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Update and Summary on Housing Inflation
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It’s worth turning for a bit to look at the housing market. Shelter is a large part of what consumers spend money on, and therefore a large part of the CPI. It also happens that primary rents (if you rent your dwelling) and “Owners’ Equivalent Rent” or OER tend to be some of the slowest-moving pieces of the CPI. I’ve said many times that if you can get the direction of OER right, it’s very hard to be extremely wrong on the direction of core inflation.
Recently, there’s been some softening in home sales, and so in some quarters there has been an alarm raised that OER is about to start softening and therefore core inflation has peaked. My purpose in this article is to examine that evidence with an eye that is a bit more studied on these matters.
I think that often, economists tend to see patterns in the data when those patterns are congruent with what their models suggest should be happening. For example, it is reasonable to think that high home prices, coupled with rising mortgage rates, ought to slow home sales. There’s certainly evidence that changes in yields affects refinancing activity, as the chart below (source: Bloomberg) relating the Mortgage Bankers’ Association refi index to 10-year yields shows. The recent rise in yields (I’ve shown Treasuries, but mortgage rates move similarly) has depressed refinancing activity – and this makes sense, since fewer mortgages are profitable to refinance at these rates.
Alas, this relationship doesn’t hold very well when it comes to purchase data. Far more important to a home purchaser are current incomes and job prospects, both of which remain relatively strong for now. This next chart shows 10 year yields against the MBA “Purchase” index. At best, interest rates are a secondary or tertiary effect. This makes sense because the decision to refinance a house is a financing decision; the decision to buy a house in the first place is an investing decision.
Nevertheless, there has recently been some softening in purchasing activity of new homes. This next chart shows the seasonally-adjusted rate of existing home sales. I can see the softening, but I’m not sure it looks like it’s a very big deal yet. This is where, though, economists’ models might cause one to say that this looks like it’s rolling over because higher interest rates and lower affordability are dampening demand. Maybe. But this might also be noise especially considering we don’t see any softening in the purchase data. It might be that there’s less home-hopping (maybe because more people have secure jobs, there’s less migration?) or perhaps there’s less activity from the pure financial buyer (pension fund, e.g.) who is paying cash. Or, it could be noise.
Now, one of the reasons that people are sounding an alarm about housing might be that equities of home builders have recently swooned. The chart below shows the S&P Homebuilders SPDR ETF (Ticker: XHB), which has been declining rather sharply of late. Weak homebuilders, weak homebuilding, right? Perhaps. But lumber prices also recently doubled and then halved so there could be some volatility on costs as well. In any event, I’m extremely reluctant to attribute dramatic economic significance, not to mention prescience, to a collection of stocks run by equity monkeys.
I think the picture of home sales and home building is a typical late-cycle picture. That shouldn’t be surprising – we’re late in the cycle, even if there are some people who believe that the expansion will still be going strong in 2020. I’m not one of those people, although I hope I’m wrong. There is definitely some softening in activity indicators. But we’re talking here about pricing indicators. How do those look in housing and rents?
The chart below is the Case-Shiller 20-city composite, y/y. I’ve definitely read commentaries recently saying that this is a sign that housing inflation is rolling over.
The problem is that the Case-Shiller survey is smoothed, lagged, and revised. Moreover, it typically has much more volatility than we have seen in the last few years. The chart below is longer-term. I don’t know that I’d read a great deal into the recent weakening. Even if it is a true reading of a slowdown in pricing, it’s a pretty small effect. My own study suggests about a 10% pass-through to rents, with an 18-month lag. So, even if you want to get alarmed, you have a year and a half to do it.
I’m not really convinced, in case you couldn’t tell, that home prices are about to plunge even though I think they’re high. For one thing, the inventory of homes available for sale remains very low (a regression of properly lagged-and-seasonally-adjusted home inventories against the change in CPI shelter suggests that the current level of inventories is consistent with a 3.6% rise in Shelter CPI between August 2019 and August 2020. Currently, Shelter CPI is at 3.39%).
A more direct effect on Primary Rents and OER is from actual rental inflation, rather than indirectly through home prices. And here the information is again pretty ho-hum. The chart below is of CBRE apartment rents, y/y percentage change. Rents have slowed from 2015-16, but they’re still well above core inflation.
There have been some anecdotal reports of cooling rentals in hot or dense markets, but so far these are mostly anecdotes. Rental prices bear some watching, of course – especially since they pass through into CPI much more quickly than changes in home prices do.
