower incomes who are less likely to own financial and real assets (such as property, as can be seen with the current rental crisis).
Source: Reserve Bank of Australia
We can see part of the impacts from inflation in the most recent consumer confidence data. The ANZ-Roy Morgan Consumer Confidence Index was released on June 14 and revealed that Consumer Confidence had fallen by 3.1 points over the prior week to 72.7–the lowest recording since April 2020 and among the lowest in the past decade. Consumer confidence has been extremely low for the past 15 weeks and has fallen 7.2 points in the last six weeks alone. The results saw higher confidence only in NSW, with declines in Queensland, Victoria, South Australia and Western Australia. The survey results followed the RBA’s increase to the overnight cash rate (OCR) by 0.25% to 4.1% just the week before, on June 6.
Source: ANZ
Data from the Westpac-Melbourne Institute Consumer Sentiment Survey (also released on June 14) showed similar results, with the index clocking in at 79.2. While this was a 0.2% increase from the prior reading, the recorded levels have been consistently amongst the lowest in the past 30 years–surpassing the Global Financial Crisis. Respondents ranked their most pressing concerns as inflation (62%), budget and taxation (43%), economic conditions (40%) and interest rates (28%). Interestingly, despite aggressive interest rate increases from the RBA over the past 12 months, mortgage costs do not appear to be the biggest concern–possibly because only one-third of households currently have a mortgage. Confidence around jobs declined significantly from the upbeat readings in prior surveys, with the unemployment expectations index increasing 21 points over the past 12 months.
Source: Westpac.
Cost of Living Crushes Consumer Spending
Weak consumer sentiment is yet to impact housing prices, which have remained strong despite the rapid rise in interest rates. It has, however, hammered the retail sector.
Homewares retailer Adairs (ASX: ADH) saw its share price plummet 20% on June 2 following a trading update that showed conditions had deteriorated further since the end of last year, which management attributed to the cost of living pressures. The Adairs share price is now almost 54% lower since the end of January and 73% below its all-time high in April 2021, when the Company was benefiting from a pandemic-induced trading boom.
The share price of fast-food retailer Domino’s Pizza Enterprises (ASX: DMP) has also been under pressure, falling almost 10% on June 13 following a press release that included FY24 store openings below the medium-term outlook (of 8-10%), the closure of all 27 stores in Denmark, and a series of aggressive cost cutting initiatives. While management reiterated the long-term growth outlook for 7,100 stores by 2033, the share price remains 16% lower than 5 years ago and a staggering 73% below the all-time high in September 2021. Another boom-to-bust beneficiary of the pandemic.
Even discount retailers are struggling, with clothing chain Best & Less warning on June 20 that its same-store-sales fell 13.2% in the prior 5 weeks. Discount stores often benefit during challenging economic periods as consumers trade down from more expensive retailers, but the cost of living crisis appears to be hitting low income households particularly hard. Best & Less is a private company (so there’s no public share price information available), but the 250-store network is currently an acquisition target of billionaire retailer Brett Blundy.
Will the Pain Persist?
The strong jobs numbers and persistently high inflation have increased the risk of further interest rate rises in the coming months. Market prices now imply a 64% likelihood of a further 25 basis point (0.25%) bump by the RBA at next month’s meeting, which is up from 36% before the latest employment data release. Should interest rates continue to rise and inflation remain stubbornly high, retailers are likely to remain under pressure from the devastating combination of lower sales and higher costs. The only exceptions appear to be the big supermarkets, namely Coles and Woolworths, where sales have proven resilient and profit margins have expanded–bringing accusations from the media about profiteering from the pandemic and inflationary conditions at the expense of the Australian public.
Think Long Term
Retail is a fundamental part of a well-functioning economy. The main risk associated with investing in consumer discretionary stocks is that they tend to be cyclical in nature. The value of cyclical shares tends to rise and fall with the economic cycle — meaning they typically outperform the market in good times but underperform in bad times. For the contrarian investor with the fortitude to withstand short-term pain, there will be opportunities to invest in high-quality ASX retailers that could provide outstanding results in the long run.
Disclaimer: Tamim does not currently hold any of the companies named in the article
This week’s reading and viewing list covers an end of year super checklist, a discussion about why this time might really be different, a throw back to an old favourite – Jim Rogers, the India growth engine and more…
📚 The ultimate superannuation EOFY checklist 2023 (Morningstar)
📚 This Time Might Be Different with Howard Marks and David Rosenberg (Oaktree Capital)
📚 Why India will replace China as the world’s growth engine this decade (Forbes)
📚 What Really Happened the Night the Nickel Market Broke (Bloomberg)
🎙️ Patrick Doyle, Executive Chairman of RBI on: increasing Domino’s share price by 23x; his vision for Tim Hortons and Burger King (Podcast, The World According To Boyar)
📚 AI’s Winners, Losers and Wannabes: An NVIDIA Valuation, with the AI Boost! (Aswath Damodaran)
This week’s reading and viewing list covers 3 attitude shifts, trying to figure if the market is cheap or expensive, a new perk called freedom, Tesla and Rivian forging ahead on charging as well as a crash course in Uranium amongst many others…
📚 UAE’s investment in China’s tech sector surges in 2023 (Pingwest)
📚 Rivian Accelerates Electrification through Adoption of North American Charging Standard and Access to Tesla’s Supercharger Network for Rivian Drivers (Rvian)
