4 Stocks I’m Buying As Inflation Disappears And BDCs Look Toppy

May you live in interesting times.

While this phrase sounds positive, it’s actually a Chinese curse. What is “interesting” in retrospect usually feels troubling and unpredictable in the moment.

The truth is, though, that there is always something to be troubled about, and the future is always unpredictable.

The job of the investor — your job — is to generate strong returns in the midst of inevitably troubling and unpredictable conditions.

We’ve got some ground to cover today, so let’s dig in. Here’s where we’re going:

• Where the CPI says inflation is versus where real-time inflation really is.
• Just how many rate cuts should we expect over the next year or so?
• A warning to fellow BDC investors.
• Highlighting a few successful picks from my buy list earlier in the year.
• Where the buy list stands today.

Onward.

What Inflation Really Is Today

It’s been a while since I’ve had a good, cathartic (and hopefully insightful) rant about inflation.

Readers of my previous weekly articles should be aware of my frustration at the Fed’s severely lagged shelter/housing metrics. Together, these metrics (“Rent of Primary Residence” and “Owners’ Equivalent Rent”) make up 35% of the headline CPI basket and, as such, exert major influence on the overall CPI and especially core CPI rates.

As you can see below, CPI ex-shelter slid further from 1.8% in June to 1.7% in July.

Wow! Under 2%, you say? And, without the shelter metrics, the CPI has been under 2% for over a year (save a few months at the beginning of 2024)?

Gee, that doesn’t seem to fit the narrative about “stubbornly high inflation” and “more confidence needed” that has predominated over the last year and a half!

But it gets worse. Let’s dig in to the Fed’s shelter metrics and how dramatically they differ from real-time changes to market rent rates. Here’s a handy chart from Apartment List:

This chart shows June CPI data combined with Apartment List’s July rent data, but it’s hardly dated.

CPI Rent remained 5.1% in July, while headline CPI declined only to 2.9%.

But if the Fed measured shelter costs using real-time market data instead of the BLS’s lagged metrics, overall inflation as measured by the CPI would have been below 2% since the Summer of 2023.

Let’s look at an amalgam of private sector residential rent indices and compare them to CPI Rent.

For June 2024, Apartment List showed -0.8% YoY, Redfin showed 0.4%, and Zillow showed 3.4%. Together, they averaged 1.0% YoY.

Plug this number into the CPI instead of the shelter component, and July’s headline CPI print would have been 1.5% YoY instead of 2.9%.

Read that again. CPI using real-time rent data is 1.5%.

That’s right. The way the Bureau of Labor Statistics (and, by extension, the Fed) measures shelter inflation causes headline CPI to overshoot real-time inflation by almost 100% — at least in July.

Wait, what about Owners’ Equivalent Rent (“OER”)?

The absurdity that is the OER does not directly measure anything associated with home ownership. It is a survey asking homeowners how much they think they could rent their home for, and it strongly correlates with the Rent of Primary Residence metric, suggesting that survey respondents simply base their answers on rent rates in their local area.

As such, OER basically just increases the weight of the Rent of Primary Residence item in the CPI.

Effective Rents Vs. Market Rents

Now, some would say that the way the BLS measures rent inflation captures the average renter’s experience, because it incorporates the fact that residential leases typically last a year or more. Thus, average or effective rents do not immediately change as market rent rates change.

The average rent paid by all renters only slowly catches up to the growth in market rent rates with a lag. The CPI’s Rent of Primary Residence metric captures this phenomenon.

But the counterargument I would make is that even if Fed policy could immediately affect rent rates (and it can’t; that happens with a lag, too), the Fed should only be concerned about market rents, not average or effective rents.

That is because market rent rates are the head of the snake. Where they go, average rent rates will likewise go.

Imagine if the Fed treated car inflation the same way as shelter inflation. Rather than simply looking at the market prices of cars, what if they assumed that the average car owner only buys a car every 5 years or so and uses fixed-rate financing? The average monthly car payment drivers pay only changes very slowly. This would cause the CPI’s measurement of car inflation to lag behind real-time market prices of cars by a span of many years.

To understand whether monetary policy is having its intended effect, the Fed reasonably looks at the market prices of new and used cars, not the average monthly cost that car owners pay, because that average cost is typically based on market prices paid years ago as well as long-term, fixed-rate financing.

And yet, when it comes to shelter (the biggest item in the CPI basket!), the Fed is using the average monthly cost renters are paying rather than market prices.