Now, here’s a cautionary note about housing in general. I am most assuredly not a bull on real home prices and I think that they’ll probably underperform CPI going forward. And here’s the reason why. For many years, the relationship between home prices and incomes was very stable. Starting in 2000, home prices began to rise sharply faster than incomes, culminating in what we now know was a pretty ugly bubble. The chart below shows that bubble, and the return to the traditional relationship between home prices and incomes…and a renewed rise in that ratio. I am not saying that home prices are as bubbly now as they were in 2005. Indeed, the easy availability of credit these days makes it plausible that the equilibrium ratio is higher than the 3.4x of the 1970s, 80s, and 90s. The caveat, of course, is that this is true only if there has been a permanent easing in the availability of credit…and as the Fed is currently starting to slowly drain excess reserves, this is less clear. So, this is the warning sign and one good reason to keep a careful eye on home prices going forward.
Adding it all up, I don’t think there’s very persuasive evidence that we are about to see a meaningful deceleration in rental inflation. But just as I’m not persuaded that rents are about to decelerate markedly, I don’t see a great chance of a strong further acceleration (and our model is strikingly boring at present, as the chart below – source Enduring Intellectual Properties – illustrates).
Ergo, core inflation (and more importantly, median), to accelerate much further, needs to see a broadening of pressures from beyond merely rent. And we’re starting to see some signs of that in core goods, and a faint whisper in other quarters. Rents are not likely to be the driving force for the next leg higher in inflation. But at the same time, we haven’t yet seen very much evidence that rents are about to collapse. Home prices are too high, relative to incomes. They’re probably higher partly because of optimism about incomes, though, and if wages validate that optimism then home prices may not be due for as bruising a correction this time. Wages are clearly accelerating, so the jury is out on that point.
I think the overall conclusion therefore is that a fair forecast for rents and OER in the CPI still calls for stability for a while. If you’re hoping for inflation to decelerate soon, you ought look elsewhere.
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Some Abbreviated but Important Thoughts on Housing
I posted this chart yesterday to my Twitter feed (@inflation_guy, or @inflation_guyPV through PremoSocial for some additional content), but didn’t have time to write very much about it. This is the Shiller 20-City Home Price Index year/year change (Source: Bloomberg).
My observation was that when you take out the housing bubble, it looks more ominous. It’s actually really the bubble and bust, which makes the recent trend look uninteresting. This is what the chart looks like if you go further back like that.
So it actually looks calm and stable, because the axis explodes to -20% to +20%. The volatility of recent years has caused us to forget that for decades before that, the behavior of home prices was actually pretty sedate. Although residential real estate over very long time periods has only a slightly positive real return, adjusted for the maintenance and other required expenditures, that means the ratio of home prices to median income has tended to be fairly stable. We have historically valued homes as a consumption good only, which meant that the home price traded as a multiple of rents or incomes within a pretty narrow range. Here’s a chart of median home prices to median household income going back to the 1970s (Source: Bloomberg, Enduring Intellectual Properties calculations).
This is true even though there have been important tax changes along the way which changed the value of the home as a tax shelter, changes in the structure of the typical family unit, and so on. Despite that, homes were pretty stable investments – really, they were more savings vehicles than investments.
The fact that home prices are now accelerating, and are rising faster than incomes, implies several things. First, as the last chart above shows, the ‘investment value’ of the home is again inflating to levels that, in 2005-2008, proved unsustainable. The bubble in housing isn’t as bad as it was, and not as bad as stocks are now, but the combination of those two bubbles might be worse than they were when they were mostly independent (in 2000 there wasn’t a housing bubble and in 2007 the bubble in stocks wasn’t nearly as bad as in 2000 and now).
The second implication is that as home prices rise, it isn’t just the value of the investment in the home that is rising but also its cost as a consumption item. Because shelter to rent is a substitute for shelter that you own, rising home prices tends to imply that rents also accelerate. Recently, “Owner’s Equivalent Rent” has been decelerating somewhat, although only coming back to our model. But the gradual acceleration in the home price increase implies that shelter inflation is not going to continue to moderate, but rather should continue to put upward pressure on core inflation, of which 42% consists of “Rent of Shelter.”
Housing Disinflation Isn’t Happening Yet
Before everyone gets too animated about the decline in core inflation, with calls for central banks to put the brakes on rate normalization, let’s realize that the main drivers of lower inflation over the last few months – zero rise in core CPI over three months! – are not sustainable. I’ve written previously about the telecommunications-inflation glitch that is a one-off effect. Wireless telephone services fell -1.38% month-over-month in February (not seasonally adjusted), -6.94% in March, and -1.73% in April. In May, the decline was -0.06%. Here is a chart, courtesy of Bloomberg, showing the year-to-date percentage declines for the last decade. The three lines at top show the high, average, and low change over the prior decade, so you can see the general deflationary trend in wireless telecom services and the historical outliers in both directions. The orange line is the year-to-date percentage change. Again, the point here is that we cannot expect this component of inflation to deliver a similar drag in the future.
