Juggling Dynamite

Yesterday, Fed chair Jerome Powell reiterated his commitment to combating inflation (lagging indicator) at the expense of economic growth, employment and asset prices (leading indicator). Stocks didn’t like the message. In an abrupt reversal, every market sector tumbled into the close, with 474 of S&P 500 members ending in the red. There’s a point of financial pain at which the Fed will pause; evidently, we aren’t there yet.

The persistent hawkishness of central banks is a new paradigm for a world of market participants who’ve been trained to presume unending monetary bailouts. Most are incredulous that gambling isn’t winning and lack the discipline to do otherwise.

Meanwhile, the most abrupt tightening cycle on record is moving through the economy faster than average. With interest rates the highest since 2007, home sales are already down 49% year over year in Toronto and 45% in Vancouver. US mortgage applications (a leading indicator) were -40.8% year over year for the week of October 28. Used car prices in October were -10.4%, the weakest since the 2008 recession.

Ex-oil and gas, S&P 500 earnings per share were -5.1% year over year in the third quarter, following a 4% contraction in Q2, registering the first successive quarterly decline since the 2020 recession.

Public company profits benefited from pandemic-era fiscal and monetary support while they were able to pass on higher input costs to consumers. But that is all in the rearview mirror. Now, consumers are tapped out and focused on how to cut spending just as excess inventories, higher borrowing costs and worsening productivity prompt companies to cut overhead/workers.

On the upside, collapsing demand and a profit recession will force liquidation selling and finally help bring inflation back to target. The policy-enabled inflation of 2021 is mean reverting through deflation in 2023.

Eric’s presentation illuminates the components of housing supply and how it impacts prices.

The Housing Shortage has been one of the most popular stories in real estate and the economy over the last year. You see headlines about the lack of inventory driving up home prices everywhere you look. Many said home prices would not fall because the inventory situation was so tight. But now, with many indications that home prices are already falling, the housing shortage narrative is feeling a bit shaky.

In this video, I will explain the true inventory situation in the US housing market and what it means for home prices over the next 6-12 months.

Given the abrupt increase in mortgage rates this year, the possibility of a buyer assuming a seller’s lower-rate fixed mortgage could be appealing. This would only be possible on existing (not new) homes and where the seller is not wanting to port (transfer) their mortgage to a next home. The buyer also needs enough cash to make up the difference between the existing mortgage and the purchase price, or they will need to increase the loan size at current rates.

A negative is that the seller can be held responsible if the buyer defaults in the first 12 months. You can read more about the options in Canada here and in the US here.

Canadian monthly home sales in September were -32% year-over-year and 12% below the pre-pandemic 10-year average for September (chart below since 2007 courtesy of Martin Pelletier). October sales appear to have been worse. Many who bought properties during the 2020-2022 frenzy are now underwater in terms of resale value. Others refinanced existing properties to extract equity which has since been spent. Private mortgages are harder to find as many previous providers borrowed funds against their own properties to lend to others and are now suffering too.

Still, as evident in this GTA billboard below, hope springs eternal that “Toronto buyers” will continue to have more credit access than math skills. Ah, the good ol’ days.In the FOMO (fear of missing out) of 2020-22, some 40% of purchases in the US and Canada were second homes bought for ‘investment,’ occasional use and short-term rental. Suddenly, negative carry has grown deadly on leaping utility and mortgage expenses. At the same time, rent disinflation is set to accelerate as more owners seek short- and long-term renters. An estimated 50% of Airbnb rental listings were added in the last two years.

With shelter costs making up a third of the consumer price index (CPI), central banks need deflation there to get the CPI back down to target; and they are starting to succeed. Their too-loose for too-long policies enabled the inflation they want to kill, but that’s yesterday’s news.

On the commercial side, a 7 million US small businesses survey found that 37% could not pay their full rent in October, up from 30% in September. See Bloomberg:  More than a third of US small businesses couldn’t pay their rent in October. About 49% of restaurants could not pay their rent, along with 37% of real estate agents.

Next comes rising auto loans and lease defaults-especially on the more expensive makes. It’s typical for auto inventories to rise during recessions. But like the mathless buying in realty the past couple of years, financial harakiri in the auto space has been extra-extraordinary too. As shown below, since 1996, parabolic prices from 2020 to 2022 are mean reverting and suggest that prices should continue to fall through 2024. Undoubtedly, some of the loans advanced in this mess will not prove money good.

On the upside, much lower shelter and transportation costs will improve productivity and financial viability. In time, clearance pricing will help fuel the next recovery out of the ashes of the unfolding bust. And so the cycle goes.