This has the inevitable effect of putting the Fed way behind any big and/or sudden swings in market pricing.

The Rate Cuts Cometh

As previously stated, real-time inflation, using market rent data instead of the BLS’s CPI Rent metric, has been at or below 2% for a little over a year now.

Therefore, the Fed Funds Rate (“FFR”) has been 2.5-3 points above real-time inflation for a year now. This is extraordinarily restrictive policy that puts the US economy at greater risk of recession.

This should not be terribly surprising. Historically, the vast majority of Fed rate hiking cycles have been promptly followed by recessions.

In large part, FFR hiking cycles cause recessions by pulling down certain cyclical parts of the economy like housing, durables, and capital investment.

Then again, a lot of unprecedented things have happened in the economy over the last several years, so perhaps we shouldn’t be too surprised by anything.

If the economy does see a soft landing, as Fed officials and many economists expect, the FFR will likely be slowly eased down over the course of this year and 2025, starting this September.

The latest Fed “dot plot” envisions 2.25 points’ worth of cuts by sometime in 2026, while the market’s view is that around 2.0 points (200 basis points) will be shaved off the FFR within a year. Basically, that would be a 25-basis point cut at each of the Fed’s next 8 meetings, and they only meet 8 times a year.

This level of market-expected decline in the FFR is consistent with an oncoming recession. It is around the same level of expected decline as seen in the late 1980s before the recession of 1991 and in 2000 before the recession of 2001. Both of these recessions were fairly mild and short, and I don’t think there’s reason to expect any different from a potentially ensuing recession today.

A mild recession in the near future continues to be the most likely scenario, in my opinion.

Pulled From The Brink By Retail Sales?

US retail sales numbers recently came in a little better than expected for July, which some view as proof of a resilient consumer and a likely soft landing — i.e. avoided recession.

That little upward tick at the very end from 1.8% in June to 2.55% in July (actually 2.7% as reported by the Census Bureau) is the “strong” retail sales number. Sure, it’s better than a negative number or a continued drop in the growth rate, especially as recession fears loom, but I wouldn’t call it strong.

From January 2010 to February 2020, US retail sales growth averaged 4.1% annually.

So July’s 2.7% growth isn’t terrible but isn’t celebration-worthy either, and I certainly wouldn’t hail it as evidence that a soft landing is now more likely.

The economy did see a soft landing… in July. In fact, the entire period from early 2023 to today could be considered a soft landing. Whether it will continue to be a soft landing in the future is a different story.

Also keep in mind that in the second quarter, US credit card debt bounced to a new record high, and delinquency rates continued to creep up as well.

Given average hourly wage growth of 0.2% month-over-month in July, the 1.0% MoM jump in retail sales could not have come entirely from wage growth. And since the personal saving rate is ultra-low right now, the bounce in retail spending in July (probably driven by back-to-school needs and a growing trend of discounting) was likely funded mostly with debt.

Recently released data shows that credit card delinquency rates continued to tick up in July, which signifies that cardholders are still having a lot of trouble servicing their debt.

From the poorest households to the lower end of the affluent, American consumers are losing steam and being forced to rein in their spending.

One decent month does not make a trend. Nor does it pull the economy away from the brink of recession.

A Warning To Fellow BDC Investors

I own six business development companies (“BDCs”), and I’m a big fan of the business model. I think BDCs make a great complement to REITs, because a rising Fed Funds Rate typically benefits the former while weighing on the latter. And all else equal, a falling FFR benefits REITs while weighing on BDCs.

BDCs make floating rate loans to middle-market businesses, and those floating rates are usually based on the SOFR, which is in turn based on the FFR.

Over the last few years, BDCs (BIZD) have soared as the FFR has risen from basically zero to ~5.5%, while REITs (VNQ) have performed remarkably badly given the resilience of the economy.

The market almost systematically prices BDCs based on the FFR, while REITs are really more like long-term bond proxies and thus correlated with the 10-year Treasury yield.

If you buy the thesis presented above that the FFR is going to come down by 200 basis points or so amid a weak economy over the next year, then BDCs current valuations look very lofty — toppy, if you will.

Here are the premiums to net asset value (“NAV”) of the six BDCs I own in ascending order of their weight in my portfolio:

Click to enlarge

Five of these six BDCs are internally managed. The sole externally managed BDC in this list is ARCC, which I like because of its defensive and diversified loan portfolio as well as its management by the masters of private credit: Ares Management (ARES).