The other main drag comes from a less-dramatic decline in a much-larger component: Owners’ Equivalent Rent. In this month’s CPI tweetstorm, I pointed out that this decline is mostly just returning the OER trend to something closer to our model (see chart below), but many observers (who don’t have such a model) have seen this as a precursor to a more-significant decline in rents.
This is actually a much more-important question than the dramatic, and easy-to-diagnose, issue of wireless telecommunications, because OER is a ponderous category. You can’t get high inflation without OER rising, and you can’t get deflation or even significant disinflation without OER declining. It’s just too big. So what are the prospects for OER rolling over?
Here are two reasons that I think it’s very unlikely that this is a precursor to a significant decline in housing inflation.
First, while I understand that rent increases in some parts of the country are moderating, they are always moderating somewhere in the country. Owners’ Equivalent Rent tends to parallel primary rents (“Rent of Primary Residence,” which measures the actual price of a rental unit as opposed to implied rent of an owner-occupied dwelling) reasonably well, and when home prices are rising it tends to imply that rents – as the price of a substitute, at least for the consumption part of home prices – are also rising. (A house is both an investment asset and a consumption good, and the BLS’s method for separating these two components of a home recognizes that the consumption component should look a lot like the substitute). And the fact is that Primary Rents are not (yet?) decelerating much (see chart, source Bloomberg).
Yes, I understand and agree that home prices are already too high to be sustainable in the long run. Either incomes need to outpace home prices for a while, or home prices need to decline again, or we need to become accustomed to housing becoming a permanently larger part of our consumption and asset mix (see chart, source Enduring Investments).
But is that going to happen? Well, here are two charts that should make you somewhat skeptical that at least on the supply side we are about to see a decline in home prices. First, here is the index of Housing Starts, which last month took a nasty drop. Even without the nasty drop, though, notice that the level of starts was not only far below the level of the last few peaks in the housing market, but actually not far above the troughs reached in the recessions of the mid-1970s, early 1980s, and early 1990s. The only reason the current level of starts looks high is because homebuilders basically stopped building for a few years after the housing bubble.
Homebuilders stopped building because there was suddenly plenty of inventory on the market! In the immediate aftermath of the bubble, the homes that were available for sale were often distressed sellers and as prices rose, more and more of the so-called “shadow inventory” (people who wanted to sell, but were now underwater and couldn’t sell) was freed. This kept a lid on overall housing starts, but the net effect is that even now, when most of that shadow inventory has presumably been liquidated (a decade after the bubble and at new price highs), the inventory of existing homes available for sale has become and has remained quite low (see chart, source Bloomberg).
The supply side, then, doesn’t seem to offer much cause to expect home prices to moderate, even if their prices are relatively high. I’d want to see an overreaction of builders, adding to supply, before I’d worry too much about another bust, and we haven’t seen that yet. So we have to turn to the demand side if we expect home prices to decline. On that side of the coin, there are two arguments I sometimes hear: 1) household formation in the era of the Millennial is low, or 2) households don’t buy as much housing as they used to.
There is no evidence that household formation has slowed in recent years. As the chart below (source Bloomberg) shows, household formation has been rising since 2009 or so, and is back in line with long-term trends. Millennials may have weird notions of home life (I don’t judge!), but they still form households of their own.
As for the second point there…notice that I phrased the question as whether Millennials are buying less housing, rather than as buying fewer homes. I think it’s plausible to suggest that Millennials might demand fewer homes to buy, but it’s hard to imagine that they’re neither going to rent nor buy homes – and if they do either, they are demanding shelter as a consumption item. It just becomes a question of whether they’re demanding rental housing or owned housing.
The upshot of this is that there’s no sign yet of a true ebbing in housing/rental inflation. And until there is, there’s scant need to fear a disinflationary trend taking hold.
Tariffs are Good for Inflation
The news of the day today – at least, from the standpoint of someone interested in inflation and inflation markets – was President Trump’s announcement of a new tariff on Canadian lumber. The new tariff, which is a response to Canada’s “alleged” subsidization of sales of lumber to the US (“alleged,” even though it is common knowledge that this occurs and has occurred for many years), ran from 3% to 24% on specific companies where the US had information on the precise subsidy they were receiving, and 20% on other Canadian lumber companies.
