Market Commentary 7/29/2022

Posted on July 29, 2022 by Damon Germanides

Bonds Rally As Recession Worries Intensify

The U.S. equity markets proved resilient taking on both a .75 bp Fed rate hike and a GDP print confirming that the economy is technically in a recession. Two negative quarters of real GDP growth support this status. Inflation continues to be a problem but has likely peaked with the Personal Consumption Expenditure (PCE) coming in at a multi-decade high, but flattening out on month-over-month readings. Now, the great unknown is the pace at which inflation moves off its highs. The Fed’s goal of 2% inflation seems almost fanciful near term. The truth is inflation will be with us for quite some time.

For Better Or For Worse?

Parts of the yield curve have been inverted. An inverted yield curve remains one of the best indications that the economy is in poor shape and financial conditions have perhaps tightened too much. One must not discount the threat of stagflation, should inflation become embedded in the prices of goods and services even as the economy slows. The equity market is forward-thinking, so even with sagging consumer and business confidence amidst a host of other negatives, the market found a way to rally. Perhaps the worst is behind the markets. Or perhaps, it is a bear market rally. Only time will tell. It is important to remember Fed rate hikes need some time to work through the system. Also, come September, the Fed will be selling close to 95 billion in bonds as part of its QT plan. It will be an interesting third and fourth quarter.

Troubles abroad cannot be dismissed either. Whether it’s the Russia-Ukraine War, European or Chinese economic slowdown (worse than what the U.S. is currently experiencing at the moment), geo-political tension, or global run-away inflation, the world continues to experience great economic stress kickstarted by the pandemic. Joblessness on a global scale will likely increase as many large businesses are cutting back on hiring. If the goal of the Fed is to break inflation, one unfortunate truth is that job casualties will be unavoidable.

As expected, home prices are starting to fall in response to higher interest rates and stricter bank underwriting. To their benefit, buyers have found themselves more optionality and a selling environment where they have a seat at the negotiating table. Mortgage rates have come down lightly as 30-year fixed rate money note rates can be found at 4.75% or below. No doubt a big move from the sub 3% range, this same product was being offered at a short while ago but removed enough from the high of 6% plus not too long ago. The move lower in mortgage rates should help some buyers make offers on homes. Adjustable rate mortgages follow the 10-year U.S. Treasury. As the 10-year Treasury moves lower so do ARM rates. This may take some time as lenders are being cautious given the current headwinds. This should be a boon for the high-end market, especially if sub 4% interest-only mortgages are offered again.

Market Commentary 7/22/2022

Posted on July 22, 2022 by Damon Germanides

Treasury Rates Decline As Corporate Earnings Disappoint

Inflation continues to deplete consumer spending power. This trend aligns with some very interesting reports from AT&T on the increase in late payments and rising defaults on smartphones. Since many of us can’t live without our smartphones for work or social interaction, failure to pay smartphone bills is concerning. It also suggests the economy may be worse off than many economists believed. Credit balances rise along with other loan types like non-performing auto loans and BNPL (buy now and pay later). The massive stimulus that was pumped into the market appears to have left the economy to work towards normalization while also battling high inflation and slowing growth. Many layoffs in the banking business are being announced. I expect unemployment to rise in the coming months as companies expand layoffs and banks pull back on lending. The recession is here, in my opinion. The big unknown is the Fed’s strategy to combat persistent inflation in a slowing economy.

The Fed’s Big Squeeze

The haste with which the Fed has risen and may continue to raise short-term interest rates is squeezing all but the biggest banks. This squeeze is distressing for housing as banks pull back on LTVs, Cash-Out Refinances, and Investment Property Loans. Prices will need to adjust to the combination of higher interest rates and tighter bank guidelines. Mortgage banks that have filled the void on the more niche product offerings are also being affected. The one silver lining in all of this? There is a dramatic increase in housing inventory from very low levels of supply. There are many prospective buyers who have been waiting to buy for quite some time. Their time may be here in the upcoming months.

The ECB raised rates and now short-term interest rates are no longer zero. Personally, I never understand negative interest rates. As an observer, why would you lend money to get less of a return in the future? As we witness this all in real-time, the winding down of easy money policies and as central banks experiment with negative interest rates, remember the old saying “it doesn’t make sense.” Should inflation persist and the recession be deeper and longer than forecasted, central bankers in the developed world should remember the damage easy money policies have historically resulted in. While we all loved zero rates (or near zero or negative in some countries), the use of these policies is so destructive that it would be wiser to shelve them for future generations. Basic finance requires a discount rate to calculate risk properly. Ultra-low interest rates increase wealth and risk-taking, while rates remain low. The flip side is what happens when rates rise and inflation becomes unanchored, as we are experiencing today. Wealth is destroyed, confidence is eroded, and the most fragile in our society suffer through the high prices of basic necessities. Free money and zero interest rates have consequences.