TRIN’s relatively low premium to NAV is understandable given its focus on tech startups and VC-backed growth-stage companies as well as its lack of NII per share growth this year.

In Q2, NII per share declined to $0.53 from $0.58 last year, and in the first half of 2024, NII per share declined to $1.03 from $1.10 last year. The $0.51 quarterly dividend is now narrowly covered. However, non-accruals remain quite low, and management still appears confident in the company’s future. CEO Kyle Brown recently purchased 3,500 shares of TRIN at $14.15 (~$50,000 worth), bringing his personal position in TRIN to almost $14 million.

I’d love own more of these BDCs, especially MAIN, CSWC, and HTGC, but given their lofty premiums to NAV, right now looks like a terrible time to be a buyer.

Of course, if the economy reaccelerates as the Fed cuts rates, then BDCs should perform well, as lending volume should increase enough to offset lower floating rates.

But if the FFR drops and the economy falters, as I suspect it will, then BDCs will get hit with a triple whammy of lower floating rates, less lending volume, and rising non-accruals.

Celebrating A Few Successful Picks From The Past Buy List

The global wireless telecommunications infrastructure REIT American Tower (AMT) was on my buy list in May and June, and it has done quite well since then, handily beating the S&P 500 (SPY) in total returns.

Yes, most REITs have performed very well since positive inflation data and not-so-positive unemployment data emerged in July, finally bringing Fed rate cuts into the foreground.

But I argued back in May and June that AMT is far too high-quality to trade at such a steep discount to its historical valuation. Its balance sheet strength, cost of capital advantage, high returns on invested capital, and broad spectrum of investment opportunities (including data centers via its CoreSite acquisition) make it a highly consistent and reliable long-term compounder.

By all rights, a company of such quality should trade at a premium. I argued a few months ago that AMT’s valuation was well below where it should be, and that thesis has so far played out.

Another successful pick that had been on my buy list as recently as early May was the Sunbelt multifamily REIT Mid-America Apartment Communities (MAA).

This REIT was most recently on my buy list in early June when I highlighted it in “Everything On My Buy List For The First Week of June.” Since then, it has really taken off:

MAA is another high-quality compounder that happens to be a REIT. Although REITs tend to be treated like bond substitutes (hence why REITs have rallied along with bonds recently), MAA is one of those all-weather stalwarts that is built like a battleship and capable of handling almost any environment in stride.

Its balance sheet is strong and under-leveraged (leaving plenty of capacity to leverage up for growth when opportunity strikes), its management team is top-notch and long-tenured, and its Class A and B portfolio is well-situated to benefit from Sunbelt population/job growth in the years to come.

Sure, new supply is hurting performance this year, but the market is already looking beyond that to the return of organic growth in 2025-2026.

Besides, the more short-term pain that Sunbelt apartments feel, the more attractive acquisition opportunities are likely to come available for a well-capitalized buyer like MAA.

It’s nice to see some of my previous picks getting some time in the sun after such a long period of being rangebound. The market eventually rewards quality.

The Buy List As Of August 17th

The buy list is down from the 5 stocks in last week’s article to 4 stocks this week.

Click to enlarge

Pertaining to life science real estate leader ARE, I suspect the market fears that an abundance of half-empty office buildings will eventually compete with ARE’s life science buildings via conversions. I’m guessing that is a reason why ARE trades so cheaply at about 12x AFFO.

This is a recession-level valuation, which perhaps makes sense given Chairman Joel Marcus’s admission on the Q2 2024 conference call that life science real estate is in its own recession.

I’m not that worried about competition from the “shadow supply” of traditional office buildings convertible into life science. The reason is because most of these weak office buildings are Class B and C assets, and I highly doubt that a Class B or C office building can be converted into a property capable of competing with ARE’s state-of-the-art Class A facilities.

As for REXR, my thinking is that a recession or even just an economic slowdown would probably extend the decline in market rent rates in Southern California, which will shrink REXR’s mark-to-market upside from Q2’s 38% to something less than that.

So while falling interest rates should lower REXR’s cost of capital, thereby increasing investment opportunities and profitability, organic growth may continue to slow over the next several quarters.

Dividend growth, then, may slow to the mid-single-digits this year and next year, but I would fully expect it to rise back to the high-single-digit to low-double-digit level thereafter.