In related news, lumber is an important input to homebuilding. Several home price indicators were out today: the FHA House Price Index for new purchases was up 6.43% y/y, the highest level in a while (see chart, source Bloomberg).
The Case-Shiller home price index, which is a better index than the FHA index, showed the same thing (see chart, source Bloomberg). The first bump in home price growth, in 2012 and 2013, was due to a rebound to the sharp drop in home prices during the credit crisis. But this latest turn higher cannot be due to the same factor, since home prices have nearly regained all the ground that they lost in 2007-2012.
Those price increases are in the prices of existing homes, of course, but I wanted to illustrate that, even without new increases in materials costs, housing costs were continuing to rise faster than incomes and faster than prices generally. But now, the price of new homes will also rise due to this tariff (unless the market is slack and so builders have to absorb the cost increase, which seems unlikely to happen). Thus, any ebbing in core inflation that we may have been expecting as home price inflation leveled off may be delayed somewhat longer.
But the tariff hike is symptomatic of a policy that provokes deeper concern among market participants. As I’ve pointed out previously, de-globalization (aka protectionism) is a significant threat to inflation not just in the United States, but around the world. While I am not worried that most of Trump’s proposals would result in a “reflationary trade” due to strong growth – I am not convinced we have solved the demographic and productivity challenges that keep growth from being strong by prior standards, and anyway growth doesn’t cause inflation – I am very concerned that arresting globalization will. This isn’t all Trump’s fault; he is also a symptom of a sense among workers around the world that globalization may have gone too far, and with no one around who can eloquently extol the virtues of free trade, tensions were likely to rise no matter who occupied the White House. But he is certainly accelerating the process.
Not only do inflation markets understand this, it is right now one of the most-significant things affecting levels in inflation markets. Consider the chart below, which compares 10-year breakeven inflation (the difference between 10-year Treasuries and 10-year TIPS) to the frequency of “Border Adjustment Tax” as a search term in news stories on Google.
The market clearly anticipated the Trumpflation issue, but as the concern about BAT declined so did breakevens. Until today, when 10-year breakevens jumped 5-6bps on the Canadian tariff story.
At roughly 2%, breakevens appear to be discounting an expectation that the Fed will fail to achieve its price inflation target of 2% on PCE (which would be about 2.25% on CPI), and also excluding the value of any “tail outcomes” from protectionist battles. When growth flags, I expect breakevens will as well – and they are of course not as cheap as they were last year (by some 60-70bps). But from a purely clinical perspective, it is still hard to see how TIPS can be perceived as terribly rich here, at least relative to nominal Treasury bonds.
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.
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.
Homes for the Holidays
It is not usually a very productive endeavor to write an article on December 22nd. In the past, I have made it more or less a rule not to post anything after about the middle of the month, unless it was a greatest-hits repost series or something. However, today’s Existing Home Sales number was striking enough that it is worth at least a brief comment.
November Existing Home Sales was reported at 4.76mm units (seasonally-adjusted annualized rate), which was considerably below expectations for a nearly-unchanged 5.35mm. The chart (Source: Bloomberg) below makes graphically clear the magnitude of this disappointment.
Recently, sales of existing homes had been back to something like normal, around 5.5mm units at an annualized rate. The big selloff will cause consternation in some quarters. It wasn’t the weather: November’s weather was, if anything, warmer than usual and so one wouldn’t have thought foot traffic and closings would have been slower. And it wasn’t payback, like in 2010 when the collapse followed the tax-incentive-expiration-induced spike of 2009. We can’t really even shrug it off as “December economic data;” I am always skeptical of economic figures from December and January because it’s just a mess to seasonally adjust most of them – especially those related to employment and income. But this was a November figure.
It was just a really bad number.
The potential significance is this: so far, analysts pointing to weakness in economic data have had to be careful about drawing too-strong conclusions because a lot of the weakness was confined to the oil and gas extraction industries, and spots of weakness in traditional manufacturing where a higher dollar hurt. Housing, however, is wholly domestic. It doesn’t depend on oil and gas extraction, and the strength of the dollar is irrelevant.
Housing data are also notoriously volatile, although that complaint is less true of Existing Home Sales than New Home Sales (which is a much smaller figure, and depends much more on what inventory of homes is being offered). I would simply ignore this figure if it was New Home Sales. It’s harder to shrug off Existing.
