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Babies and Bathwater
Before I descend into the mundane discussion of economies and markets, let me first congratulate the Duke and Duchess of Cambridge on the birth of their son. In watching the pictures of the royals leaving the hospital with their child, I was struck at the fact that when his wife passes off the child, Prince William looks as uncomfortable holding a baby as most first-time fathers are. He did, however, have more luck with the mechanics of the car seat…as, again, most new fathers do.
However, when he drives home, he won’t have to worry about the rising cost of housing, and probably doesn’t fret much about whether his child will be able to afford a comfortable life in an inflationary future. “Will my son be better off than I am?” is a question for non-royals!
I have no idea what the rents are for a Kensington Palace apartment, but I will bet they are rent-controlled. Meanwhile, housing prices in the U.S. continue to rise rapidly. Today’s announcement of the FHA Home Price Index suggested prices have risen 7.3% over the last year (the fourth month in a row over 7%), while the median price of a home in the Existing Home Sales report yesterday was 13.2% above the year-ago level (see chart).
Aside from inflation, however, where the future trajectory is clear, the performance of the economy is probably best characterized by the word “muddled” (thank you, John Mauldin). Last Thursday, the Philly Fed index was published at 19.8 – a two-year high – versus expectations for 8.0; on Monday the Chicago Fed index showed -0.13 versus expectations for flat, and today the Richmond Fed index was -11 (the second-worst since 2009) versus expectations for +9.
And, in the meantime, Microsoft (MSFT) and Google (GOOG) missed earnings badly and Detroit declared bankruptcy. Apple (AAPL) is just out with earnings and pulled the old trick of “beat on current earnings, match on revenues, but guide lower for next quarter.” The current consensus for Q2 GDP (the advance estimate is due out next week) is a mere 1.3%.
With all of this, equity prices are doing well with stocks up 5.4% for the month. Bond yields are fairly flat, with 10-year yields up 4bps from the end of June, but TIPS are doing relatively well (10y real yields -14bps; 10y breakevens +18bps). And even the DJ-UBS Commodity index is +4.3%. Gold is up nearly 10%.
Three weeks do not a turn in sentiment make, but I do find it interesting that real estate, inflation breakevens, gold, and commodities generally are all enjoying a renaissance right after inflation-linked bonds and commodities were buried in late June, with large outflows especially from TIPS funds (the shares outstanding of the TIP ETF went from 183 million at year-end, to 165 million in late May, to just 139 million now). It got so bad that my company reached out to customers in late June with a thorough explanation and presentation of why we thought the market was ‘getting it wrong.” Investors were throwing out the baby with the bathwater.
To be sure, I think real yields, breakevens, and nominal yields will eventually be much higher. But if nominal yields can simply avoid breaking higher for the next few weeks, I think the stage will be set for a fixed-income rally into September and October. As I have written before, in the aftermath of a convexity event such as we have just seen, a “cool down” period of a few weeks is usually necessary to work off the bad positions induced and trapped by the market’s sudden slide. Once these positions are worked off, I think the weak economic growth and weakening corporate internals will pressure stocks lower and the stock and bond markets will get back into some semblance of what static-equilibrium types think of as “fair value” relative to one another.[1]
Even so, I think that commodities, breakevens, and even gold might have already seen the worst of their markets. In this suspicion I have been wrong before. Money velocity in Q2 will have declined further (probably to about 1.50 from 1.53 in Q1), but I think it will be higher – or at least not much lower – in Q3. And once velocity turns, time has run out. I am reminded of an old quote from Milton Friedman, from his book Money Mischief: Episodes in Monetary History
“When the helicopter starts dropping money in a steady stream – or, more generally, when the quantity of money starts unexpectedly to rise more rapidly – it takes time for people to catch on to what is happening. Initially, they let actual balances exceed long-run desired balances, partly out of inertia; partly because they may take initial price rises as a harbinger of subsequent price declines, an anticipation that raises desired balances; and partly because the initial impact of increased money balances may be on output rather than on prices, which further raises desired balances. Then, as people catch on, prices must for a time rise even more rapidly, to undo an initial increase in real balances as well as to produce a long-run decline.” (p.36)
When this happens, stocks will take a beating. But it may be the final beating in this long, drawn out, secular bear. I guess it is far too early to say that, but I recently saw two news items that I have long been waiting for. The first is that CNBC is having ratings “issues,” and it is starting to get bad enough that the producers are thinking about “tinkering with primetime.” The second, which is clearly related, is that Maria Bartriromo is thinking of leaving business news to take her inestimable talents elsewhere.
