February was a continuation of many trends that were established in January. Although lacking the swell of the preceding month, all asset classes nonetheless appreciated: stocks, bonds, and major commodities. While the conclusion of 2018 was tumultuous, we continue to project that there will not be an economic recession in 2019. That said, it is worth noting that a broad asset class sell off is still a possibility at some point this calendar year. The robust rebound of the past two months has made finding new investment positions more challenging. Equity markets continue to be fundamentally overvalued (Market Capitalization, Gross National Product, Robert Shiller’s CAPE, etc). Nonetheless, February was a profitable month and we naturally want this to continue
The United States economy continues to grow in spite of concerns overseas. We would like to draw your attention to the following domestic developments:
- Housing Data – The housing market took a sharp downward turn lower at the end of last year as construction plummeted across all building types and regions. The plunge in builders’ sentiment, in November and December accurately forecasted the sizable drop. This is significant because a sharp rebound in the NAHB sentiment index since the end of 2018 suggests housing activity will recover in the spring. Affordability will be helped by the recent deceleration in home-price growth below wage gains. For our purposes, we will continue to seek out well-capitalized homebuilders especially on the high end of the capital structure.
- Business Investment – The December durable goods report was an illuminating, estimating a 4.5 percent growth in business investment in equipment (3.4 percent growth in the third quarter of 2018). We are cautious about the near term though, as the estimated average quarterly growth for 2018 as a whole would slow down to 5.3% from 9.6% in 2017. Additionally, prospects for the beginning of 2019 do not look encouraging. The latest Federal Open Market Committee meeting noted recent signs of mixed business sentiment, and suggested that the slowdown in capex investment was due to uncertainty about growth in Europe and China, trade policy, fading fiscal policy stimulus, and the partial government shutdown. While the shutdown has resolved, we will monitor the remaining issues.
- American Consumer – American consumer spending will continue to be a main driver of economic growth. A strong labor market and increasing growth of wage gains help to provide a strong foundation for consumer spending. Consumer confidence surged in February after the government reopened. However, the uptick in confidence has yet to manifest in increased retails sales. Looking forward, project a continued slowing of planned purchases for the three major durable goods: homes, automobiles, and major appliances. February’s report was weak for those particular goods. For the consumer to keep spending, we have to have strong average hourly earnings growth throughout the year.
Please review the following updates from some of the existing positions that we manage.
Oxford Square Capital Corp Bond due March 2024- (OXSQL): Oxford reported solid fourth quarter results at the end of February. Asset coverage was very high (our primary consideration as a bondholder) but the operating performance left something to be desired. The company took some unrealized losses on certain CLO assets with the December mini-crash, so the net asset value was reduced. Portfolio ratings maintain strength as all assets received either Grade 2 (89 percent) or 3 (11 percent). This means no assets were in non-accrual. On the earnings call, Oxford management indicated that those unrealized losses in the fourth quarter have already rebounded with the overall market rebound. The company reported a 3.1x asset coverage ratio excluding cash (including cash would produce an even higher asset coverage ratio). We continue to like this investment and would make it a larger allocation, if not for the more than five-year maturation.
Unit Corporation Bond due May 2021 – (CUSIP: 909218AB5): Unit produced good fourth quarter numbers. Leverage remains below 2x with consistent operating revenues even after the 50 percent sale of their midstream business. EBITDA for the quarter was $88 million, similar to $90-91 million in the third and fourth quarters of 2017. Overall, annual EBITDA came to $350 million—up from $314 in 2017. Production increased seven percent and midstream volumes increased as well. Unit’s business mix remains diversified, 50 percent from oil and gas production, 23 percent from contract drilling, and 27 percent from midstream assets. Our bonds are the only debt on the capital structure right now, which is very encouraging. Unit does have an unused credit line of $425 million. The only potential weakness is that capital expenditure spending is high. Management has indicated their intention to reduce capital expenditure spending over the next two years to a point where Unit can self-fund projects