Something’s Going To Break

From past experience, we can be pretty sure that the bear market doesn’t begin until the inverted yield curve returns to a positive slope. Usually this happens because of a major disruption in the financial markets. Here are some of the opportunities for breakage.

• The average 30-year mortgage rate, as of today, is 7.13% according to Bankrate.com. Housing affordability has dropped to what Redfin deputy chief economist Taylor Marr calls the “lowest level in history.”
• Office occupancy in major city centers is ranging from 40-60% as a result of WFH practices. Pressure on bricks-and-mortar retailers from online shopping continues to build. The overall US CMBS delinquency rate jumped 18 basis points in February to 3.12%. (The all-time high on this basis was 10.34% registered in July 2012. The COVID-19 high was 10.32% in June 2020.) . Giga-investor Blackstone just defaulted on $562 million of CMBS.
• CPI/PCE inflation continues. While energy prices continue to be contained by withdrawals from the SPR, labor prices continue to increase. Fed chair Powell says that his primary measure of inflation is core PCE less housing, which implies a heavy weight on labor costs when evaluating inflation.
• The Fed continues to raise short-term interest rates to reduce business activity and therefore reduce inflation. So far with little success. Financial markets are busily fighting the Fed’s attempts to tighten financial conditions. History says this does not end well.
• There’s a war on, into which black hole the US continues to pump money and armaments. These will need to be replaced at great cost. Defense spending will be increased. The big risk is of further escalation, which could include the use of nuclear weapons.
• The primary source of inflation is deficit spending by government. Half of the government’s debt has a maturity of less than five years. The Fed’s rate increases are quickly running up the government’s interest bill, which of course will increase the deficit – that’s how the black hole works. Interest is already nearly as large a budget item as defense spending.
• China’s recovery from its draconian COVID policies is limping badly after a small initial surge. In addition, the US is actively hampering the development of technology in China and relations are a historic lows. There is a significant risk of another war, this time over Taiwan, where TSMC is the crown jewel of semiconductor manufacturing. All this means that China is unlikely to be the source of cheap manufactures goods that have helped quell inflation for the last twenty years or so.
• The US stock markets remain highly overvalued and not investable as the flood of liquidity during the COVID era has supported speculation. The options market has grown to be larger than the equity market of which it is supposedly a derivative, leading to extreme gambling activities such as 0DTE options..

Get the idea?

Honne And Tatemae

There are many financial conditions indexes, but in general terms they represent the cost and availability of credit and equity financing, interpreted as relatively “tighter” or “loose, easy”. Markets were surprised that Powell appeared unconcerned that these indexes showed that financial conditions were more or less unchanged by the Fed’s rate and QT actions. His unconcern was interpreted as conceding that the bulls were right in believing that rates would soon come down.

My interpretation was that he simply didn’t think it was a problem. One of the Fed’s primary concerns is to keep financial markets functioning normally, and the indexes show that they are. However, it is important to remember that the Fed is very well informed. The Japanese have words for this, “honne” and “tatemae”. “Tatemae” is the outward appearance of conformance to society’s norms and rituals, while “Honne” is what is really going on behind the scenes. In this case, the “Tatemae” is the traditional information bureaucracy – the BLS, BEA, and even the Fed itself – and the ritual announcements of  lagged and often politicized estimates of economic data. The “Honne” is that the Fed uses all kinds of information services and is very much in touch with the high-frequency data that is gathered by state governments, industry associations and many other private services. The recent callout of the BLS by the Philly Fed shows that the Fed has little faith in the BLS. Powell knows that the economy is either on the verge of recession or already in one regardless of the NBER’s view. He knows that deflationary collapses are underway in markets like housing and used cars. He probably also expects that taking down inflation, as happened in the GFC, will likely require a severe correction in financial markets, probably worse than the GFC. But I am of the opinion that  he is willing to be wrong about that, so if markets are right to “look through” the recession to a return to low inflation he would be perfectly OK with that. He did warn that no rate reductions should be expected in 2023, nor would he back off prematurely, but this was widely ignored.

Edit: This morning’s employment report demonstrates the useless, erratic nature of the BLS data.

Res Ipsa Loquitur

Kumquat

Recession is here. The official dating will come later, much later. But the economy is slowing quickly. Commodity prices are falling due to lack of demand. Property – real estate – is slowing. China is struggling with Covid – and trying to infect the rest of the world with whatever variants they have incubated over the last couple of years. Europe is struggling with the Ukraine war and self-inflicted wounds from sanctions and immigration.

But equity markets don’t care. The S&P 500 looks to be making a bottom at a level that was the May bottom. The Dow seems to be heading for all time highs. Only the NDX seems to be close to a new low as some hypervalued “tech” stocks have been clobbered.

