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August: More Esther, Less Mester
The last two weeks of July felt a lot like August typically does. Thin, lethargic trading; somewhat gappy but directionless. Ten-year Treasury note futures held a 1-point range except for a few minutes last Thursday. The S&P oscillated (and it really looks like a simple oscillation) between 2160 and 2175 for the most part (chart source Bloomberg):
In thinking about what August holds, I’ll say this. What the stock market (and bond market) has had going for it is momentum. What these markets have had going against them is value. When value and momentum meet, the result is indeterminate. It often depends on whether carry is penalizing the longs, or penalizing the shorts. For the last few years, with very low financing rates across a wide variety of assets, carry has fairly favored the longs. In 2016, that advantage is lessening as short rates come up and long rates have declined. The chart below shows the spread between 10-year Treasury rates and 3-month LIBOR (a reasonable proxy for short-term funding rates) which gives you some idea of how the carry accruing to a financed long position has deteriorated.
So now, dwelling on the last few weeks’ directionless trading, I think it’s fair to say that the markets’ value conditions haven’t much changed, but momentum generally has surely ebbed. In a situation where carry covers fewer trading sins, the markets surely are on more tenuous ground now than they have been for a bit. This doesn’t mean that we will see the bottom fall out in August, of course.
But add this to the consideration: markets completely ignored the Fed announcement yesterday, despite the fact that most observers thought the inserted language that “near-term risks to the economic outlook have diminished” made this a surprisingly hawkish statement. (For what it’s worth, I can’t imagine that any reasonable assessment of the change in risks from before the Brexit vote to after the Brexit vote could conclude anything else). Now, I certainly don’t think that this Fed, with its very dovish leadership, is going to tighten imminently even though prices and wages (see chart below of the Atlanta Fed Wage Tracker and the Cleveland Fed’s Median CPI, source Bloomberg) are so obviously trending higher that even the forecasting-impaired Federal Reserve can surely see it. But that’s not the point. The point is that the Fed cannot afford to be ignored.
Accordingly, something else that I expect to see in August is more-hawkish Fed speakers. Kansas City Fed President Esther George dissented in favor of a rate hike at this meeting. So in August, I think we will hear more Esther and less Mester (Cleveland Fed President Loretta Mester famously mused about helicopter money a couple of weeks ago). The FOMC doesn’t want to crash the stock and bond markets. But it wants to be noticed.
The problem is that in thin August markets – there’s no escaping that, I am afraid – it might not take much, with ebbing momentum in these markets, to cause some decent retracements.
Homes Are Where the Heat Is
This week’s main event is supposed to be the FOMC meeting. Certainly, for some time now that has been the case: in a week with a Fed meeting, nothing else matters. Knowing this, many investors will probably over-parse the language from the FOMC statement following the meeting, even though there is little to no chance of any policy change at this meeting nor at any of the next few meetings (it certainly would be a huge surprise if the Fed were either to tighten, or even to indicate a growing likelihood of a future tightening, after Cleveland Fed President Mester recently mused about helicopter drops).
In the meantime, though, we have some housing data that is somewhat interesting. New Home Sales were released today, showing a new seasonally-adjusted post-crisis high. To be sure, sales are still well off the bubble highs, but they are back to roughly average for the period prior to the bubble (see chart, source Bloomberg).
New Home Sales is more regular (outside of a bubble) than Existing Home Sales, because additions to the housing stock are partly driven by household formation and that’s reasonably constant over long periods of time. The more important number (in part because it is also it is much larger) is Existing Home Sales, which was released last week and looks even stronger (see chart, source Bloomberg).
Existing Home Sales is also affected by household formation, but the level of the aggregate stock of housing matters as well so this measure tends to rise over time. Even so, it looks to be at least back on the long-run trend.
Now, as an inflation scout I spend a lot of time looking at housing. Housing is the largest part of the consumption basket almost everywhere in the world, whether the shelter is owned or rented, and it is an even larger part of the more-stable core inflation basket. If you get housing right, in short, it is hard to be very wrong on inflation overall. This is why I’ve been persistent in saying that deflation in the US, outside of the energy price collapse, isn’t coming any time soon. The rise of home prices in the US, as measured by the S&P CoreLogic Case-Shiller index (which becomes more of a mouthful every time someone new buys the index!), has eased to around 5% per annum versus a rebound-inspired 10% in late 2013/early 2014 (see chart, source Bloomberg).
