REIT - Worried About A Recession? We Are Too

2023-03-14 06:20:00 ET

Summary

• Recession indicators are concerning.
• Bank runs are particularly concerning.
• Certain companies may outperform in a recession.

As negative economic and financial news piles up, there are increasing concerns about a potential upcoming recession. As we speak with market participants and clients, their single biggest worry is the risk of a deep, protracted downturn. The future is unknowable and we’re not calling for a recession, but we are worried too.

Bison’s Chief Investment Officer likes to joke that his “short-term crystal ball is broken,” but several economic indicators are showing an elevated risk of an impending recession. In the context of broad fears and high hit-rate indicators, it is timely to consider which asset classes and what types of companies and securities might outperform the market across reasonably probable economic outcomes, including a potential recession.

Recession Indicators Are Concerning

There are several metrics that are broadly followed that indicate an elevated risk of recession. We address these indicators and their implications below.

Inflation and Interest Rate Hikes

The Federal Reserve has been aggressively raising the Federal funds rate to tame accelerating inflation:

As can be seen above, this tightening cycle in the US is one of the most aggressive in decades. And as suggested by Federal Reserve Chair Jerome Powell recently, the Fed may continue to raise rates faster and beyond their initial 5-5.5% target if inflation doesn’t subside, which casts some uncertainty over when this hiking cycle might end.

In several prior instances, rapid Fed tightening in response to higher inflation has occurred immediately prior to a recession. It is worth noting that many dovish investors and economic participants who had expected a “Fed pivot” earlier in the cycle were caught off guard by the Federal Reserve’s resolve to continue to raise rates to fight inflation. Many of these participants are now poorly prepared to deal with the much higher cost of capital today.

Yield Curve Inversion

The yield curve the market is focused on is the spread between 2-year and 10-year US government bonds. When the yield curve inverts, short-term bond yields are greater than long-term bond yields. Higher short-term yields may indicate investor concerns that long-term rates will decline in response to a recession. The inversion of the yield curve has historically marked cycle highs and preceded U.S recession with a reasonable degree of accuracy, and therefore, it is worth monitoring closely.

The yield curve inverted in July 2022 and has been steepening ever since, with the 10 year-2 year yields currently around -1%, a 30-year low. Based on the current slope of the yield curve, Bloomberg estimates the probability of a recession is 71%:

Housing Market Deterioration

The status of the housing market is an important gauge of consumer and overall economic health. The bulk of the average person’s wealth is tied up in their home equity, and construction is a major employer. Therefore, declining real estate prices and construction activity may help gauge the health of the economy. Real estate prices and building activity peaked in mid-2022, and the latter has been falling since in response to rising interest rates:

Rising rates also make it harder for the average person to own a home, due to higher interest payments. This also reduces the amount of capital available to buy homes, putting further downward pressure on prices. US housing affordability is at a multi-decade low, as can be seen below:

Commercial Real Estate

The ~$21 trillion commercial real estate market is coming under significant pressure as well from higher rates and work from home. Office building real estate is in particularly bad shape, with the trend of working from home after the pandemic hurting revenues, while $92B of nonbank office debt will mature this year:

Risk of Broader Financial Contagion

Higher interest rates are pressuring the balance sheets of financial institutions, which is increasing the risk of a broader market contagion like that of previous financial crises. The financial system is already beginning to crack under the pressure of higher rates, with tech-focused Silicon Valley Bank ( SIVB ) having shed 60% of its market cap this week following a bank run, and now potentially going to zero after bank regulator intervention:

In the tech boom in 2020 and 2021, SIVB’s deposits soared. The bank mostly invested that money into long-duration U.S. Treasuries and mortgage-backed securities. Soon after, the Fed started raising rates and those bonds came under pressure - triggering $2B in mark-to-market losses and a capital deficit. Depositors subsequently rushed to pull their funds out of the bank, worsening the liquidity crunch.

SIVB isn’t the only bank that has poured a substantial portion of deposits into U.S. Treasuries and MBS - many have done the same and are significantly exposed to duration risk from higher interest rates. And with financial institutions intertwined, there is elevated financial systemic risk.