Market Commentary 07/01/2022

Posted on July 1, 2022 by Damon Germanides

Mortgage Rates Fall As Recession Fears Intensify

Treasury yields quickly raced to well under 3.00% this week. In my opinion, this is not a good sign of things to come. Recession fears have escalated. The long bond acts like this when recession fears rise. GDP now has economic growth at -2.1%. Micron, a major chip supplier, guided down and reaffirmed what many of us already know. The economy is slowing. The combination of Fed rate hikes and quantitative tightening is a dangerous cocktail for the equity, real estate, and debt markets. I am hearing from several banks that liquidity is quickly drying up. They are weary to lend, and risk spreads have increased. As expected, housing supply has jumped as homeowners look to sell before things get worse, or in some cases unload their second or third home. A violent stock market and bitcoin correction have consumer confidence at a many years low, with liquid savings and retirement accounts down a great deal. With margins being squeezed and earnings estimates falling, S&P year-end estimates have come down with year-end S&P to be somewhere in the range of 3,200 and 4,100.

Where Do We Go From Here? Equity, Real Estate, Inflation.

First, let us start with the equity market. Equities rise and fall and are prone to large drawdowns and rebounds. Many of us got into trouble chasing momentum stocks and high beta tech stocks, which have no earnings power. Stocks represent ownership in a business, but zero rates and money spraying had fooled many professionals into believing that stocks only go up. The same applies to crypto.

Two, regarding real estate, price is what you pay, and value is what you get. Homes are a bit different asset class than other real estate as many homeowners were able to lock in exceptionally low-interest rates. Even if the housing market declines, homeowners will be able to service their debts. Home appreciation over the last few years has been unsustainable. The new listings appearing amidst the dwindling economy warrant the need for a correction. People are becoming increasingly cautious. As interest rates return to the historical mean, speculation will lighten, and buyers and sellers can enter a more even playing field.

Three, the Fed will beat inflation. It is already happening. It will occur at a significant cost and over time, but inflation will come down. The Fed’s tools are very good at breaking inflation (higher rates and quantitative tightening). The collective negative sentiment compounded with quickly deteriorating financial conditions indicates the need for the Fed to halt its rate-hiking cycle expeditiously. The 2-year Treasury has fallen mightily the last few days which supports the notion of fewer rate hikes ahead.

Finally, it is important to remember that this is a long game. Absent the last 20 years or so, recessions and rebounds were much more common. Recessions clean out the financial system and are healthy. Speculators are taught about assessing risk, bad companies die off – clearing the way for new more innovative businesses, and prices reset allowing investors to buy assets for cheaper. While I may be negative on the markets currently, I am always bullish on America. We have so much to be grateful for, even in tough times.

Have a great 4^th of July.

Market Commentary 06/24/2022

Posted on June 24, 2022 by Damon Germanides

Treasury Yields Dip On Fears Of Slowing Economy

The economy is slowing. This is evidenced by the recent layoffs amidst many technology companies, lenders, and other businesses that were benefactors of stay-at-home and low-interest rates. The leisure industry remains strong as people continue to spend money on experiences and travel, with the exception of restaurants, which seem a lot less busy. Many clients are complaining about the cost of living which becomes exacerbated in a downward trending equity market. The front-page news of a looming recession and its potential certainly does not help quell public concern. Consumer and business confidence remains low. In my opinion, there is a fairly good chance the economy is already in a recession. It certainly feels that way.

Inflation Is Always And Everywhere A Monetary Phenomenon

If the Fed has the resolve to break inflation, it will. More clarity should be available by the end of next week when the PCE inflation reading (the Fed’s favorite gauge of inflation) is released. Should that reading come in hot or as expected, the Fed will most likely go up 75 bp again in July. The old saying that “inflation is always and everywhere a monetary phenomenon” rings true these days. The markets will stay volatile during the next few months as the new terminal rate for rate hiking is established. There’s a big chance that the Fed’s double-barreled strategy of increases in rates and balance sheet runoffs could result in them breaking something in the financial system. Caution remains warranted even during strong rallies like today.

I expect the Fed to move above 3% on Fed funds sooner than later. 40% of Americans are now living paycheck-to-paycheck and are struggling to pay for life necessities. The one positive here is that I think the Fed is now taking inflation seriously enough to ensure that it should come down fairly quickly, maybe by the fall. That is just my best guess. Earlier this week, the yield curve continues to be flat and briefly inverted. This is almost always an ominous sign.