Here is where it pays to be a bit careful. A simple-lag model would predict that rents and owners-equivalent-rents should shortly be declining from current 9-year high rates of increase. But logically, that can’t make sense – if home prices rose 5% forever, then obviously rents would eventually rise something like 5% per year as well. This is a case for a distributed-lag model (even better would be distributed lags on real prices, reflecting the fact that if overall inflation rises then the same real home price increase would reflect a higher nominal home price increase, but there isn’t enough “exciting” inflation in the last couple decades of data to calibrate that well). And one simple such model, shown below (source: Enduring Investments),[1] suggests that the current level of OER is sustainable even though it currently incorporates the lagged effects of that post-2013 deceleration.
Now, of interest is that all of our models currently predict that rents will continue to rise for a bit, but only for a bit. Shelter inflation seems baked-in-the-cake through 2017, which is as far as our models project, but doesn’t seem to have a lot of acceleration left (maybe 0.25%) before levelling off. Having said that, there is another consideration that bears comment. The chart below (source: Bloomberg) shows the S&P CoreLogic CS Index again, this time plotted against the number of “Existing Homes Available for Sale” (and a 12-month moving average of that not-seasonally-adjusted index).
The relationship here is a bit loose, for a bunch of reasons, but the point to be made is this: the inventory of homes for sale has returned to levels that prevailed in the late-90s and early-00s, leading to home price increases in excess of the current 5%-per-annum level. When inventories first fell to this level, there was some fear that a large “shadow inventory” of homes that would have been sold at higher prices would be released into the market, holding down prices. If that has happened, it has been gradual as the inventory of homes actually listed has not risen appreciably in the last three years; moreover, it hasn’t held down home prices very well. The upshot is, I think, that home prices are likely to continue to rise by around 5% per year, or possibly faster; this will likely keep upward pressure on rents for the next couple of years.
But, as noted above, the upward pressure on rents will probably be limited from these levels, unless and until prices ex-housing begin to rise more aggressively. We expect them to do so; in any case, current CPI swaps quotes that imply core inflation will be at or below 1.5% for the next three or four years remain egregiously mispriced.
[1] Please contact me, or contact us through our website, if you’re interested in inflation-related products and services, including institutional consulting arrangements. Interested in investing in Enduring Investments? We are currently raising equity in the firm through a Crowdfunding campaign. See https://www.crowdfunder.com/enduring-investments-llc/ or contact me for more details as we expect to close subscriptions soon.
Summary of My Post-CPI Tweets
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation, just published! The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.
- Ah, CPI day!
- Writing today from the skies above…Pennsylvania maybe? Hi Pennsylvania!
- Not sure how well this will work…bear with me.
- Street forecast for core is 0.182% or so m/m, rounding to 0.2% and 2.2% y/y.
- But if core is only 0.187% m/m, y/y will rise to 2.3% after rounding. So a low hurdle for a “surprise”
- Since this year core has averaged 0.208% (and 0.243% ex-March), I suspect a good chance of a 2.3% y/y print.
- Over the next 2 months we have comparisons of 0.173% and 0.155% from year-ago, so core likely rises further.
- As a reminder, median CPI is already at 2.53% and a 7-year high so such a move in core isn’t a shock.
- But all that is in the future. We get today’s CPI in 14 minutes.
- Note my response to tweet messages will be worse than normal today… from 35,000 feet this is a bit wonky.
- 17% on core. y/y to 2.23% from 2.24%. Be still my heart.
- Have to wait for the breakdown…not trusting numbers at this altitude. But looks like Medical Care jumped. Not sure what went dn then.
- OK, Housing 2.39% from 2.38%. Apparel 0.42% from 0.53%; Medical Care – 3.65% from 3.17%! Small drips elsewhere.
- Core services stayed 3.2% and core goods dripped to -0.6% y/y.
- Within Housing: Primary rents 3.81% from 3.80%. Should keep rising. OER 3.25% from 3.26% ditto.
- Big jump in Lodging Away from Home: small category and volatile but excites some people. Not me.
- Motor vehicles -0.82% from -0.50%, still dragging on core goods.
- In Medical Care: Drugs 3.40% from 2.34%. Yes, >1% acceleration in y/y. Volatile but…
- Balancing that a bit was Professional Services 2.60% from 2.81%. But Hospital Services 4.12% from 3.25%.
- And Health Insurance? +7.10% vs 6.30%. Thanks, ACA.
- With drugs pushing core goods higher, not sure what was going the other way enough to make core goods decelerate some.
