Here's Where My Portfolio Will Remain Underweight
The coming Fed funds cuts will help but only offer marginal benefits to this economic sector.
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The market continued to hit new all-time highs last week even as economic growth cooled dramatically in the first half of 2024 from the levels in the back half of 2023. It remains an incredibly bifurcated market with the small cap Russell 2000 now flat for the year and the equal-weight S&P 500 up only 4% or so. The major indices have benefited recently as two of the Magnificent Seven, Tesla, Inc. TSLA and Apple AAPL, have rejoined the mega-cap party, which has a very exclusive invite list at the moment.
The job market continues to see deterioration with the June unemployment rate ticking up to 4.1% from a cycle low of 3.5% in July 2023. Job openings are at three-year lows. However, the Friday BLS report sent treasury yields down and pushed up the chances of the first Fed funds rate cut in September to 77%. This was up from the 64% level the probabilities were at to start last week.
Slightly lower interest rates will do little to alleviate the huge stress in many parts of the commercial real estate sector and I expect delinquency and default rates on CRE loans and CMBS to continue to move higher well into 2025. Lower rates might marginally help on the residential side of the real estate market. Mortgage rates moving back down to the mid-6% range might entice a few more buyers onto the market. With existing home sales at their lowest levels since the mid-1990s, the housing sector can use whatever boost it can get. However, tens of millions of homeowners still have the "golden handcuffs" of mortgage rates with a "three handle." Mortgage rates moving down 50 bps or even 100 bps will do little to lower the incentive to keeping their existing mortgages and continuing to be reluctant sellers.
Lower mortgage rates could boost home builder sentiment a bit. They could use that assistance. One of the hidden costs of higher interest rates is the amount of incentives home builders are being forced to use to move their inventories, which impacts margins and profits. Lennar LEN reported the percentage of sales dedicated to incentives, such as mortgage rate buydowns and free upgrades, rose to just over 10% in the first quarter of this year. That is over $47,000 to move the average house in Lennar’s portfolio. As my late father would say, "Now we are talking real money." Speaking of which, D.R. Horton, Inc. DHI took a $65 million charge to cost of goods sold in the first quarter. This was the result of not quite getting their hedging strategy right around the mortgage rate buydowns Horton is offering customers to move its inventory.
Hopefully, interest rates starting to come down will at least incrementally boost consumer sentiment and help the prospects of retailers that depend on the housing sector. Both Home Depot HD and Lowe's Companies, Inc. LOW mentioned the increasing reluctance of their customer base to purchase big-ticket items like appliances, in their first quarter earnings reports. Other industries that rely on the housing sector, such as furniture makers like Ethan Allen Interiors Inc. ETD, whose first quarter sales were down 20% from the same period a year ago, will take any relief they can get at the moment. Unfortunately, interest rate cuts will come too late for names like LL Flooring Holdings, Inc. LL which is heading toward bankruptcy.
In summary, the real estate sector and the industries that rely on it can’t see rate cuts soon enough. However, a 25 bps cut or two will only offer modest relief and I will remain significantly underweight in these parts of the economy within my portfolio.
At the time of publication, Jensen had no positions in any securities mentioned.