What Happens Next

Well 2022 is just about over. I traded badly this year but that is behind me, I hope. Especially annoying since I have been expecting this bubble to burst for a long time. The big question is, where do we go from here. Some thoughts:

• Housing. Sales volumes are falling very rapidly because affordability is poor, but prices are holding as sellers are reluctant to drop their expectations. In the last housing bubble pop, it took a year and a half for this process to work through so that sellers finally acknowledged that prices could actually fall. This means that housing costs, which make up a disproportionate share of CPI, will be sticky.
• Employment. The pandemic significantly reduced the labor pool as many people retired or just dropped out. In China, the pandemic and measures to suppress it have badly damaged the economy and look to continue to do so. It seems likely that the offshoring that reduced labor demand in the US is over, and will be replaced by onshoring and relocation of production. Either way, labor demand is likely to remain relatively strong well after consumption growth falls. Labor looks to reclaim at least part of the loss of its share of economic output, at the expense of capital, i.e. profits.
• Energy. The idiocy of belief that minor reductions in CO2 output will have a material affect on the climate is hampering investment in energy sources. Of course this will throttle growth in energy production and keep prices high, even as a slowing economy will reduce demand for other commodities. I was amused to find that DNA recovered from northern Greenland revealed that during the region’s warm period, when average temperatures were 20 to 34 degrees Fahrenheit (11 to 19 degrees Celsius) higher than today, the area was filled with an unusual array of plant and animal life, including aurochs and mastodons. Then of course there are the (hopefully temporary) supply constraints that have been caused by the sanctions on Russian production.
• Food. The good news is that more CO2 in the atmosphere helps food production. But modern farming depends heavily on diesel fuel for big equipment and natural gas for fertilizer production. Fossil fuel prices directly affect food prices, because even though yields may be good, farmers will not plant crops on which they cannot make a profit. In addition to high prices, shortages of some crops will develop as farmers pivot to crops which require less of these costly inputs.
• Interest Rates. It seems that no-one believes that Fed Chair Powell will actually carry out the attack on inflation that he has outlined. Some argue that a recession will “force” him to abandon his current goals and resume ZIRP and QE, redefining his goals in the process to accept a higher level of inflation on an ongoing basis. Others believe that the recession will cause inflation to fall quickly and make the question moot as his goals, such as positive real rates across all maturities, will be automatically met.It is certainly true that this long-suppressed business cycle is moving fast, but there is a long way to go to normal. My personal view is that his vision for his legacy is an economy that does not depend on massive growth of debt relative to GDP as has been the case in recent years, and he will do “whatever it takes” to get there

In summary, inflation will prove sticky although not runaway, and Powell will accept a recession. But as the recession gains hold, it will accelerate as defaults reduce credit availability regardless of Powell.

China Property

Price to Rent ratio compares median sales price to median annual rents for similar properties. Here (read off a chart so approximate, then annualized) are price to rent ratios for major cities in China:

1. Shenzhen: 58
2. Shanghai: 53
3. Beijing: 51
4. Guangzhou: 48

Here, from Yahoo Finance, SmartAsset reports Price to Rent ratios for the top 50 cities in the US.

1. San Jose: 42
2. San Francisco: 37
3. Long Beach : 33
4. Seattle: 33

While in San Jose it takes 42 years of rent to buy the property, which is expensive enough, in Shenzhen it takes 58 years. Comparing the top four cities, China is around 45% higher – or more speculative. And you thought that we had a real estate bubble.   At the other (cheapest to buy) end, in the US, you can buy the property for as little as 6 years rent:

1. Detroit: 6
2. Cleveland: 8
3. Baltimore: 12
4. Milwaukee: 14

And of course this ratio uses gross rent and, unlike the “cap rate” often used to evaluate rental properties, does not take into account the expenses of operating a rental property, such as taxes, maintenance, security, insurance, etc.

Housing Collapse Redux

Take a look at this chart:

That is a collapse in process. An unprecedented collapse in modern times. Perhaps 1346-53 showed something similar. It will take 4-6 months to work its way into the hard data, but it is coming. Recall Stephanie Pomboy’s observation that in July of 2008, inflation was at 5.6%. By July of 2009, it was at -2.1%. There’s a Fed pivot of some kind. Now look at John Hussman’s pivot chart:

Which clearly shows that the real bear market will follow the pivot. Then contemplate another of Hussman’s charts which shows the potential losses from here:

Now look at the international context. China has its own housing bubble collapse going on, to say nothing of choking its economy with a stupid Covid strategy because a dictator like Xi cannot admit error. Europe is seized with political correctness, internal division over immigration from Africa and an energy catastrophe. Oh and there’s a proxy war with Russia going on and another with China waiting in the wings, to say nothing of a demented President. Just don’t choke on that turkey.