I don’t believe a collapse is coming, though. Despite the fact that I have just made several observations that tend to increase the significance of this number, keep in mind that unlike in 2005-2007, there is no apparent bubble in the inventory of existing homes (see chart, source Bloomberg – note it is not seasonally adjusted so there is a distinct annual pattern).
The National Association of Realtors blamed the drop on a new regulation affecting closing documents, which is leading to a longer time-to-close for sales. If that is true – keep in mind that the NAR produces the existing home sales figure, but also keep in mind that they have an incentive to downplay declines – then we should see Existing Home Sales rebound in the months ahead. But even if we do not, the fact that there is no bubble in inventory means that we should not necessarily expect the rate of increase of existing home sales prices (which has been running around 6.5%, as the chart below shows) to decelerate any time soon. And that, of course, helps to drive a big piece of the CPI.
All in all, this is a disturbing number and one that bears watching. My intuition is that this is not a sign of broadening weakness in the US economy. While I expect such a broadening, I don’t think we have seen it yet.
Inflation Risks Behind, Beside, and Ahead
To be sure, it looks like growth slowed over the course of the difficult winter. The cause of this malaise doesn’t appear to me to be weather-related, but rather dollar-related; while currency movements don’t have large effects on inflation, they have reasonably significant effects on top-line sales when economies are sufficiently open. It is less clear that we will have similar sequential effects and that growth will be as punk in Q2 as it was in Q1. While I do think that the economy has passed its zenith for this expansion and is at increasing risk for a recession later this year into next, I don’t have much concern that we are slipping into a recession now.
Given how close the Atlanta Fed’s GDPNow tracker was to the actual Q1 GDP figure, the current forecast of that tool of 0.8% for Q2 – which would be especially disappointing following the 0.2% in Q1 that was reported last week – has drawn a lot of attention. However Tom Kenny, a senior economist at ANZ, points out that the indicator tends to start its estimate for the following quarter at something close to the prior quarter’s result, because in the absence of any hard data the best guess is that the prior trend is maintained. I am paraphrasing his remark, published in today’s “Daily Shot” (see the full comment at the end of the column here). It is a good point, and (while I think recession risks are increasing) a good reminder that it is probably too early to jump off a building about US growth.
That being said, it does not help matters that gasoline prices are rising once again. While national gasoline prices are only back up to $2.628 per gallon (see chart, source Bloomberg), that figure compares to an average of roughly $2.31 in Q1 (with a low near $2/gallon).
It isn’t clear how much lower gasoline prices helped Q1 growth. Since lower energy prices also caused a fairly dramatic downshift in the energy production sector of the US economy, lower prices may have even been a net drag in the first quarter. Unfortunately, that doesn’t mean that higher gasoline prices now will be a net boost to the second quarter; while energy consumption responds quite rapidly to price changes, energy producers will likely prove to be much more hesitant to turn the taps back on after the serious crunch just experienced. I doubt $0.30/gallon will matter much, but if gasoline prices continue to creep higher then take note.
Inflation traders have certainly taken note of the improvement in gasoline prices, but although inflation swaps have retraced much of what they had lost late last year (see chart of 5y inflation swaps, quoted in basis points, source Bloomberg) expectations for core inflation have not recovered. Stripping out energy, swap quotes for 5-year inflation imply a core rate of around 1.65% compounded – approximately the same as it was in January.
And that brings us to the most interesting chart of all. The chart below (source: Bloomberg) shows the year/year change in the Employment Cost Index (wages), in white, versus median inflation.
Repeat to yourself again that wages do not lead inflation; they follow inflation. I would argue this chart shows wages are catching up for the steady inflation over the last couple of years, and for the increased health care costs that are now falling on individuals and families but are not captured terribly well by the CPI. But either way, wages are now rising at a faster rate than prices, which will not make it easy for inflation to sink lower.
Let me also show you another chart from a data release last week. This is the Case-Shiller 20-city composite year/year change. Curiously (maybe), housing prices may be in the process of re-accelerating higher after cooling off a bit last year – although home price inflation as measured by the CS-20 never fell anywhere near to where overall inflation was.
Inflation risks are clearly now moving into the danger zone. I showed a chart of a lagging inflation indicator (wages), a coincident indicator (energy), and a leading indicator (housing). All three of these are now rising at something faster than the current rate of core inflation. In my view, there is not much chance that core inflation over the next 5 years will average only 1.65%.
Make Hay While the Sun Doesn’t Shine
Today new Fed Chairman Janet Yellen jumped on the bandwagon in blaming the recent growth slowdown on the weather.
Here’s what I have to say about the news and the weather.
