Market Commentary 5/20/2022

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 5/6/2022

Fed Chairman Comments Fail To Calm Markets

Fed Chairman Powell appeared to be in high spirits after his press briefing on Wednesday this week. His commentary, along with the only a .50 bp hike to the Fed funds rate, was lauded by U.S. equity markets.  Markets appreciated his willingness to take a .75 bp rate hike off the table. They also found relief in the fact that an impromptu FOMC did need to take place to address current economic conditions. Despite the temporary mirth, Thursday’s depletion of markets around the world suggests the Chairman’s comments were flawed.  Critics question the removal of any policy response with so many conditions at play: a tight labor market, aggregate demand greater than what suppliers can deliver, a war in Ukraine, and COVID-induced lockdowns in China. The bond market is skeptical of this rhetoric, as the 10-year Treasury is now above 3.000%. This is an interest rate that many experts believed would not come to light for a long time, if ever.  In addition, mortgage rates are now touching 13-year highs. Equity markets are re-pricing risky assets as speculators are getting crushed amidst fear running high.  

Just How Bad Are The Markets?

The traditional 60/40 stock to bond ratio is down over 10% year-to-date. Ultra-low bond rates have not provided the ballast that higher-yielding bonds would have given in previous down markets. With inflation running above 5%, even as high as 8.5% in some cases, there is nowhere to hide. 

Although investors are worried, it is important to note that the U.S. economy is currently doing well. This is evidenced by the April Jobs report and the fact that wage growth is moderating. The stock market can be irrational and is not always indicative of actual economic health. Inflation does remain a problem. Fortunately, the Fed is doing its job by speaking tough on inflation. High beta stocks have lowered along with other speculative investments.  As consumer and business confidence crumble, prices will eventually come down. The big question is whether the Fed should be tightening more aggressively or continue to proceed with a “go slow” mentality.  Many experts would like to see the Fed move quickly to get in front of inflation and then adjust policy once inflation is tamed. 

Moving Into Creative Financing Options

As we indicated a couple of weeks ago, the WSJ is now writing about rising rates and borrowers becoming more creative with financing choices. Most notably is the move into adjustable-rate mortgage products. ARM loans adjust after a fixed-rate period but have much lower note rates. With 30-year fixed-rate mortgages above 5.00%, ARM products can still be had at rates under 3.00%. While these products are not for everyone, given the escalation in rates, these programs offer lower monthly payments and are becoming quite popular in the current rate environment. This is especially true in more expensive areas like Southern California.  

Watch the full statement from Fed Chairman Powell here.

Market Commentary 4/29/22

GDP Slows As Fed Eyes Rate Hikes

It’s becoming clear to everyone that the Fed failed to act sooner. There is now a 50% -50% chance of a .75 bp Fed hike next week, in addition to the many other indicators that are turning negative on the U.S. economy.  Stagflation is now being talked about as a real threat (stagflation is the combination of slow growth and rising prices). The employment picture remains tight which supports the “no recession” argument, but this time may still be different. The combination of the geopolitical issues in Europe, global inflation, rising energy costs, a zero-Covid policy in China, and general overall unease, may produce a recession quicker than many analysts believe. Big tech names such as Apple and Amazon reported worse than expected earnings and warned of tougher times ahead due to supply chain disruption and margin declines due to inflation. While the major indexes are down from 12% to 23%, many stocks are down 50% or more. Speculation is being sucked out of the equity markets which will affect how investors look at all types of assets: private equity, real estate, and bonds. The risk premium is increasing on investments as both equity and bond markets get hammered. Remember the human psychological component of investing, when every investor runs for the exit, the price is whatever you can get and not what that asset is worth. Watch the VIX index this week, also known as the fear gauge, to blow out as a sign that near-term market capitulation is finally over.

Personal savings is going in the wrong direction as inflation outpaces gains in income.  This speaks to the heart of the issue and why I believe the Fed will let the equity market fall much further than some pundits believe. Why, you ask?  The bottom 40% of the U.S. workforce cannot handle double-digit inflation. The combination of zero interest rates and too much stimulus has now created a massive demand shock, too much money chasing too few goods. While raising interest rates will not solve this issue overnight, the downside volatility in equities will discourage consumers and businesses from spending money. This should quell inflation over time.  The Fed will come to the equity markets rescue at some point (if need be). However, we are a long way away from that conversation. 