Bracing for Recession Without Timing the Market

“Far more money has been lost by investors trying to anticipate corrections than has been lost in all the corrections combined.” - Peter Lynch

Market timing is hard and rarely profitable. Despite the elevated risk of a recession, it has historically been more profitable to focus on long-term equity fundamentals. In our view, the risk of missing out on further potential upside is similar to that of being over exposed to the downside. We view the common mantra, that one should sell equities and buy bonds in anticipation of a recession, as an unsound approach to portfolio management, as did Peter Lynch.

This is particularly true as the widely adopted 60% equity / 40% fixed income risk parity portfolio construction approach has performed poorly in the current inflationary environment. 2022 was the first year in decades in which the passive approach adopted by many large financial institutions and their financial advisors failed:

The Best Defense is Good Offense

While timing the market is hard and unlikely to be successful, a passive portfolio approach also tends to not perform well in a recession. For this reason, an alternative approach of exposure to equities that may perform well in a downturn, or those that may recover faster than the broader market, is more compelling.

In a downturn, all asset correlations initially tend to converge as investors liquidate their portfolios to meet obligations. And while oil & gas equities will likely be no exception, we think these may quickly recover and outperform the broader market in the event of a recession, as they did in the recovery from the financial crisis in 2009.

Oil prices themselves may hold up better than expected in the event of a recession, due to strong fundamentals. Demand is rising steadily, and the world needs more oil, not less - even in a recession. For instance, global oil demand in April 2020 - when many countries were in total lockdown - was estimated to be ~82MM bbl/d by the EIA, only ~15% less than pre-Covid highs!

On the supply side, persistent underinvestment, lack of drilling and exploration activity, declining well productivity and rising oilfield services costs are driving higher production breakevens for producers. And OPEC+ likely won’t bail the market out this time, as it is nearly out of spare capacity and leaning towards additional production cuts:

Even if oil prices don’t hold up, there are numerous small-cap oil producers currently pricing in lower-than-market commodity prices. Simultaneously, these are trading at material discounts to both large-cap peers and the broader market, while generating material cash flow. In our view, these ultra-low valuations for high-quality oil & gas producers offer additional potential downside protection.

Sandridge Energy Could Outperform in a Downturn

Sandridge Energy ( SD ) is an example of a Bison portfolio company that could outperform in this environment. As we have discussed previously , Sandridge has been rapidly increasing its oil production and has hedged a portion of its gas prices opportunistically, which may drive improving margins in subsequent quarters:

Ever since it emerged from bankruptcy, Sandridge has been rapidly paying down debt and building a substantial cash balance. As of the end of Q3 2022, Sandridge had ?$6.5 in net cash per share, and we estimate it has built over $260MM in net cash as of the end of 2022:

Sandridge’s low valuation, commodity price hedges and substantial cash flow offer downside protection in the event of a recession. The company’s cash flow would likely suffer in a downturn and hedges would eventually roll off, potentially mitigated by its low valuation.

What really sets Sandridge apart from the rest of the pack is the substantial cash balance it is looking to deploy to buy assets at depressed valuations in a downturn, which would be highly accretive to cash flow. If oil prices were to subsequently recover, the company would emerge with significantly more production and a strong balance sheet. Sandridge has a board selected by Carl Icahn, its largest shareholder, and $1.6 billion in “tax shields” to offset acquired cash flows. With a view that oil prices are headed structurally higher looking past current economic uncertainty, we are accumulating shares in companies like Sandridge.

Implications

As investors, we are constantly trying to gauge risk and adjust our portfolios accordingly. The risk of a recession is certainly elevated, based on key indicators and the recent failure of Silicon Valley Bank. However, there is no guarantee that a recession is imminent, or will happen at all. For this reason, we believe it is better to focus on long0term equity fundamentals than to try to time the market, while also building exposure to companies like Sandridge that are well-positioned to exploit a downturn.

We continue to see the compelling opportunity in that deeply discounted, high-quality, small-cap oil & gas companies. In an upside scenario, these offer substantial torque to commodity prices, while also having the potential to catch up to large-cap peer valuations. And in a downturn, companies like Sandridge may deploy their accumulated cash on deeply discounted assets and materially outperform.

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