First, although it’s becoming quite passé to point this out, the weather should account for a slowdown in economic activity – but, since economists were aware of the weather (presumably), it is less clear that it should account for a surprise in the amount of slowdown we are seeing. The chart below (source: Bloomberg) shows the Citibank economic surprise index, which measures how much recent data have exceeded (positive) or fallen short (negative) of expectations. It is not a measure of growth, per se, but merely of the direction in which economists are missing. I have plotted both the US index and the Eurozone index.
Obviously, economists were far too pessimistic about the numbers in December and January (reflecting data from October to December, and data kept exceeding their estimates. But now they are over-exuberant. So it isn’t that the numbers are falling short; it’s that they’re falling short of where economists (who can presumably recognize snow) thought they would be incorporating the known weather drags. That could simply mean the weather had a worse impact on real people than the bow-tied set thought it would. Or it could mean data is weaker than it ought to be.
Second point: just because the weather was bad should not be taken as carte blanche for the economy to collapse. If the economy was really as strong as equity investors seem to think, should weather be able to derail it so easily? Yes, weather makes it harder to detect the natural rhythm of what is going on, but it wasn’t as if that was easy to begin with. The danger is, as I suggested a week and a half ago, when all news can only be neutral or good. That’s a bad sign for once the weather normalizes again and it gets impossible to shrug off bad news as easily.
Third point: was the weather as bad in Europe? Because, as you can see from the chart above, economists have also been missing on the optimistic side for European figures. To be sure, they’ve been missing by less, and the numbers surprised less on the positive side over the last couple of months, but I don’t know that the Polar Vortex ought to be affecting Italy as seriously as it is affecting Chicago.
All of which is simply to say that the weather isn’t going to be bad forever, so … make hay while the sun doesn’t shine, I guess. Stocks are flat on the year, the hard way (but commodities are +6.5%, measured by the DJ-UBS index; according to our valuation estimates, that should be the normal case over the next few years rather than the rarity it has been over the last few).
It is interesting, too, that as bad as the weather effect has been on the construction industry and sales it hasn’t really impacted the price dynamics at all. The chart below (source: Bloomberg) shows Existing Home Sales in white, and the year/year change in median sales prices of existing single-family homes. Sales are 14% off their highs (seasonally-adjusted, which you should take with a grain of salt due to the unseasonal weather, but notice that the decline started in August when the snow was appreciably lighter), yet prices are still rising at nearly 11% year/year.
Now, a housing bull will say that these are the opposite faces of the same coin. They would say, “because there is so little inventory available – according to the NAR, only 1.9mm homes are for sale, which is higher than last winter but otherwise the lowest since 2002 – prices are rising and fewer are being sold because of the shortage of supply.” This is certainly possible, although I wonder at where all of the ‘shadow supply’ and bank REO property got off to so quickly, especially since the pace of existing home sales (and new home sales) remain at such low fractions of the pace prior to 2007 (existing home sales is currently 64% of the peak rate in 2005; new home sales are at 34% of the 2005 peak). How do you get rid of inventory without selling it?
The housing market continues to be a conundrum, but without a doubt prices are rising. And, also without a doubt, rising home prices are beginning to push rents higher. More economists are raising their forecasts for core inflation looking forward over the next year. Of course, readers of this column know that this is old news here. Speaking of which, Enduring Investments’ Quarterly Inflation Outlook for Q1 has been published. Institutional investors and others interested in our services can register for this private report on our website by filling out the contact form and requesting access to the blog.
Finally, I want to make one observation about the complete impotence of the Republicans to respond to the Democrats’ push for a higher minimum wage. It is terribly distressing to see such bad economics from one party (in this case, the Democrats) and such utter lack of common sense responses to bad economics from the other party (in this case, the Republicans). Here is the only question that needs to be answered: if raising the minimum wage has only salutatory effects on the economy and on the working class, then why not raise it to $1000/hour? Why not $10,000 per hour? Surely, if raising the minimum wage is good, then raising it more can’t be bad. Republicans should be amending the bill to make the minimum wage $10,000/hour.
The obvious answer is that if the minimum wage was $10,000/hour, no one would hire anybody – and we all know that, and even Democrats know that, and we all know why: because there is almost no one in the country who can produce enough goods or services to be worth $10,000/hour. If you are hiring people, you have to decide whether you will get enough out of them to afford their labor and still stay in business. The answer is obvious at $10,000. But it’s the same question at $10: can this group of workers produce enough so that I can afford to pay them all $10? If not, they will not be earning $10/hour but $0/hour (or at least some of them will be). We know exactly what would happen with a $10,000/hour minimum wage, and it’s easy to demonstrate it. But the Republicans are absolutely inarticulate on this point, and on most points, and that is why they keep losing arguments where they have the stronger position.