The yield curve remains on recession watch as the 2-10 and 5-10 year U.S. Treasuries are flat. This is beginning to affect lending rates across all product offerings since ARM’s vs. Fixed rates are also pricing at nearly the same note rate.  With mortgage rates on the rise, and affordability becoming stretched due to higher interest rates, the housing market appears to have peaked. Unlike 2008, loan underwriting remains robust, so while there could be a drift down in home values, it is hard to see an outright correction on the horizon. There are also many potential homebuyers who gave up the last year and a half on buying a home, who may re-enter the housing market should prices correct slightly. The refinance market is drying up as ultra-low interest rates have pulled forward demand and so many mortgages were written with sub 3.00% debt. As stated previously, caution is warranted as the return of capital becomes more important than the return on capital.

Market Commentary 4/15/2022

Economic Worries Intensify As CPI Hits 40 Year High

Central bankers across the globe are raising rates in response to inflation. The world has become increasingly volatile and dangerous with the war in Ukraine, China-Taiwan tension, Israel-Iran flare-ups, Covid lock-downs in China, and rampant inflation globally. The long-term consequences of inflation are quickly becoming a major threat to world harmony.  Rising prices impact the poorest people most, and in any measure of inflation anywhere in the world inflation is at 40-year highs. 

Once thought to be a problem for past generations, the combination of too much stimulus and a Fed that was certain (wrongly) that inflation would be contained even with zero interest rates, has put the Fed Chairman on his back foot.  The Fed definitely has the tools to crush inflation, however, their blunt instruments to combat inflation could also create a recession or worse. Many important economic indicators are flashing warning signs: yield curve inversion, CPI over 5%, and oil doubling in price are major headwinds to the economy.  Consumers are worried while businesses are struggling to keep up with increased costs and a lack of workers. Full employment complicates the story as the economy appears to be healthy, but, inflation readings this high and a Fed committed to multiple rate hikes in 2022 can quickly slow down economic activity (this is what the Fed is desirous of).   

Interest rates have risen dramatically, especially on 30-year fixed-rate mortgages.  With 30-year money near 5%, adjustable-rate mortgages are gaining traction as the preferred product. While ARM products carry interest rate risk after the fixed-rate period ends, the delta between ARM products and 30-year fixed products is wide enough to be the product of choice for jumbo loans. Should rates move higher (which is likely), expect housing demand to slow. There are already signs that housing has peaked as new home builders are sitting on more inventory, and second home sales are slowing. Finally, one important point to ponder is the massive amount of homes bought by investment companies such as Black Rock.  These institutional buyers may flood the market with homes at the first sign of a slowing down. While a major downdraft in housing is unlikely, it is quickly turning into a buyer’s market in certain areas.  Southern California remains supply-constrained. To date, the rise in rates has not materialized into a major slowdown as of yet. Caution remains the word of choice.

Market Commentary 4/1/2022

U.S. Economy Complicated By War, Inflation, Yield Inversion & Strong Jobs Data

Nonfarm payrolls added close to 500,000 new jobs in March in an already tight labor market.  The unemployment rate dipped to 3.600%, a tick above the 50 year low of  3.500% back in February 2020. The long-term jobs picture is concerning as there are many more job openings than jobs available. The large number of job openings relative to the population actively seeking work could cause wage inflation to rise faster than economists prefer. Wage inflation is both sticky and a big component in overall inflation readings. Should companies have to pay even more for new hires, those companies will do all they can to raise prices to offset the higher employment cost. This in turn raises all prices, and so on and so forth.  It becomes clear how inflation can become embedded throughout the economy as you game this out, and why the Fed is talking up rate hikes to cool off the economy and lower inflation expectations. 

The PCE, the Fed’s preferred method of inflation came in at 6.40%, a 40 year high. PCE strips out volatile food and energy costs. Many forecasters see a 9% plus CPI number for March. Inflation is real and probably not going away any time soon. Using the PCE as an example, the Fed funds rate in real term is -6.15% when measured against inflation. This is destructive to savers and imposes a hidden tax on the population. Caution is warranted as the Fed’s policy shift stands for the benefit of main street, which may very well come at the expense of Wall Street.   

With the Fed moving away from QE and intending to initiate both higher rates and QT, there is an increasing probability that the Fed may put the U.S. into a recession. This may not occur in the immediate moment, but prior to the end of 2023. The flattening and momentarily inverted 2-10 yield curve is supportive of this thought. How far the Fed will be able to raise short-term rates is unknown, but bond trading supports not much more than 2.00%-2.500%, which still leaves short-term rates negative when measured against present inflation. Fed hikes much higher than this level could be quite destructive given the absurd amount of U.S. debt. The Fed is truly embarking on a journey “where no man has gone before” when it comes to Fed policy. 