Interest Rates In The Ether

How higher interest rates will affect home prices is yet to be established. My belief is that prices will need to come down. Some models are showing a 20% or so draw down in values. However, in supply-constrained cities like Los Angeles, there are still not enough homes to meet demand. Should interest rates remain persistently high, I imagine home prices will slide even in supply-constrained markets. I am hearing from commercial bankers that higher interest rates will have an immediate effect on cap rates and that exit cap rates have been reduced as well. Cautious underwriting is being implemented across the board, which I applaud. Better to stress-test loan applicants than be sloppy in a rising rate environment. I expect as interest rates remain elevated, refinance of real estate will be used to pay down more expensive personal or business debt. ARM loans and interest-only loan demand has picked up. Borrowers are attempting to offset the rise in interest rates with an interest-only payment.

Market Commentary 6/17/2022

Posted on June 17, 2022 by Damon Germanides

Fed Committed To Fighting Inflation With .75 BP Rate Hike…Expect More To Come.

“Don’t fight the Fed” was last week’s theme. Until recently, many of us failed to understand that this statement is tantamount to their management over both easing and tightening cycles. As stated previously, the Fed’s primary concern is inflation. Their policy decisions will be centered around curbing inflation. Should housing, crypto, or equities continue to get crushed, the Fed will not intervene. The great washout has begun. The Fed is reducing liquidity from the markets by raising short-term interest rates and letting bonds run off their balance sheet. In many ways, the equity market is doing a lot of the Fed’s work. As many equities are down from anywhere between 20% to 80%, we can’t help but feel poorer and less eager to spend. This sentiment will make its way through the economy, and eventually help to bring costs down. This includes costs of goods and services, as well as wages, all of which constitute a large business expense for companies.

Adding Salt To The Inflation Wound: Rates & Real Estate

Mortgage rates are back to 2008 levels. Housing starts are down dramatically. Consumer business confidence is miserable. The pain load placed on our investments is all part of the plan to crush inflation. It is disappointing that the Fed and Treasury placed their bets on inflation being transitory. Much of this destruction could have been avoided by slowly removing extra-accommodative policies from the financial system last year. Now, we face a very turbulent financial period. All this amidst having just a glimpse of a return to normalcy after experiencing a once-in-a-century pandemic. Ouch.

Part of me never thought we would see 6.00% 30-year fixed mortgage rates again in my lifetime. Yet higher rates are upon us. Housing prices have to adjust in the face of higher rates. Mathematically, you cannot have a doubling of interest rates without an adjustment to home values or cap rates on commercial properties. It will take some time for the market to adjust, but there will be an adjustment. Banks are also tightening credit standards as the fear of a recession increases. Personally, I think we are already in a recession. I don’t believe the recession will be too severe, given the strong balance sheets of businesses and a tight labor market. However, the Fed is committed to slowing the economy down and they will probably succeed.

Interest-only loans adjustable rate mortgages (ARM’s) will become much more popular with home buyers, especially with the elevated mortgage rates. It seems fairly certain that short-term rates will come back down if inflation readings abate, but only after the Fed raises rates by as much as 300 bp in the next 12 months. Should the S&P fall by another 20% down to around 3,000, it is hard to imagine the Fed would continue the tightening cycle. Those taking short-term ARM”s may benefit from falling rates a couple of years from now.

Market Commentary 6/10/2022

Posted on June 10, 2022 by Damon Germanides

Who’s Most Impacted By Inflation? All Of Us.

Things are looking grim. Today’s inflation report came in hotter than expected much to the disappointment of the bond and equity markets. Equity markets are getting slammed, while Treasury yields are rising. Today’s report puts the Fed substantially behind the curve on inflation. A dramatic action might be necessary to provide even the smallest form of relief. Until today, you wouldn’t hear this from most commentators on CNBC – that one cannot take a 75 or 100 bp event totally off the table. This blog has advocated for rate hikes for quite some time and believed a 75 bp hike a few months ago would have been appropriate. Signaling from the Fed has been very poor, as well as, from the Treasury. Letting inflation run hot was a terrible mistake. Like most Americans, inflation has been evident in our daily purchases for months. Let’s hope the Fed makes the right decisions soon, to avoid recession. It is becoming an increasingly difficult environment to navigate. In my opinion, inflation, and not the equity or housing market, remains priority number one. So, there will certainly be more pain ahead.