Housekeeping Note: earlier this week I published an article on the Mt. Gox/bitcoin fiasco. If you didn’t see the note (it didn’t get out on all of the syndication channels), you can find it here.
Catching Up on the Week
Friday before a long weekend is probably the worst time in the world to publish a blog article, but other obligations having consumed me this week, Friday afternoon is all I am left with. Herewith, then, a few thoughts on the week’s events. [Note to editors at sites where this comment is syndicated. Feel free to split this article into separate articles if you wish.]
Follow the Bouncing Market
In case there was any doubt about how fervently the dip-buyers feel about how cheap the market is, and how badly they feel about the possibility of missing the only dip that the equity market will ever have, those doubts were dispelled this week when Monday’s sharp fall in stock prices was substantially reversed by Tuesday and new all-time highs reached on Wednesday. Neither selloff nor rally was precipitated by real data; Friday’s weak jobs data might plausibly have resulted in a rally (and it did, on Friday) on the theory that the Fed’s taper might be downshifted slightly, but there was no other data; on Tuesday, December Retail Sales was modestly stronger than expected but hardly worth a huge rally; on Wednesday, Empire Manufacturing was strong – but who considers that an important report to move billions of dollars around on? There were some memorable Fed quotes, chief among them of course Dallas Fed President Fisher’s observation that the Fed’s adding of liquidity has done what adding liquidity in other contexts often does, and so investors are looking at assets with “beer goggles.” It’s not a punch bowl reference, but the same basic idea. But certainly, not a reason for a sharp reversal of the Monday selloff!
The lows of Monday almost reached the highs of the first half of December, before the late-month, near volume-less updraft. Put another way, anyone who missed the second half of December and lightened up on risk before going on vacation missed the big up-move. I would guess that some of these folks were seizing on a chance to get back involved. To a manager who hasn’t seen a 5% correction since June of last year, a 1.5% correction probably feels like a huge opportunity. Unfortunately, this is characteristic of bubble markets. That doesn’t necessarily imply that today’s equity market is a bubble market that will end as all bubble markets eventually do; but it means it has at least one more characteristic of such markets: drawdowns get progressively smaller until they vanish altogether in a final melt-up that proceeds the melt-down. The table below shows the last 5 drawdowns from the highs (measuring close to close) – the ones you can see by eyeballing a chart, by the date the drawdown ended.
|
6/24/2013 |
5.80% |
|
8/27/2013 |
4.60% |
|
10/8/2013 |
4.10% |
|
12/13/2013 |
1.80% |
|
1/13/2014 |
1.60% |
I mentioned last week that in equities I’d like to sell weakness. We now have some specificity to that desire: a break of this week’s lows would seem to me to be weakness sufficient to sell because it would indicate a deeper drawdown than the ones we have had, possibly breaking the pattern.
There is nothing about this week’s price action, in short, that is remotely soothing to me.
A Couple of Further Thoughts on Thursday’s CPI Data
I have written previously about why it is that you want to look at some measure of the central tendency of inflation right now other than core CPI. In a nutshell, there is one significant drag on core inflation – the deceleration in medical care CPI – which is pulling down the averages and creating the illusion of disinflation. On Thursday, the Cleveland Fed reported that Median CPI rose to 2.1%, the first 0.1% rise since February (see chart, source Bloomberg).
Moreover, as I have long been predicting, Rents are following home prices higher with (slightly longer than) the usual lag. The chart below (source Bloomberg ) shows Owners’ Equivalent Rent, which jumped from 2.37% y/y to 2.49% y/y this month. The re-acceleration, which represents the single biggest near-term threat to the continued low CPI readings, is unmistakeable.
Sorry folks, but this is just exactly what is supposed to happen. An updated reminder (source: Enduring Investments) is below. Our model had the December 2013 level for y/y OER at 2.52%…in June 2012. Okay, so the accuracy is mere luck, but the direction should not be surprising.
For the record, the same model has OER at 3.3% by December 2014, 3.4% for OER plus Primary Rents. That means if every other price in the country remains unchanged, core inflation would be at 1.4% or so at year-end just based on the weight that rents have in core inflation (of course, median inflation would then be at zero). If every other price in the country goes up at, say, 2%, then core inflation would be at 2.6%. (Our own core inflation forecast is actually slightly higher than that, because we see other upward risks to prices). And the tails, as I often say, are almost entirely to the upside.