Bubble Rupture

Interesting tidbits from Stephanie Pomboy. In July of 2008, inflation was at 5.6%. By July of 2009, it was at -2.1%. The price peak of the housing bubble was in September 2005. The shelter component of the CPI continued rising until its peak in February of 2007, nearly a year and a half lag. The total seasonal adjustment so far this year is +1 million, the largest ever. Of course seasonal adjustment needs to net to zero over the year. Of course the BLS is not political.

Disintegration

The world is disintegrating. Trust has been lost, both within countries and between countries. Without trust, economic relationships cannot operate.

China

China is a poor country, despite the glitz and glamor of its big cities and its showpiece infrastructure, with a per-capita annual GDP of about USD 11,000.

Chairman Xi presented his plan for world domination at the opening of the party congress. Not going to happen, sir. Your country is an economic and social house of cards that is in the process of collapsing. The housing market, investment of choice for the masses, is a bubble bursting and desperate local governments are even buying their own land use rights from themselves or one another because retail buyers have left the building. So to speak. Your Covid-zero policy has shaken the people’s faith in the benign CCP, while wreaking destruction on millions of small businesses. Unemployment is high and rising, college graduates cannot find jobs. Biden’s withdrawal of support for your semiconductor industry has condemned it to a bleak future without the production technology that your people cannot build. Export demand from the rest of the world is shrinking fast. Sir, your country is likely heading for a deep economic depression and social turmoil. This will further weaken China’s positioning for the world hegemony which you desire.

United States

In the USA, we live in a world now that George Orwell and Aldous Huxley would readily recognize. The state has commandeered the legacy media, as well as the new social media, to not only put out the “progressive” state’s version of reality but to identify, spy on, ostracize and  punish critics and dissenters.

President Biden, your “progressive” policies are not working. Democrat-run inner cities are being abandoned to crime and homelessness. Illegal immigrants are flooding in without any prospects for employment or training. You are continuing to feed the inflation which is mostly damaging the people you claim to represent. Your support for expansion of NATO triggered the invasion of Ukraine, with severe economic and social consequences.

You and your Democratic predecessors, notably Hillary Clinton, have created a deeply divided society, with those who have drunk the purple Kool-Aid and accept the state’s lies and propaganda on one side, and those with a more traditional view of reality on the other. Neither side trusts the other, respects the other’s views, or is willing to compromise. Both sides are preparing for more direct conflict as the sporadic clashes increase in frequency and severity. This is a recipe for a failing state with extremism on both sides. Negative economic consequences are to be expected.

Europe

Neither China nor Europe are democracies – by design. The architects of the European Union claimed that, since democracy had enabled Hitler, it could not be a part of the EU’s structure. As a result, bureaucrats who suffer no consequences for their failures and care little for the fate of the citizenry run the EU. Ursula van der Leyen is no less of an autocrat than Xi. Deep rifts have emerged as democratically elected governments have resisted the orders of the bureaucrats. These rifts are between rich north and poor south as well as conservative east and “progressive” west. It is only a matter of time before a second country leaves the EU, and that will spark a rush for the exits.

The coming winter is going to be hard, as the bureaucrats’ energy policy has been disastrous. Immigration policies have resulted in shocking increases in crime, with many countries reporting zones where the police dare not go in fear for their lives. Mario Draghi’s “whatever it takes” has left a legacy of irresponsible debt, as in the USA. As  interest rates increase, this is going to be a huge problem

Russia and Ukraine

Russia’s invasion of Ukraine has no winners. Regardless of the outcome, the invasion is an economic disaster for both of them. Their economies depend heavily on the export of commodities, such as food, energy and metals. The volumes of these commodities are large, and their absence are also a problem for the countries that have come to depend on them.

Conclusion

I could go on, but it is time to recognize that the future is not bright. Economies will get worse. Much worse. Be careful out there. Don’t focus on the narrative of the “Fed pivot.” The Fed is irrelevant.

China

The Covid-zero policy seems to be slowly destroying the Chinese economy and civil society. Even the slightest sign of infection sets off massive lockdowns, quarantines and daily testing, enforced by anonymous people with automatic weapons. Of course social media censorship is stringent, but even so there is trouble brewing in my opinion.  It seems to me that a single positive test is enough to shut down a city – haven’t they heard of false positives? It seem that at this rate the turmoil will never end.

And then there’s the collapse of the housing market, in a country where speculation in residential real estate, often sold and paid for pre-construction, has been the investment strategy of choice for most people.