Now, a few general observations. The war in Ukraine remains an international concern, but the markets for the moment seem to have moved past the troubling headlines. Also, the oil markets are trading better which will provide some relief to consumers over time. Mortgage rates are no longer cheap and the rise in interest rates will slow the pace of refinances. There are approximately 6 million homes that can still benefit from a refinance, down from 14 million not too long ago. However, the purchase market remains active. The dream of homeownership has not cooled as of yet. On the higher end, many potential buyers we speak to are looking to make gains from the stock market, or crypto market, to buy real estate. The recent volatility which saw many asset classes get crushed early in the quarter and then resurge probably has a lot to do with the desire to move into the safety of real estate. Moreover, lack of supply (as we have spoken about in many blog posts) will provide a natural floor to how low housing in markets such as Southern California may go down, even if the overall housing market is slowed by rising rates.

Market Commentary 3/25/22

Flattening Yield Curve Worrisome As Economic Growth Slows

I feel as if I have seen this movie before. With that thought in mind, the idea that this time may be different is what makes previous patterns in markets hard to handicap.  But, make no mistake, a flattening yield curve is a worrisome sign. This is especially concerning, given how hot inflation is currently running and where low-interest rates are at present.  The bond market had a terrible week as 30-year mortgage rates hit near 5.000%, which is a dramatic increase from the 3.25% or so rates were at the beginning of the year. I also find it strange that the equity markets are surging on a week when bond yields have risen to levels not seen in several years. The erratic behavior of the market is one reason why it’s so difficult to both predict the future or place big investment bets in one direction or the other. Even when all signs point to an outcome, that outcome may not happen.   

Take housing as an example. Given the lack of housing supply, the way in which rates will affect housing demand remains uncertain. I do expect sales to slow as the combination of very high inflation and much higher mortgage rates are not favorable. Yet, at the moment, many real estate brokers remain very busy and our office has a near-record amount of purchase volume.   

One of the great joys of my job is speaking to so many people each and every week. One client who is in the online retail business informed me that as soon as gas hit $6 per gallon, the business fell off a cliff.  Disposable income is getting eaten up by life’s necessities in a way unseen in over 40 years. Gas prices, food, rent, you name it, and the price is higher.  There is much talk of the strong possibility of a 9%-10% CPI print.  Should this happen, the Fed will need to act quickly and strongly with at least a .50 bp increase in rates and perhaps even do so sooner than their next meeting.  Inflation is beginning to erode economic growth. Bond guru, Jeffrey Gundlach, said recently that he is on recession watch. He looks at the 2-10 and 5-10 Treasury spread as one of his main predictors of a recession. Should both of these spreads go negative from very flat, he fully expects a recession.  A steepening yield curve will give the all-clear. 

Now for the positives. One, real estate has historically been an excellent hedge against inflation. This means that should the markets swoon, investors may want the security of a hard asset such as real estate. Two, a more downbeat mood opens the door to better negotiations between buyers and sellers.  As the market normalizes, there is a chance there will be more homes for sale or that sellers will be willing to work with potential buyers in ways that have not been seen over the last two years. Finally, rates are still attractive from a historical perspective (real rates are deeply are negative when measured against inflation), especially adjustable-rate mortgages (ARMs).  While it seems likely the 30+ year bull market in interest rates has been broken, let’s not forget the 10 year Treasury is still only at 2.48%. 

Market Commentary 3/18/2022

Inflation Is Real As Fed’s Hawkish Signals End Of Ultra-Low Interest Rates

Inflation is real. Consumers are getting hit at the pump, in the grocery store, and beyond.  Don’t be fooled, inflation will not magically go away any time soon. The reality is that the Ukrainian-Russian war will keep oil high as well as, some other key commodities. China and South Korea are in lock-down due to a surge in cases that will add more disruption to the global supply chain. Pile on the other disruptions over the last year and it seems virtually impossible that inflation will cool anytime soon. The Fed will continue to act as it has moved its focus from Wall Street to Main Street. With employment next to full and inflation anywhere from 5% – 8% (and probably going higher), there is a minimal political will to keep interest rates low. Although equity and real estate investors love low-interest rates, Fed inaction has caused inflation to become embedded in the economy. As a result, inflation will be harder to tame. I was happy to hear the Fed admit some error with inflation and offer a stance on rate hikes and balance sheet tightening.  The old saying of “don’t fight the Fed” applies not only when interest rates fall, but also when those same rates rise. Be careful of more volatile markets as the Fed raises rates and all investments become re-rated based on higher discount rates. This will lower the present value of all investments.