Famous Last Words?
So, Dr. Bernanke is riding off into the sunset. In an interview at the Brookings Institution, the “Buddha of Banking,” as someone (probably himself) has dubbed the soon-to-be-former Chairman spoke with great confidence about how well everything, really, has gone so far and how he has no doubt this will continue in the future.
“The problem with Q.E.,” he said, with more than a hint of a smile, “is that it works in practice, but it doesn’t work in theory.” “I don’t think that’s a concern and those who’ve been saying for the last five years that we’re just on the brink of hyperinflation I would point them to this morning’s C.P.I. number.” (“Reflections by America’s Buddha of Banking“, NY Times)
Smug superiority and trashing of straw men aside, no one rational ever said we were on the “brink of hyperinflation,” and in fact a fair number of economists these days say we’re on the brink of deflation – certainly, far more than say that we’re about to experience hyperinflation.
“He noted the Labor Department’s report Thursday that overall consumer prices in December were up just 1.5% from a year earlier and core prices, which strip out volatile food and energy costs, were up 1.7%. The Fed aims for an annual inflation rate of 2%.
“Such readings, he said, ‘suggest that inflation is just not really a significant risk of this policy.’“ (“Bernanke Turns Focus to Financial Bubbles, Instability”, Wall Street Journal )
And that’s simply idiotic. It’s simply ignorant to claim that the policy was a complete success when you haven’t completed the round-trip on policy yet by unwinding what you have done. It’s almost as stupid as saying you’re “100 percent” confident that anything that is being done for the first time in history will work as you believe it will. And, of course, he said that once.
I will also note that if QE doesn’t have anything to do with inflation, then why would it be deployed to stop deflation…which was one of the important purposes of QE, as discussed by Bernanke before he ever became Chairman (“Deflation: Making Sure “It” Doesn’t Happen Here”, 11/21/2002)? Does he know that we have an Internet and can find this stuff? And if QE is being deployed to stop deflation, doesn’t that mean you think it causes inflation?
On inflation, Bernanke said, “I think we have plenty of tools to manage interest rates and tighten monetary policy even if (the Fed’s) balance sheet stays where it is or gets bigger.” (“Bernanke downplays cost of economic stimulus”, USA Today)
No one has ever doubted that the Fed has plenty of tools, even though the efficacy of some of the historically-useful tools is in doubt because of the large balance of sterile excess reserves that stand between Fed action and the part of the money supply that matters. No, what is in question is whether they have the will to use those tools. The Fed deserves some small positive marks from beginning the taper under Bernanke’s watch, although it has wussied out by saying it wasn’t tightening (which, of course, it is). But the real question will not be answered for a while, and that is whether the FOMC has the stones to yank hard on the money supply chain when inflation and money velocity start heading higher.
It’s not hard, politically, to ease. For every one person complaining about the long-run costs, there are ten who are basking in the short-run benefits. But tightening is the opposite. This is why the punch bowl analogy of William McChesney Martin (Fed Chairman from 1951 to 1970, and remembered fondly partly because he preceded Arthur Burns and Bill Miller, who both apparently really liked punch) is so apropos. It’s no fun going the other way, and I don’t think that a wide-open Fed that discourses in public, gives frequent interviews, and stands for magazine covers has any chance of standing firm against what will become raging public opinion in short order once they begin tightening. And then it will become very apparent why it was so much better when no one knew anything about the Fed.
The question of why the Fed would withdraw QE, if there was no inflationary side effect, was answered by Bernanke – which is good, because otherwise you’d really wonder why they want to retreat from a policy that only has salutatory effects.
“Bernanke said the only genuine risk of the Fed’s bond-buying is the danger of asset bubbles as low interest rates drive investments to riskier holdings, such as stocks, real estate or junk bonds.But he added that he thinks stocks and other markets ‘seem to be within historical ranges.’” (Ibid.)
I suppose this is technically true. If you include prior bubble periods, then today’s equity market valuation is “within the historical range.” However, if you exclude the 1999 equity market bubble, it is much harder to make that argument with a straight face, at least using traditional valuation metrics. I won’t re-prosecute that case here.
So, this is perhaps Bernanke’s last public appearance, we are told. I suspect that is only true until he begins the unseemly victory lap lecture circuit as Greenspan did, or signs on with a big asset management firm, as Greenspan also did. I am afraid that this, in fact, will not be the last we hear from the Buddha of Banking. We can only hope that he takes his new moniker to heart and takes a Buddhist vow of silence.