As with commodities and inflation breakevens recently, a sine qua non for the start of a new bull market of substantial magnitude – not a 100% rally from the lows, but a 100% rally above the old highs – is that everyone stops thinking that stocks are smart and exciting investments, that they are “where it’s at,” and that all the cool people are buying stocks. And I have never been able to figure out how an environment sufficiently depressing to germinate a new bull market can occur if the cheerleaders are televised 24/7. Honestly, I had just about given up. While we still need cheap valuations and rotten sentiment to start a bull market (and we are very far from both of those standards in equities), a move towards general indifference among investors would be a good start.
[1] As the quote marks suggest, I don’t think that they will be right when you hear people declare that “stocks now offer good value relative to bonds again.” I think the people who use the “Fed model” tend to overprice stocks generally…and they tend to be much more diligent disciples of the model when yields are falling than when they are rising. When yields rise, they tend to say that stocks are better values than bonds because bond yields are going to rise, while when yields are low they tend to say that stocks are better values than bonds because of the current level of bond yields.
A Broken Record But It’s A Good Song
There has been a bunch of new data over the last couple of days, but I am afraid that all of the new stuff will not keep me from sounding like a broken record.
Consumer Confidence jumped yesterday, but more interesting is the fact that the “Jobs Hard to Get” subindex rose to the highest level since late last year, suggesting that weak jobs data isn’t entirely a one-off. Today, the ADP report was weaker-than-expected, at 119k (versus expectations for 150k) and a downward revision to last month. The Chicago Purchasing Managers’ Index on Tuesday was the weakest since 2009, but the ISM Manufacturing report today was on-target. Still, neither manufacturing index is generating much confidence that the economy is about to take off, and the early-year bump has been entirely reversed (see chart, source Bloomberg).
The Shiller Home Price Index, reported on Tuesday, was higher-than-expected at 9.3% year-on-year, rather than the 9.0% expected (and versus an 8.1% last!). What’s really interesting about this is that the recent surge in year-on-year growth has come because the usual seasonal pattern that sees prices sag in the springtime hasn’t been in evidence this year – accordingly, the year-on-year comparisons have gotten easier as prices have gone sideways rather than falling as they tend to do between August and March (see chart, source Bloomberg).
That’s interesting because such a phenomenon was also a condition of the bubble years prior to 2007 – prices generally rose steadily with only a hint of seasonality. Post-bubble, if you wanted to sell your house in February you had to offer a concession on price. Those concessions aren’t happening any more, which is a back-door confirmation of the overall price action.
As I have said before, ad nauseum, we are seeing slow and/or falling growth and firm and/or rising inflation in the pipeline, and that’s not at all inconsistent. Mainstream economists, and journalists of all stripes, seem to accept as a fundamental verity the linkage between growth and inflation, but the only minor problem with this firmly-held belief is that it ain’t so. Growth is bad, and inflation is still going to go up. In Q1, core CPI rose at a 2.1% pace, and I still think that for the full year core CPI will rise at 2.6%-3.0%.
I want to add a quick word here about a thesis that has been advanced recently. The thought is that if the abrupt housing demand is coming from investors rather than consumers, then rising housing prices might be consistent with pressure on rents. I think it’s important to clear up this confusion. Microeconomics tells us that when the price of a good goes up, the price of a substitute tends to rise as well. It is possible, if the overall price level is flat, that a phenomenon such as is described in this hypothetical could happen, with home prices rising and rents falling. But what is much more likely is that rents simply go up more slowly than home prices, so that they decline relative to home prices, rather than declining absolutely. This is, in fact, what we see historically: large increases in home prices tend to lead to increases in rents, but not of the same magnitude, and vice-versa. Whether the mechanism for this is a systematic institutional investor presence or just a large number of one-off instances of individuals renting out their second “investment” homes doesn’t really matter. Accordingly, I don’t expect to see a drastically different course carved out by the rental/home price relationship from what it has been historically. The main difference may be that the lags between home prices, inventories, rents, and so on might get screwed up somewhat, if institutional investors cause this to happen in a more organized way than the organic way in which it usually happens.
Another aside: there has also been a lot made recently, especially in commodity markets, about weak data from China. It is amazing how important it is to global commodity markets that China grows at 9% and not 8%. If I were a member of Chinese leadership, I would be trying to convince my data bureau to release slightly weak figures, since every time it does the hedge funds of the world offer large amounts of commodities as discount prices, which is just what a growing economy needs. It’s not like anyone believes the figures when they are reported to be high; I wonder why we believe it when they are reported to be low?
