By Chung-Hong Fu, Ph.D., Managing Director Economic Research and Analysis, Timberland Investment Resources, LLC.
Economic Uncertainty Clouds Timberland Outlook
Recent monetary and market signals show increasing headwinds facing the United States economy. Inflation in the United States has reached a 40-year high. In response, the U.S. Federal Reserve is aggressively raising interest rates and is reversing the easy monetary policy that has been in place since the Global Financial Crisis. Combined with the global fallout from the Russia-Ukraine war and persistent supply-chain disruptions, many economists are projecting a downturn or even an outright recession for the U.S. before the end of 2023.
Any slowdown or recession will obviously hurt the U.S. housing market. Already, several key housing indicators have turned negative. Home mortgage rates in June have reached their highest level in 13 years (Figure 1). This may have helped cause housing starts to fall in May and home builder confidence to decline in the second quarter. 1 The health of the housing market bears watching because home construction is the leading consumer of wood products such as lumber, plywood, and oriented strandboard. Three-quarters of the 53 billion board feet of softwood lumber consumed last year in the United States, for example, went into equal parts building new homes or repairing and remodeling existing homes.
The concern is that a correction in lumber and panel markets could translate into weakened timber prices. This has worried some investors as timberland returns in the United States have only recently turned the corner following an extended period of below-average performance from 2016-2020 (Figure 2). In the year ending first quarter of 2022, the NCREIF Timberland Property Index returned 11.92%, the best one-year performance since 2008. That recovery now may be under threat. The question is this: Will the rising economic headwinds push the timberland asset class into another long cycle of weak performance? We argue that this is unlikely, and our reasons are as follows.
Housing Correction Likely To Be Mild and Short-Lived
One reason we believe timberland returns will hold up well against the coming economic downturn is because a correction to the U.S. housing market likely will be mild and relatively brief. This is based on historic experience. Over the past 50 years through May 2022, housing starts averaged 1.42 million a year in the United States. If we define a housing downturn as three or more consecutive months of below-average starts, then the U.S. has experienced 14 slowdowns in home construction since 1959 – the year when the U.S. federal government began reporting housing starts (Figure 3). The average length of those 14 housing slumps was 23 months – effectively less than two years. If one were to exclude the major housing crash of 2007, which coincided with the Global Financial Crisis, then the average housing recession lasted only 13 months.
Fortunately, a housing correction of similar magnitude to the 2007 housing bubble is unlikely to occur. The 2007 crash, from which the market required more than a decade to recover, was the result of (a) excessive overbuilding of homes above fundamental demand; (b) very lax lending standards for home mortgages; and (c) the inaccurate profiling of credit risk of mortgage-backed derivatives. None of those factors, however, exist in the current housing market. To the contrary, demographic growth has created an estimated housing deficit of 3 or 4 million2; mortgage underwriters have maintained strict lending standards on home buyers; and the mortgage-backed securities markets face rigorous issuance standards to prevent underestimation of credit risk. Hence, a dramatic, long-lasting collapse of home construction is not anticipated; the conditions that created the last housing bubble – due to excessive overbuilding and very weak lending and credit rating standards – does not exist in this cycle. Timberland investors with long-term horizons should stay invested over a possible 1-or 2-year housing downturn. Thereafter, investors could reap the benefits of rising timber markets as the housing market rebounds.
Timberland Investments in a Down Cycle
Although most housing corrections are relatively short in length, it may be of little comfort to an institutional investor whose portfolio of forest assets sinks in value in the face of falling housing starts and weak economic growth. To test this risk, we reviewed all of the housing downturns since the inception of NCREIF’s Timberland Property Index (Table 1).
During the life of the timberland benchmark from 1987 to today, there have been eight periods of depressed housing starts. Interestingly, timberland performed strongly in six out of the eight periods – either concurrently with the housing downturn or with a two-quarter (six-month) lag. In fact, those six cases exhibited returns well above the average return of 10.76% for the life of the Index. The two exceptions were the 2007 housing crash, which helped trigger the Global Financial Crisis, and the 2020 collapse, which was caused by the Covid-19 pandemic lockdowns. During those two events, timberland produced returns of 5.0% and 0.4% respectively. Of course, the 2020 event relating to the coronavirus pandemic only lasted four months and preceded a rush of demand for new housing.
The mixed performance of timberland against housing cycles indicates that there are other market factors at play. Home construction (and the lumber demand that results from it) is just one of several economic forces that affect timberland returns. Supply is another major factor. In fact, the exceptionally high returns recorded during the late 1980s and early 1990s were due to a supply shock when harvests on publicly owned forestlands in the U.S. Pacific Northwest were halted to protect the endangered Spotted Owl.
While the Spotted Owl timber crisis was a black swan event, the North American forest products sector is now experiencing another form of supply shock. As with the Spotted Owl court decree, which dramatically reduced access to timber in the Pacific Northwest three decades ago, North America is now facing another timber supply deficit because of evolving circumstances in the western Canadian province of British Columbia. Actions to protect old-growth forests, combined with losses from forest fires and beetle outbreaks, and with efforts to protect the endangered woodland caribou, are projected to result in timber harvest rates in the province dropping over the coming decade. As a result, 2.2 billion board feet of sawmill capacity is projected to close by 2026. This will represent a decline of 18% of the region’s lumber production potential. Bear in mind that Canada exports around 25% of the lumber that the U.S. consumes, and British Columbia produces roughly 40% of that lumber. As with the Spotted Owl event of the late 1980s, British Columbia’s timber losses could mitigate the downside effects of a housing correction for U.S. timberland investors.
