One step forward and one step back. The labor market remains strong even after some spring “jitters” in the financial sector (good for the economy), BUT wage pressures surprised meaningfully to the upside (bad for the inflation outlook). The American economy added 253,000 jobs in April with the official unemployment rate falling back to 3.4%. Meanwhile, U6 dipped to 6.6%-- well below the 7% threshold last seen in August 2022. Hourly earnings increased 0.5% MoM, which is the strongest monthly gain thus far in 2023. It is important to note that this is happening despite a slowing American economic engine. April figures suggest continued contraction among US manufacturers, though the services side of the economy is in slightly better shape. Data released in April also indicate consumers tightened their purse strings significantly with retail sales declining by 1.0% and personal spending flatlining MoM. So, it shouldn’t be too surprising when we say that the outlook from corporate America during this earnings season has been decidedly undecided! As a result, our earnings expectations are coming in with the economy slowing and credit conditions tightening— we now see S&P earnings growth in the low single digits (if at all) in 2023. The primary culprits are global macro uncertainty and rather sticky inflationary pressures. The upshot is that Mr. Powell may have reached the terminal rate for this hiking cycle, which has meaningful ramifications for asset valuations and returns in the coming months and quarters. Suffice it to say, this cycle has taken A LOT of patience and discipline. So, let’s revisit some of the basics about assets and returns.
One of the common misconceptions about assets (and asset management for that matter) is that there is some magical way to disassociate oneself from negative asset returns once you own the asset itself. We only want to participate in positive asset returns— “pick the good stocks, not the bad ones.” When you own an asset (a house, a car, a stock, etc…), you will receive the return on that asset. Some assets depreciate (cars, equipment, technology, certain stocks etc…), others appreciate (your home, portfolio, etc…) All of this makes sense. However, one of the ways that people think about asset returns is by putting them into buckets— my car is different from my home which is different from my portfolio of liquid assets. As long as I diversify my assets appropriately, they should take care of my living expenses and fund my lifestyle through retirement. This approach bears a large degree of semblance to the Strategic Asset Allocation (SAA) model, which is under quite a bit of scrutiny at the institutional level. The concept is pretty simple: diversify assets in order to meet various financial objectives and reduce risks where possible. It’s not that this line of logic is “wrong” per se; it’s just that many times it isn’t necessarily the best financial fit-- “a half-truth” as Robert Shiller might say. An alternative approach to this methodology is known as the TPA, which we will discuss below. Of course, whether or not a TPA is the right fit will be a function of investment objectives, time horizon, financial condition, attitude toward (and ability to tolerate) risk, etc..., but let’s zoom out for a moment before we formally introduce the TPA model.
The assets owned fall on the balance sheet, whether we like it or not, and it naturally follows that the liabilities associated with them land on the opposite side of the ledger. Each asset has a return profile (positive or negative) and each debt has a cost (interest rate, terms, etc..). Looking at the assets (and debts) comprehensively is a better way to view your overall return profile and a far more useful means to measure your ability to grow sustainably over time. Naturally, we all expect some assets (our cars and computers for instance) to depreciate and our portfolios of financial assets to appreciate. The real question is: What is your exposure to each of these return streams throughout an economic cycle OR life cycle? Have you been able to adapt to the various market environments in order to amplify positive return streams and mitigate negative ones? The Total Portfolio Approach (TPA) is a unique way of addressing these concerns— a comprehensive strategy that fully integrates balance sheet management.
Consider the following example from yesteryear. If I have the choice to buy an asset (a home for example) with an expected annual return rate of 5% and the ability to finance the asset at 3% (a fixed mortgage in this case), does it make sense to buy the asset outright or to use debt? Of course, there are a number of other relevant factors to consider when purchasing a home, but for the sake of this analysis, let’s isolate these two variables…
Return on Asset= 5%
Cost of Financing= 3%
If you own the asset outright, then you can expect the return on your asset (ROA) to equal your return on equity (ROE). In this case, ROA and ROE are the same because there isn’t any debt to factor in. Let’s not forget the age-old accounting equation: Assets = Liabilities + Equity. In this scenario, Assets = Equity. So, the return profile is the same from a balance sheet perspective. It is important to think of liabilities (debt) as return amplifiers. It would be silly to amplify the negative return stream on a depreciating asset. Wealthy people understand this and the business community thrives off of it. We want to “accentuate the positive” as Dr. John would say. So, let’s consider an alternate path rather than owning the asset outright.
Return on Asset= 5%
Cost of Financing= 3%
Loan to Value (LTV)= 80% (after a 20% downpayment)
Return on Equity= (Leverage Ratio * (Return on Asset- Cost of Financing)) + Return on Asset
Leverage Ratio= Debt/ Equity
Leverage Ratio= 80%/20% or 4
Return on Equity= (4 * (5% - 3%)) + 5%
Return on Equity= 13%
13% is far greater than 5%, so it makes plenty of financial sense to use debt in this case. For the sake of objectivity, we are also assuming that using debt is a choice. The rational investor will certainly prefer a 13% rate of return over 5%. Let’s not forget that since you own the asset you will get the rate of return on the asset REGARDLESS. The only real question is how much you get (which is the ROE or “return on ownership”). Most people would choose 13% over 5%, if it was presented in these terms, and there is the additional benefit of further diversification across your asset base. You only committed 20% of the capital required to purchase this particular asset; the bank (theoretically) provided the rest. You can invest the remaining 80% elsewhere. Generally speaking, this illustration serves as a guiding principle behind the private equity boom and has undoubtedly played a key role in its outsized influence on the financial universe over the past decade. Of course, this principle is also important for commercial real estate as well. Accentuating the positive is a VERY popular theme! BUT what about the negative? When does it not make sense to amp up an expected return stream? Let’s look at another example where our cost of financing/ debt has shot up to 6% all else equal.
Return on Asset= 5%
Cost of Financing= 6%
Loan to Value (LTV)= 80%
Return on Equity= (4 * (5%-6%)) + 5%
Return on Equity= 1%
5% is much better than 1%. So, in this scenario the investor is better off with less or no debt at all, which makes sense intuitively, but it also elicits a very important question: what do I do if the economics change during my holding period? After all, these sorts of strategic investments/ capital allocations are typically made with longer-term economic trends (and holding periods) in mind. Practically speaking, the investor must be able to lever and de-lever the asset at his or her discretion—an important advantage (and luxury)!
Banks as we have learned (yet again) can be a flighty source of capital, and quite frankly the times that they are least likely to lend also happen to coincide with the times that credit is needed most. Naturally, there are also times during the cycle that conventional lenders are very helpful and competitive, but that isn’t always the case. So, availability of credit/ liquidity is of the utmost importance during certain phases of the economic cycle. The cost and terms of financing are also relevant decision-making factors; we will spend a bit of time on that subject (among others) in the coming weeks. Have a great weekend!
News Release: Bureau of Labor Statistics (The Employment Situation- April 2023)