Tremont Realty Capital: Portfolio Management

Market Commentary
Third Quarter 2012
By Daniel Owen Mee

“Hey! What's all this laying around stuff? Why are you all still laying around here for?”
- Bluto (Animal House, 1978)

The above quote could easily be applied to many of today’s investors. Evidence indicates that there is significant capital available in the market; some has even been allocated. However, the anemic growth of our economy is testimony that most investors are inactive. This can be illustrated by the following chart, which shows that all banks are effectively on the sidelines as they hoard cash levels and resist making loan investments.

To be fair to the players in this lethargic market, we must appreciate that there are ominous signs all about us. The most frustrating sign is that the economy’s largest driver, consumer spending, remains down. Driven by higher gas and energy costs, atrocious weather in most of the country this summer and a number of other contributing recessionary factors, the American consumer has also been “laying around.”

These fears of a recession have much credibility. The “Fiscal Cliff” Congress built into the budget is both real and frightening. If it is not addressed this year, all reports point towards a US recession in the first quarter of 2013. The drafters of this “poison pill” believed that a full year was enough time to work out the issues. Meanwhile, the option of not resolving this crisis is so severe that neither party wants to be hung with the blame, leading most observers to believe the stalemate will be resolved. However, nothing has been done all year, and it is likely nothing will be done until after the election. There is now the risk that the lame-duck congressional session will not have the same urgency to pass a bill that would otherwise exist with Members who would all have to live with it. Also, the debt ceiling needs to be raised by the end of January 2013… again, during the lame-duck session. The last time Congress looked like it would run out of money and default on its debt, the markets all but crashed! Such an event would certainly add to recessionary risk.

Adding to all of the previously mentioned uncertainty, we are nearing a Presidential Election that offers one of the most polar choices in history. The Republican and Democratic candidates could not be more dissimilar in virtually every position. Thus, policies and the investing climate are going to be very different depending on who is elected. Since the election polls are close, it is not unreasonable for many investors to make the decision to stand down until this uncertainty abates.

Despite the above, there are many encouraging signs in this economy. First, although consumer spending is down, the US consumer is in better shape due significant household debt reduction over the last several years. A 2012 Q2 NY Fed study indicates that the downward trend in household debt, in place since the third quarter of 2008 has continued. As of June 30, 2012, total outstanding household debt was down nearly $1.3 trillion since its peak in the third quarter of 2008. The detailed report stripped out the effect of charge-offs (the removal of obligations from consumers' credit reports because of defaults) and determined that households are continuing to reduce their indebtedness by borrowing less and paying down existing liabilities. These facts would tend to indicate that when the headwinds and ambiguities outlined above abate, consumers will be in a strong position to increase spending.

Many will point to the 8% unemployment rate and declare that the economy will not improve until we have more jobs, but the fact is that we have had very significant job growth over the last year. A recent PwC study indicated that if all the new job positions were actually filled, the unemployment rate would drop to 5.6%! The conclusion is that our unemployed require different skills for the new jobs. Such a state of employment is often a relatively short term phenomenon until retraining fills the gap. This indicates that a lower unemployment rate may not be too far off. There are a few sectors that are actually seeing good growth. Many technology fields are enjoying solid sales as older systems (at work, in many cases, since 2007) are finally being updated or replaced. The energy field, including natural gas and alternatives, is seeing historic growth. Certain manufacturing areas, such as autos, computers and aircrafts, have all seen recent gains as well.

Behind many of the weak areas of the economy, such as for-sale housing, there is significant pent-up demand. The unsustainably low number of new households created over the last few years holds the promise of accelerated growth once the economy gains solid footing. This factor should also play a role in sustaining growth in the multifamily sector once sales return. In addition to general growth, the key to a housing rebound is the return of some sanity to the financial markets. The Dodd-Frank legislation thankfully put an end to the abuses of no-doc and sub-prime mortgages. However, as it often happens in Washington, this bill has swung the pendulum too far and currently credit is not being extended to worthy borrowers, retarding growth. This is further evidenced by the fact that 30% of housing sales over the last two quarters have been in cash. We can only hope Washington sends guidance to the relevant agencies for more rational lending.

Summing up, the massive uncertainty that will exist for the balance of 2012 indicates that investor reluctance will continue. Since most of this uncertainty should be cleared up in the first quarter of next year, 2013 holds strong potential for a turnaround. We should remember that while the investor “laying around” frustrates us, not unlike how the Delta House members “laying around” frustrated our hero Bluto, we can take some solace in the fact that significant action often follows such low activity, be it a sabotaged homecoming parade or a rebounding economy!

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