Although consumer and business confidence remains weak, a combination of stock market volatility, the slowing housing market, and 120 oil may be doing some of the work for the Fed. Anecdotally, this week I happened to be out to dinner more than usual, and I noticed that restaurants are less busy. The gas attendant at the local gas station said fewer people are filling up. Bank management is less eager to lend. All these things suggest the economy may already be in recession. With unemployment at 3.60%, it is hard to envision a major recession taking place. Nonetheless, I am reading about many layoffs, especially in higher-paying jobs such as technology.

The Housing Market & Our National Reality Check

There is not much good news to talk about. Rising rates and a cooling economy will lead to lower house prices. Supply-constrained markets such as Southern California probably won’t see a big price dip unless the bond market and equity market do not steady, but home prices will come down as demand wanes. This is a positive note for those waiting to buy, but not so much for those who recently bought.

The one benefit of this reset is that wages, the cost of living, and people’s expectations of what a normal rate of return looks like, have gotten a major reality check. There is no such thing as a free lunch, unlimited debt financing, or continued parabolic returns on investments. You can’t spend your way out of inflation. There is now a return to the mean and that is good news for the next generation. Easy money is never easy. Success is earned and above-average returns require skill and thought.

Market Commentary 06/03/2022

Posted on June 3, 2022 by Damon Germanides

Strong Jobs Report Supports More Fed Tightening

Concerns over the Fed’s progress on quelling inflation have been heightened considering May’s solid Jobs Report. The 10-year Treasury Bond is now nearing 3.000%. The Fed has publicly stated they see no reasons to pause rate hikes (even after the expected 100 bp hikes expected in the summer) and the Jobs report has reinforced a tight labor market. Inflation will not come down for some time. It may have peaked, but the slide to lower inflation is expected to linger. Since labor makes up over 65% of corporate expenses, rising incomes will continue to put pressure on companies to raise prices when possible. Additionally, commodities inflation (especially oil) remains high. Case in point, gas prices hit $8 per gallon in California recently.

Lookout: The June Balance Sheet & Major CEO Premonition

Expect ongoing volatility as the Fed is willing to let markets fall to wring inflation out of the system. This includes equities and housing. I advise you to watch the Treasury market closely. The Fed begins to run off its balance sheet in June, but the real action begins on June 15^th. It will be interesting to see the effects of QT after so many years of liquidity support in the financial system by the Fed. This reinforces the need to be a fundamental thinker when buying real estate, a home, or any other security. Price always matters.

Some major CEOs are beginning to warn of a looming recession. These individuals have access to troves of data and have the best minds in the world advising them. It goes without saying that the economy is too complex to truly predict what could happen. Economists and forecasters get things wrong more often than not. However, all this negativity is causing banks to be more cautious in underwriting. The need for volume is creating competition for high-quality loans. Rate spreads are tight as banks compete to obtain the safest credit candidates in the jumbo space. Non-QM and alternative documentation loans have fallen out of favor with the investor community. Such products are not getting a bid in the secondary market. Insignia remains focused on portfolio lending solutions for our customers who are mostly self-employed or foreign nationals.

The combination of a slowing economy and elevated inflation is a worst-case outcome for the economy. The Treasury market leads the way as a signpost for where the economy is headed. In some ways, we must hope for higher long bonds as an inverted yield curve portends recession. Given all the debt in the system, one must not forget that things can still get worse.

Market Commentary: 5/27/2022

Posted on May 27, 2022 by Damon Germanides

Inflation Falls Slightly, Mortgage Rates Edge Lower.

Finally, some good news. The Fed’s favorite gauge of inflation, Core PCE, rose at a slower pace than last month. While this number is still way too high, it did not rise above the April reading that wreaked havoc on the equity markets and spooked the bond market. Personal spending is still going strong, but customers are opting for cheaper-priced goods. This week’s market action – equity higher and bond yields lower – is a welcome break from one of the worst 4 plus months in the market’s history. Nonetheless, there are many headwinds to be mindful of. The Fed will begin quantitative tightening in June and is slated to increase rates in both of the next two meetings. Additionally, there is a lingering fear that this recent rally is what is causing a bear trap (a quick temporary move higher in the equity markets, only to reverse lower a short while later). This false technical indication inflicts painful losses on investors, pocketbooks, and the psyche. Home sales quickly slowing, consumers are dipping into savings, and I don’t foresee the Fed reversing course on interest rate increases any time soon. Inflation is public enemy number one and a huge burden on the least wealthy members of our society.

