Author: S.C.
1. Executive Summary
The Timber Finance Carbon & Storage Index was down -11.3% in Q2 in USD terms and down -11.5% YTD at the end of the quarter (30.06.2024). Performance during the quarter was volatile, broadly in line with the swings of the homebuilding sector. Macro weakness continues to affect the construction cycle, which is going through a very challenging period given persistently high long-term interest rates. The recent cuts in policy rates by major Western central banks could point towards much needed further normalisation, as long as inflation continues with its trajectory towards the consensus 2% target.
2. Macro Overview
Long-term yields, a key driver for the housing sector, were volatile in Q2. After some weaker macro data from the U.S. at the beginning of May, which put downward pressure on yields, surprisingly strong numbers, including PMIs, led to a rebound in longer-term rates by the end of the month. Slightly improving European macro numbers also provided support for increasing yields in the Old Continent. In June, yields were down on risk-off sentiment, driven by weaker labour and housing data in the U.S. and some nervousness about the political situation in France, as President Macron called for snap elections.
Looking at short-term indicators, however, one may lose sight of the big picture. Ultimately, in the long term, the latter matters more than short-term macro data. In Figure 1, we look at the longer-term construction spending cycle. After the subprime peak in 2006 and the collapse in construction spending until 2012, we have seen – on a per capita and inflation-adjusted basis – an acceleration in the aftermath of the Covid-pandemic, which peaked in 2022, and corrected in 2023. Spending on improvements was, over the cycle, significantly less volatile than new construction spending. Also longer-term, going back to the 1980s, as per research by A. Will (2008), the improvement cycle has displayed somewhat lower cyclicality compared to new construction. 2021-2022 were two spectacular periods for timber companies as well as other construction and remodelling companies, with strong demand and strong prices, which led to extraordinary profitability.
2023 has been a normalisation year, with a decrease in spending, due to various factors, such as
- Higher interest rates, negatively affecting affordability – this affects new home buyers as well as repair & remodelling (R&R); more muted R&R demand is also linked to reduced existing home sales.
- Channel destocking, after above-normal inventory levels due to supply-chain factors and strong demand.
Figure 1: Inflation-adjusted per capita spending on new construction and improvements in the U.S.. Sources: U.S. Census Bureau, U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, Timber Finance. Data retrieved from FRED, Federal Reserve Bank of St. Louis.
The path to be taken by interest rates is impossible to predict with sufficient certainty, since it depends on exogenous factors including geopolitical tensions that may impact supply chains and energy prices; and economic and fiscal policies that may be particularly volatile, with U.S. elections approaching in November this year. In any case, we should not be surprised if spending continues to retrace somewhat from the 2022 peak, going back towards more average levels, before picking up once interest rates will be lower or at least stable, and consumers (and their finances) will have adjusted to a new normal.
In Europe, see Figure 2, building permits have weakened since the peak in 2022, which however was significantly below the peak corresponding to the great financial crisis. Also in Europe, we should not be surprised if we see a further slowdown in the coming quarters, reflecting with a time-lag the decrease in permits. It should be noted that the situation in Europe is quite inhomogeneous, with countries such as Germany and France particularly affected by the permitting slowdown. So far, the Timber Finance Forest-Based Construction Basket had limited exposure to Europe compared to the U.S., while the rebalancing at the beginning of April increased the relative weight of European stocks. The rebalancing was timely, as a reversal in the relative outperformance of U.S. vs. Europe occurred right at the beginning of Q2.
Figure 2: EU-27 construction production and building permits. Source: Eurostat.
During Q2, we saw several central banks cutting rates: ECB, SNB, BoC and Riksbank all cut rates, while the U.S. and the U.K. kept rates unchanged. While it is too early to consider this the beginning of a new upswing in the construction cycle, moderating inflation and further normalising rates could provide needed support to the real estate and construction sector.
3. Timber Stocks
After a long period of outperformance by U.S. companies, it was European stocks’ time to outperform. It is always easy with hindsight, but one may argue that the rotation was somewhat overdue, given the pessimism priced in by European valuations and the optimism reflected in the bull-run by secondary wood products manufacturers in the United States. During the quarter, companies reported their 1Q results and provided some insights on the outlook for their businesses. Remarkable post-earnings moves by Builders FirstSource and Louisiana Pacific went into opposite directions, after a cautious outlook by BLDR and more upbeat comments by LPX. BLDR has been the strongest underperformer in Q2, after stellar performance in the last years. The company has significant exposure to the multi-family sector, which was reported in Q2 to have strongly decelerated. At the same time, the last datapoints for multi-family showed some stabilisation and the largest-ever purchase of apartment buildings (5’200 units for USD 2.1bn by a leading private equity firm) could be an indication that the market might be bottoming, as long as long-term interest rates do not rise further.
When it comes to European real estate, some interesting indications have been provided by French developer Nexity and Austrian developer UBM. Nexity has been feeling the slowdown in the last quarters, but in Q1 the company’s sales to individuals were at least resilient. While it is too early to conclude that this is the bottom of the cycle, it was nevertheless a positive datapoint in an overall weak environment. Nexity’s stock rallied strongly in the weeks after the report, highlighting the level of pessimism that was already priced into the share price. The stock later retraced when the French market corrected sharply on political worries. UBM, which is focused on Germany and Austria, with some additional activities in Poland and the Czech Republic, reported strong rental trends, noted undersupply of real estate in its focus areas, and was able to offload some properties during the quarter in a difficult environment. The sales were mostly at book value, though, and one was to Porr, which is part of the controlling shareholder’s group – this highlights the challenges in the current market. UBM shares were not included in the index or tracker during the quarter.
The most recent macro data pointed towards a further slowdown in construction activity, not only in markets like Germany, but now again also in the U.S. All this, combined with weaker lumber prices, catalysed the negative contribution from most U.S. and Canadian stocks in the index. The rebalancing at the beginning of April was timely, reducing exposure to North American stocks and increasing exposure to outperforming European companies, also partially supported by activities in non-construction sectors.
4. Disclosures and Conflicts of Interest
Some or all the companies mentioned in this report may be included in the Timber Finance Forest-Based Construction Basket tracker and are part of the Timber Finance Carbon Capture & Storage Index. Timber Finance Management and/or the Timber Finance Initiative may have commercial relationships or be in discussions with some of the companies mentioned in this report. Specifically, Stora Enso is a member of the Timber Finance Initiative association.
Please note that this research is prepared for information purposes and targeted to institutional investors in Switzerland. It does not represent investment advice and does not take into consideration the individual requirements, risk tolerance and goals of an investor. Recipients who are not Swiss institutional investors should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents.
The information presented in this report is obtained from several different public sources that we consider to be reliable. Nevertheless, we cannot guarantee the accuracy of the presented information. The information used may change quickly and we are not committed or obliged to modify the reports base on new information. The opinions and views expressed in this report reflect those of the author at the point in time of its compilation and may vary at any time. Valuation methods like DCF and any other analysis or expert judgement do not provide any guarantee that the target price or fair value will be reached, for example because of unforeseen changes in financial or economic conditions.
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