- Good Lord they just said we’re over Wisconsin. Already?
- Take this projection for Median CPI with a grain of salt, but looks to me like +0.19% and the annual rate stays 2.5%.
- biggest monthly declines were toddlers’ apparel, jewelry and watches, footwear, and used cars/trucks.
- biggest monthly gains in fuel oil, motor fuel, car and truck rental, and medical care commodities (drugs).
- core ex-housing still fairly low at 1.37%.
- Overall – core and median inflation still are in rising trends, but nothing particularly alarming about this month’s figure.
- Certainly, nothing that is going to turn Pres. Mester from talking about helicopter drops to talking about tightening.
- That’s all for now…thanks for bearing with me.
- Be sure to look at our Crowdfunder equity raise: https://www.crowdfunder.com/enduring-investments-llc … The subscription package is up and live!
Last month’s core inflation number was not pretty. Medical care rose, rents jumped, and in general it was a sloppy mess. This month is not like that. The story is one of continuing trends: a trend to higher rents, higher medical care inflation; continued weakness in apparel and transportation and other core goods. The key point though is that there is no sign that inflation is about to fall. Whether bottom-up, aggregated from the detailed pricing data, or top-down, looking at money supply growth and possible velocity outcomes, the uptrend in prices looks steady.
While that could change, if interest rates continue to decline and depress money velocity even further, it can’t be the null hypothesis at this point. What is amazing is that the market, in its pricing of inflation, has made that the null hypothesis. Breakeven inflation is low, low, low for more than a decade in the future according to the market. Considerably lower than today’s core inflation. It is a bet that looks increasingly out-of-whack.
UK Property Price Declines – Rational or Overdone?
A couple of weeks after Brexit, and the world has not ended. Indeed, in the UK the fallout seems relatively tame. Sterling has weakened substantially, which will increase UK inflation relative to global inflation; but it will also help UK growth relative to global growth. That’s not a bad tradeoff, compared to predictions of the end-of-days. Although I am not so sure I like the tradeoff from Europe’s perspective…
There are a number of UK property funds that have been gated – but this appears to be not so much a Reserve Fund moment, and certainly not a Lehman moment, but just a natural reaction when a fund gives broader liquidity terms than the market for the underlying securities offers.
I think the property panic is probably overdone. It is partly triggered by fears that the financial center is going to leave London. This strikes me as absurd, having worked for several of the institutions that have offices in Canary Wharf. I checked my gut reaction with a friend who actually headed up a large banking institution for a time. His answer was “you are right to be very skeptical: English, availability of workforce, taxation, labor laws, contract law and legal framework. There will be some shifting at the margin but that’s it.” Brittania is not about to sink beneath the waves, folks.
Were UK property values overinflated? At least UK home prices don’t appear much more out-of-whack than US home prices do. The chart below (source: Bloomberg) shows the UK national average home price from the Nationwide Building Society (in white) versus the US median existing home sales price.
The picture looks more concerning if, instead of median home sales, you use the Case-Shiller Home Price Index as a comparison (see chart, source: Bloomberg). But while the CS20 is a superior measure of home prices, I’m always a bit wary of comparing two series that are constructed methodologically very differently. Still, this comparison would suggest UK prices have risen more than their US counterparts.
These comparisons are all on residential property, and I am comparing two markets which are likely both a bit overheated. But the scale of decline in the UK property funds seems to me to be too large relative to the overpricing that may exist, and I suspect it is more due (as I noted above) to the structure of the funds holding the property – which would suggest, in turn, that halting redemptions is the right thing to do to protect existing investors who would be disadvantaged if the portfolio was liquidated into a market that is not designed to have daily liquidity. Of course, the right answer is to not offer those liquidity terms in the first place…
One little niggling detail, however, deserves mention. I noted that UK home prices do not appear terribly out-of-whack relative to US home prices. The problem is that US home prices themselves appear out-of-whack by roughly 15-20%. The chart below (source: Bloomberg; Enduring Investments calculations and estimates) shows median home prices as a multiple of median incomes. What is apparent is that for many years these two series moved in lock-step, until the bubble; the popping of the bubble sent everything back to “normal” but we’re back to looking bubbly.
That said, I don’t believe the current drop in listed UK property funds is a rational response to correcting bubble pricing, and it’s probably a good opportunity for cool-headed investors…and, more to the point, cool-headed investors who aren’t expecting to liquidate investments overnight.