Housing is not the only economic force to which timberland investors should be paying attention. Two other major economic forces that are at play include (1) declining economic growth and (2) inflation. One could assume that periods of economic weakness – such as those caused by recession – would result in timberland returns declining. Along with recessions, inflation is another risk that can harm the long-term performance of a portfolio. In order to protect the purchasing power of a portfolio, timberland returns should scale with inflation. To test these two theories, the chart in Figure 4 matches the rolling average of five-year timberland returns with the corresponding U.S. economic growth rate. A similar chart was developed for inflation in Figure 5.
The conclusion we can draw from these two charts is that timberland returns are only mildly linked with the health of the overall economy, but strongly linked with inflation. A regression line was drawn in both charts. The strength of that regression is measured by the R-square (R2 ), where a 1.0 value indicates a perfect association, but a zero (0) value shows complete independence. With that in mind, an R-square of 0.10 between economic growth and timberland returns suggests a relatively weak connection (Figure 2). In comparison, the inflation and timberland return are closely intertwined with a R-square 0.62 (Figure 3). This implies that between the two economic forces, inflation has a stronger effect than economic growth on timberland returns. This attribute of the asset class could work to the benefit of timberland investors when they are facing periods of high inflation combined with anemic economic growth (which economists sometimes term as stagflation).
Conclusions and Recommendations
We are facing a series of economic and market signals that indicate a housing downturn and an economic slowdown – or even recession – could be imminent. If either or both occur, the concern among investors is that the nascent recovery of the timberland asset class in the United States could be reversed. While the risk does exist, there are four good reasons timberland investors should nevertheless remain committed to their timberland portfolios for the long-term:
1. Housing corrections typically are short-lived, often lasting less than two years. A long correction such as the decade of depressed housing starts following the 2007 housing crash is unlikely to occur due to the large, pent-up demand for homes, which is a result of years of accumulated demographic growth exceeding rates of new home construction.
2. A fall in home construction does not always lead to weak timberland returns. Timber markets are a balance of supply and demand. Falling demand could be mitigated by falling supply. In this case, lumber capacity in British Columbia is expected to decline by close to 20% over the coming decade, which could help ameliorate the effects of falling lumber usage from a weak U.S. housing market.
3. Timberland is a defensive asset play. Timberland is, of course, not immune to the effects of a recession or slow economic growth. Nevertheless, wood goes into many defensive sectors that hold up well against challenging macroeconomic environments, such as the demand for packaging papers (e.g., shipping boxes), tissue (e.g., toilet paper, paper towels), bioenergy (e.g., wood pellets), and industrial activity (e.g., pallets, railroad ties, and utility poles). In addition, the biological growth of trees invariably generates value regardless of the market. This helps partially insulate timberland investments against economic shocks and market volatility.
4. Inflation risks can be hedged, as timberland has, over the long-run, shown an ability to react positively to rising inflation pressures. In a strong inflationary environment, an allocation to timberland can help buffer a portfolio’s real returns.
In summary, a short-turn setback in the U.S. housing market or economy does not alter the long-term fundamental outlook for timberland investments. We may see several quarters of weaker returns in this economic cycle, but that may create a window of opportunity for investors to build or add to their portfolios of forest assets, which will enable them to take advantage of the recovery that will naturally follow.
Footnotes:
1. U.S. housing starts were down 14% in May from the previous month to 1.549 million, on a seasonally adjusted annualized basis. Home builder confidence, as tracked by the National Association of Home Builders and Wells Fargo in the Housing Market Index, fell to 67 in June, the sixth consecutive month that builder sentiment has declined.
2 Freddie Mac: “Housing Supply: A Growing Deficit” (May 7, 2021).
About the Author:
Chung-Hong Fu, Ph.D. oversees all economic and market analysis and forecasting for TIR and plays a key role in the development and implementation of the firm’s investment strategy. He was a founding member of TIR and was instrumental in establishing the firm’s research-driven investment ethic.
Hong began his career at Temple-Inland Forest Products Corporation where he served as a resource utilization specialist and business analyst. In these roles, he provided economic and research analysis services that were used by senior executives within the company to make strategic decisions across a range of issues, including asset securitization, acquisitions and resource and business optimization. Prior to joining TIR in 2003, Hong served as senior investment analyst with Global Forest Partners where he performed global timber acquisition analysis, created a variety of decision support models and directed currency risk management analysis. Hong is recognized in the timberland investment arena for his measured and comprehensive analysis of the trends and events that drive investment performance and that influence the long-term risk and return profile of the timberland asset class. He writes extensively on these and related topics and is frequently consulted by market participants and analysts, including the news media, for his unique and well-informed perspectives. Hong is a graduate of Northwestern University where he received a BS in biology. He also earned an MS in environmental management at Duke University and an MBA at Columbia University. He received his Ph.D. in forest economics at North Carolina State University.
Disclaimer This paper is provided for the education of its readers. The opinions and forecasts made are for informative purposes only and are not intended to represent the performance of an investment made through Timberland Investment Resources, LLC. No assurances are made, explicit or implied, that one’s own investments in timberland or with Timberland Investment Resources, LLC specifically, will perform like what has been described in the paper.