The Diamond in The Rough: Finding Value In The Current Market

Most of the experts I follow are more bearish in nature, with a target on the S&P of 3,800 to 3,900. This does not mean that one cannot find value during difficult market periods. For example, a nervous home seller is likely to be more willing to settle for a lower price. In this case, real estate brokers will follow suit and be inclined to negotiate more to make a deal happen. Tougher times create opportunities that cannot be forgotten. The same principles apply to other investments. You just have to be willing to do the work to find value.

As the WSJ and other financial papers write about rising mortgage rates, mortgage rates have quietly and quickly come down. The 2-10 year yield curve has also steepened a bit, providing relief to those worried about a recession. Inflation remains a wild card. Recent lock-downs in China have weakened its growth, which is also quite worrisome. All of these economic issues combined will keep markets on edge for quite some time. One could say that interest rates have gotten more attractive- when viewed in the context of their downshift. However, with the short end of the curve controlled by the Fed, I hold the belief that the direction of interest rates is higher. A 10-year Treasury at 3.500% would not surprise me in these coming months, especially if inflation recedes, but not as quickly as hoped for.

Market Commentary 5/20/2022

Posted on May 20, 2022 by Damon Germanides

Equity Market Volatility Pushes Bond Yields Lower

It was another week of agonizing volatility in both the bond and equity markets. Big box retailers reported tighter margins due to high inflation. Economists continue to move year-end targets down. One wonders if all of this negativity signifies an end to selling. S&P touched correction territory before trading higher into the close on Friday. Long-dated bond yields fell below 2.800%. Trading remains volatile but orderly. As we have mentioned previously, don’t expect the Fed to step in and backstop the equity or housing market anytime soon. Inflation is the Fed’s primary concern and they will tolerate a falling equity market and a higher unemployment rate to subdue inflation. Case in point, the WSJ reported that subprime credit delinquencies are rising from historically low levels as the increased cost of food and energy preys on consumers. Even the wealthy appear to be cutting back on spending. The soaring costs across all corners of the economy are weighing on people’s confidence and willingness to spend.

Impact On Real Estate & The Global Economy

Limited housing inventory will keep home prices from falling too dramatically. However, given the wealth destruction incurred in both the bond and equity market, it is difficult to see real estate being impervious to recent events. The dramatic rise in mortgage rates over the last 60 days will push some buyers to the sidelines.

With China shut down, and the world economy slowing, perhaps long-term interest rates will continue their recent descent. This would be helpful to growth stocks in addition to homebuyers, consumers, and businesses. We hope that long rates don’t move too low, as an inverted yield curve would be worrisome. Housing demand remains healthy, which bodes well overall for the economy. Should this change, we would become very nervous over a deep recession.

Next week is important for the markets as the Fed’s favorite inflation gauge, the PCE, is released. The markets will respond favorably should inflation appear to be topping out. However, should the reading come in hotter than expected, be prepared for a sobering market reaction.

Market Commentary 5/13/2022

Posted on May 13, 2022 by Damon Germanides

Hot Hot Hot – Inflation Data Substantiates More Fed Rate Hikes

Inflation paired with a sluggish economy wreaked havoc on the equity markets this week. Equities fell hard (before rising on Friday) while bond spreads widened. Inflation remains public enemy number one as a hotter than expected CPI report confirmed what many of us already know… Inflation is running strong and has yet to subside. Once inflation seeps throughout the economy, it is notoriously difficult to regain composure without the Fed breaking some part of the economy or the market. Fed Chairman Powell suggested this much when he said he “cannot guarantee a soft landing” with the economy as the Fed raises short terms rates and begins to tighten its balance sheet.

Prepare For Continued Volatility

Expect continued volatility as market participants work through their models on where the Fed funds rate will settle in. This will determine if earnings and multiples on equities require recalibration. The highly speculative crypto space had a horrible week with $800 billion in value evaporating from the market. Fears of systemic risk have been discussed but have since been discounted. These types of conversations take place during bear markets and are often preludes to a market blow-up or recession.

Real estate remains a favored asset class in times of inflation. This should bode well for a housing market that is already constrained by supply. However, in bad markets, all asset classes tend to re-price. It is hard to say if the supply limits are such as to not affect a drawdown in home valuation. Banks remain eager to lend and with interest rates increasing, we expect a very competitive lending landscape. This should result in lenders willing to take a tighter margin to get money out the door. Underwriting standards remain robust, so loan quality remains high. This is good for banks and ultimately the economy. We don’t expect a repeat of the 2008 financial crisis, even though we see a tough year in markets.

Interest rates touched well above 3.000% before falling later in the week. The yield curve remains very flat as we stay on recession alert. With consumer sentiment and business sentiment negative, this should help slow down spending… And hopefully, bring down demand while lowering inflation.