In addition to the data today, the Federal Reserve finished its meeting and announced no change in monetary policy for now. And there isn’t one coming for a while, either. There was no important change in the statement, although the Fed did take care to remind us that it “is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” [emphasis added] That’s comforting. But the simple fact is that the economy isn’t going to be booming any time soon, and the Committee isn’t going to taper its purchases unless it does because they labor under the delusion that they’re helping. Perhaps next year.
For the rest of the week, investors will be focused on Friday’s Employment Report. I am not really worried about the report being weaker-than-expected, because from everything I read it seems that the market is already anticipating something close to Armageddon (or at least, that’s how they are explaining the continued pressure on breakevens and commodities). So far, this is a routine slowdown that might be slipping into a renewed recession. Meanwhile, expectations on Friday are for Payrolls of 145k, up from 88k but down from the pace of the last year. And the ‘whisper’ number seems to be lower than that. I suspect the more likely surprise is that there is an upward revision to the 88k and the number exceeds estimates. Somehow, that will be also perceived as a negative for breakevens!
TIPS suffered today, even as nominal bonds rallied. Our Fisher yield decomposition model currently suggests that TIPS are as cheap, relative to nominals, as they have been since early September last year (when 10-year breakevens were at the same level they are at now). I am quite bullish on breakevens from here.
The Economy in the Plastic Bubble
We’re going to leave behind the topic of Cyprus for a day. It does seem as if events are coming to a head, but with banks there closed until Tuesday (and the ECB lifeline in place until Monday), there will be lots of news over the next few days but most of it will be heat without light.
So, speaking of heat and light, let’s look at today’s data. Specifically, let’s look at Existing Home Sales.
While the total sales number fell just shy of the 5mm-unit level, the 4.98mm print still represented the highest number (aside from the home-buyer-tax-credit induced surge in 2009) since 2007 (see chart, source Bloomberg).
The inventory of homes available for sale bounced off of 14-year lows, but remains at levels lower than any we’ve seen in over a decade.
And, near and dear to my heart, the median price of existing homes accelerated from last month (although, due to historical revisions, last month’s y/y was revised down to 10.67%) and stands at 11.34%. The January Home Price Index from FHA also came out; the 6.46% year-on-year rate of increase in that index is also the highest post-2007.
There are long lags between both of these indices and the appearance of price pressures in the Consumer Price Index, but at the moment all indicators of housing point the same direction: Owner’s Equivalent Rent should be in the 2.75% neighborhood by year-end, and could be as high as 3%. This is a key part of our forecast that core CPI should reach 2.6%-3.0% by year-end, and accelerate further in 2014.
The amazing recent run in home prices – which I suspect is driven in part by institutional investor interest in real estate – has caused existing home prices as a multiple of household income to move above levels that prevailed for the last quarter-century of the 20th century. The housing industry likes to present charts of housing affordability, which takes into account the current level of interest rates, because currently those interest rates make even the relatively high home prices look more affordable.
Yes, I said “relatively high home prices.” The median sales price of existing homes averaged 3.36x median household income from 1975 to 2000, with a relatively small range of values around that average. Even including the bubble, when the multiples reached 4.8x, the average through 2011 only rose to 3.54. As of year-end 2012, the multiple was back to approximately 3.48 and if median prices rise “only” 8% this year (remember, the current pace is 11.3% and rising) the multiple will be around 3.6x by the end of the year (see chart, source U.S. Census Bureau, National Association of Realtors, Enduring Investments).
Notice that even at the depths of the crisis, home prices were only slightly cheap by pre-2000 standards. Similarly, equity prices at the lows only reached approximately fair value by pre-2000 standards. There are two interpretations of this fact set. It could mean that the pre-2000 era valuations were too low, and that modern financial markets and structures make higher valuation multiples permanently viable. Or it could mean that the Federal Reserve continues to artificially support markets at multiples that are not likely to be sustainable in the long run. I suspect the latter point is more accurate, although I am open-minded about whether the former point might have some validity.
This isn’t necessarily a bad strategy, if the idea is to let the market stair-step down to equilibrium rather than letting it crash there all at once. But I don’t see anything that suggests the Federal Reserve has the slightest idea how to value assets. I understand that they don’t want to substitute their own analysis for the market’s judgment (at least, that would be the counterargument), but that’s what they’re doing anyway – with no indication that they plan to back off anytime soon. The Fed is just more comfortable in the bubble, and afraid to leave it entirely. But don’t we have to, eventually?
The VIX returned to 14 today, which makes a bit more sense to me than the 12.7 level of yesterday. It still seems low to me, but at least there is a way for long-vol positions to actually lose.
