This Recovery Means Business

In a normal cyclical recovery, consumers soon tire of being cautious, saving money, and eventually “pent-up demand” results in a burst of new consumer spending which signals the start of a new expansionary phase of economic growth. Businesses, waiting for and responding to the increase in consumer spending, soon joins in the recovery and eventually hiring picks up as well. One of the many ways that this cycle is different is that consumers, which comprise about 2/3 of economic spending, are de-leveraging their balance sheets, cutting back on spending in order to pay back loans, rather than tapping their borrowing capabilities in order to buy more stuff. If measured strictly by consumer spending, I think most economists would agree that we’re still in a Recession.

Business spending, however, seems to be recovering. Business balance sheets are fairly healthy. The excess inventory problems have been resolved – at least for now. Global expansion is enabling manufacturing sales growth. Low interest rates and cutbacks on labor expense are keeping costs in line. The economic recovery, this time around, means a recovery for business, while consumers languish.

It probably can’t last for long. That may explain why this recovery is so unnerving, and doesn’t feel like a real recovery. A business-led expansion, though, explains why this recovery is being led by such an unusual cast of characters in our portfolio.

One aspect of a business recovery that we have long anticipated is that business debt will generally be repaid. Whereas 18 months ago, high yield bonds were being priced as if that vast majority of corporate America would default on its obligations, today’s resurging profitability and cash on the balance sheet means that default rates will remain under control. Since the 2008-2009 market panic subsided, junk bond returns have left even most stock sectors in the dust. The May-Investments portfolio still has nearly 30 percent invested in junk bonds and real estate income investments, and looking backwards they remain among the highest returning asset classes in our asset universe.

Businesses buy a lot of technology gear and electricity, which helps explain why we own 20 percent in hardware/software companies and our 10 percent position in utility companies (which have benefitted from falling interest rates as well).

The remaining 40 percent of the portfolio is invested in healthcare, where profits remain strong and valuations reasonable, or in Asia and gold that benefit from global growth and uncertainty surrounding the value of the U.S. dollar. The healthcare investments, however, are struggling to retain their place in the portfolio.

How far a business-led recovery can take us remains to be seen. If this market insists on rallying, we want to take advantage of those sectors that benefit most from this unique cycle. It might be an industrial up-cycle in the midst of a continuing secular bear market, yet still be able to generate some short-term profits for investors in spite of our long-term skittishness. But possibly (hopefully) an industrial sector recovery could be enough to jump start consumer spending, which would allow a full economic recovery to follow.

This recovery means business. As long as it does, our portfolios will tilt heavily in that direction.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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