Ivy Insights – Housing, Health Care and Utilities
Commentary as of October 26, 2020
Question: What are your thoughts on the current trends and strength in the homebuilding industry?
Housing has been a beneficiary of certain trends due to the pandemic. This is somewhat surprising in what's typically an economically-sensitive industry and group of companies, but the industry has been incredibly strong. It’s across all categories whether it's lower priced items like do-it-yourself (DIY) paint, outdoor products like decks, or actual home purchases.
Despite the economic situation the country is in, one of the largest homebuilders in the country saw net new order growth up more than 50% in May and June of this year. Initially, there was a concern it was just demand that got pushed out from March in April, which are two of the strongest months historically for new home sales. But the volume trends have remained strong throughout the pandemic.
Housing, particularly new housing, has enjoyed several tailwinds or trends, many of which existed before the pandemic, and have continued or accelerated as a result of the pandemic. First, interest rates have declined, and the average mortgage rate is now below 3%. Additionally, demographic trends are supportive as the millennial cohort has entered peak home buying age. On top of this, there's been a lack of inventory of both the existing home level and new homes. Lastly, the pandemic has forced people to stay in their homes, which has impacted individuals living in small apartments who may consider a move somewhere with more space.
Home spending has benefited from government stimulus. Unlike past recessions, people were somewhat limited with where they could spend money. Housing and home improvement spending increased at the expense of categories like travel and entertainment. Now the question for housing is the sustainability of these tailwinds will be going forward. While the impacts from the pandemic and the stimulus have provided a boost, it's unclear if housing will benefit from additional stimulus in the future. Additionally, I think once the economy opens and a vaccine is released, people are likely to start to pull back on spending on their homes and shift to spending on travel and entertainment.
Considering the DIY demand, what's your opinion on whether returns have just been pulled forward? You mentioned sustainability, but from this point going forward, what does the group look like from a fundamental and valuation standpoint?
I believe valuations have become stretched for some of the homebuilding stocks. The trends have been incredibly strong and some of those, such as the demographics I mentioned earlier, are sustainable. In terms of the DIY paint products, you have to question the sustainability of that going forward, since that product category pre-COVID-19 wasn’t growing. Longer term, I think there are sustainable trends, especially on the new home side. However, other categories lifted by the stimulus impact aren’t likely to have the same long-term tailwinds and received a potential one-time bounce.
In terms of geography as it relates to homebuilding, are there certain pockets of the country that may have had more meaningful tailwinds?
The key markets for the homebuilders have been Florida, Texas and California – Florida and Texas have been notably strong throughout the pandemic. It's been broad-based in terms of strength in housing, apart from tourism-dependent areas like Orlando. Even then, there are still signs pointing to improvements in those areas. Texas has continued to be strong and not much different than before the pandemic. Texas has seen quite a bit of migration and just generally strong housing markets across its cities.
Part of your research responsibility is managed health care companies. With the backdrop of the upcoming U.S. Presidential election, how are you thinking about that group?
The U.S. Presidential election is the biggest driver of the managed health care stocks at this point. That's been the case since March or April of 2019 when people started thinking about the Democratic primary and it looked like the party could have a candidate who supported Medicare for all. With polling over the last six months showing an increased likelihood of Democratic sweep, there has been a renewed concern around what that could mean for health insurance. Vice President Joe Biden is calling for a public option in which people who are in states that did not expand Medicaid under the Affordable Care Act (ACA) could be covered under the public option. Or, if individuals don’t like their employer-sponsored plan or the ACA exchange plans available to them, they could go on the public option. His description of the public option and who would be covered by it has not always been consistent. The concern for the health insurance companies is that a public option draws people away from their employer-sponsored coverage. I believe that a public option, or any sweeping health care reform, is extremely difficult to do even with a Democratic majority.
I think many of the stocks in the managed care space are attractive, particularly those that have a relatively small exposure to the ACA exchanges, which would be more disrupted by potential changes. Given the reduced exposure, I think these stocks have attractive valuations.
One of the final groups that you cover is utilities – could you provide some thoughts around that sector and what’s going on in the space?
Historically, utilities have been kind of a boring industry from a stock perspective, as well as the fundamental perspective. However, utilities, especially European utilities, are vital to the energy transition away from fossil fuels towards renewables like wind and solar. In Europe, policy to combat climate change and reduce emissions is becoming more aggressive. Consequently, many of the European utility companies have wind and solar development businesses, so the policies are largely a positive.
Since this will lead to more renewable development, it should benefit the companies to own and operate the electricity grid. Renewable development means new connections and the grid will need to be built out ahead of increase electric vehicle penetration and electrification of other parts of the economy. I have a positive view on European utilities, particularly based around this thesis.
In terms of the U.S., most of the policy decisions that matter for U.S. utilities done at the state level. Some states are more aggressive at fighting climate change than others. But for the most part, I think the U.S. is behind Europe in terms of thinking about the energy transition and the investment spending needed outside of a handful of states.
When thinking about U.S. utilities, do you think some of the European trends already in place will make their way to the U.S.? Do you think that's going to be driven more by policy decision or by consumer demands?
While I mentioned policy decisions are largely done at the state level, I think one of the biggest potential drivers is that Vice President Biden has talked quite a bit about clean energy and that is a top priority for him. In the event he is elected, I think he could possibly implement his policies, which seem more aspirational and target-focused rather than focused on how we get there. But I do think he has ambitious goals in terms of climate change and shifting the energy mix to more renewables.
His plans calls for a carbon-free power sector by 2035. Right now it’s roughly 60% fossil fuel driven in terms of the power mix, so we have a long way to go to get there, but I think it illustrates the point the aggressive push towards renewables. I think that's a potential tailwind for the group. Some states are pushing into renewables, but there are concerns with utilities in terms of customer bills. That's always a consideration. I think there are some considerations that could make it challenging in the U.S., but I do think we're moving in a slow and more measured pace than what is happening in Europe.
Since utilities are typically a bond proxy, how do you view the potential dividend risks associated with moving towards clean energy and the associated costs?
In my view, I'm not overly concerned about the rate pressure. We probably would need to start thinking about increased investment and the potential for higher customer bills, but I don't know that it's a huge concern right now. And generally, over the last few years, utility bills have increased less than inflation, so I think there is some room to go in terms of customer bills.
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