Ripping The Bandage
As a follow-up to yesterday’s article, we take note of the home price data in today’s reports. New Home Sales median prices didn’t echo the spike in existing home sales, but as I said yesterday it is hard to draw much conclusion from this series, when there is so little volume that prices jump around significantly (see Chart, source Bloomberg).
However, on the other side the FHFA Home Price Index showed its biggest leap in at least a couple of decades. Again, one point does not a trend make, but the odds that existing home prices are actually rising – at least for the homes that are changing hands – just went up again.
But not all observers agree, to be sure. Readers of yesterday’s comment fell into several natural categories. One large such category was the group that feels the large amount of shadow inventory that is held by banks in their REO books, as well as homeowners who are holding their homes off the market in hopes of higher prices, virtually guarantees lower prices.
I don’t disagree with the general notion. The housing overhang is certainly not cleared, and it will take a while for it to do so. But the expectation that this inventory will depress prices further is based on a misunderstanding of the supply and demand relationship. It’s really the fault of sloppy microeconomics texts, that tended to draw “supply and demand” charts with “Price” on the vertical axis and “Quantity” on the horizontal axis. This is accurate in the static equilibrium sense, when we are just taking a snapshot of the demand and supply curves to figure out the clearing price and quantity right now. But it glosses over an important detail and so misses conveying the richness of the relationship.
The “Price” axis need not be in dollars. There’s no reason that it must be so – any exchangeable good will do. If I have a supply and demand curve for Yankees tickets,[1] there is no reason that I can’t have the ‘price’ axis in units of cups of beer. (In actual fact, that exchange regularly happens, as when one person says “come on buddy, I’ll take you to the game and you buy the beer.”) The curves will look similar, and there will be an intersection quantity and the clearing price will be in units of beer cups. Or ounces of gold. Or acres of farmland.
By putting the units in terms of dollars, we have to be very careful about interpreting shifts of the supply curve or the demand curve. Importantly, we must remember that when we shift those curves the assumption is that the shift happens instantly. When we use units of price that change in value constantly – as does the dollar – the intersection of quantity and price can move just because time passes. It is perhaps more useful to think of the “Price” axis as being in terms of “consumption baskets.” How many consumption baskets will I exchange for that new car? Let’s say the answer is ten. Next year, the answer will still be ten (assuming no change in my preferences). But if I answered in dollars, then the answer is different, and will tend to rise over time as the value of that dollar diminishes.
So yes, to clear excess housing inventory it’s essential that home prices fall. But it isn’t essential that they fall in nominal terms. If home prices rose 5% next year, but the price of everything else went up 25%, homes would be cheaper. This is actually better than seeing nominal prices fall by 20%, because it removes any incentive to default on a mortgage that is fixed in nominal terms.
Remember: supply and demand cross at the clearing real price and quantity, not the clearing nominal price and quantity, unless we are explicitly speaking only about an instantaneous equilibrium.
This misunderstanding is the same one that is at the heart of the commodities slide, which is beginning to feel to me more like momentum trading than investment flows. I keep hearing that commodities are declining on growth fears, but if that is so then why are coffee, hogs, and cotton leading the way down and not gasoline and copper? (And, by the way, how come when stocks decline it’s a “buying opportunity” but when commodities go down, everybody thinks the world is coming to an end?) Commodities got pummeled again today, with the DJ-UBS down by -1.6%. Stocks got smacked early on and played with the 1300 level again, but managed a rally in the afternoon and actually ended with a gain of +0.2%. Bonds rallied again, and inflation swaps fell.
The near-term concern of course is Greece, with more and more stories coming out confirming that various European institutions have been developing “contingency plans” in the event that Greece leaves the Euro. Some observers think that Greece might even do it this weekend.
Once you’ve decided that the bandage needs to come off, the best way to take it off is to just rip it off in one motion. So, if Europe has finally come to that view, then the right thing to do is to just go ahead and do it at a time of your own choosing rather than letting events take the timing out of your hands. I seriously doubt that Greece will leave the EZ this weekend, with an election just a few weeks away, but it wouldn’t completely shock me. I’m more shocked by the idea that all of these institutions are just now developing their contingency plans, when it has been clear for months, years even, that Greece had to leave the Euro. And I am a little shocked that markets apparently had completely discounted this possibility until recently, and are surprised.
Thursday’s economic data consists of Durable Goods (Consensus: +0.2%/+0.8% ex-Transportation), which ought to show a partial rebound after an awful -4.2%/-1.1% showing last month. Initial Claims are expected to be unchanged at 370k. And liquidity will begin to suffer in the afternoon before a thin session on Friday.
[1] We assume here that they intersect above a zero price.