Mortgage rates are up dramatically. The 30 year fixed rate touched a low of about 2.500% during the pandemic. That same rate is now near 4.000%, which is a 60% rise. This impacts the demand for housing and the pool of available refinances. The one wild card is the low level of new and existing inventory (which I have spoken about) as a natural floor to prices dropping by much, even in the face of higher interest rates.  Nonetheless, higher rates will hurt economic growth as everything from home loans, to corporate, auto, and personal loans will come with higher interest rates.  This will limit the amount of money available to consumers to buy other goods and services. Luckily, our office is still seeing strong demand for purchase money loans, a sign that the higher rates have not cooled the market just yet.  We are witnessing savvy buyers negotiate better prices. 

The overall global market remains very hard to handicap. There remain several headwinds that could create a “flight to quality” scenario into U.S. Treasuries including escalation by Putin, a new variant of COVID, or shutdowns in China and throughout Asia. This could further complicate Treasury yields.  The world is also experiencing geopolitical tensions at a level not seen since the Cold War. I am keeping an eye on the flattening yield curve as a recessionary signal, as well as the VIX index as a sign of bullish/bearish sentiment as the equity markets work through varying degrees of concern. I will also be monitoring consumer sentiment and housing demand in the coming months. 

Market Commentary 3/11/22

Spreads Widen On Mortgages As Inflation & War Weigh Down On Markets

The global economy remains on edge with the war in Europe and surging inflation. Many of us are worried about the state of the world, our savings, and the cost of living; especially after two years in a pandemic. Consumers are very concerned about the rising costs of food, gas, as well as other goods and services. Too many headwinds remain to write with any conviction about where the economy or the markets are headed. It certainly feels eerie, but may encourage some greater risk-taking for those who can stomach the volatility. Fearful times usually present opportunities. However, no one can say for certain if this time will be different. 

I remain of the mindset to look for good quality investments which require digging into financial statements and determining if the business has an investible moat around it and a good balance sheet. The meme stocks have been crushed and unfortunately many people have learned the hard way how challenging investing can be. The same thought process applies to buying real estate when volatility picks up and sentiment sinks. The combination of more fear and higher interest rates should be a tailwind for new buyers. Also, with no more easy money being made perhaps buyers will be less excited about bidding up houses. However, the limited supply of homes in big cities such as Los Angeles will provide a floor to prices. This will keep home valuations steady even as the major U.S. indices flirt with bear market drawdowns. 

Interest rates should go higher near term. Regardless, the flattening yield curve must be watched closely and could limit how tight Fed policy may become. Recession talk has picked up as of late. High commodity and food prices along with ongoing supply chain issues do not bode well for GDP growth.  Consumer confidence, the best form of stimulus there is (when we feel good about the world we spend more) has languished. The war in Ukraine touches many emotional nerves and should keep consumer confidence low until it ends (hopefully soon).  Put all of this together, on top of our massive deficit, and it makes one wonder how far the Fed will be able to go with rate increases.

Market Commentary 3/4/2022

Ukraine Weighs Down On The World As Bond Yields Drop

The Ukrainian-Russian conflict is top-of-mind for global markets. Volatility has soared with the VIX index, a.k.a. the fear gauge rising above 30. This number is important because it represents a more fearful market, as investor sentiment has been trashed by the recent wild market moves. While contrarians would argue to buy when fear is high, this time may be different. It is hard to handicap Mr. Putin. For the moment, neither sanctions nor the threat of being banned from Western nations’ economies has deterred his desires over Ukraine. 

The February Jobs report was solid. Unemployment fell to 3.80% and wage inflation was moderated, which is helpful for bond yields. While oil prices have broken through 100 per barrel and other food sources and commodities linked to Ukraine have also risen greatly, the reason can be explained away due to the Ukrainian conflict.  Wage inflation is the most sticky type of inflation. As those numbers came in below expectation, the Fed has more time to raise rates in the coming months.

These are truly scary times. It feels as if the world has become much more dangerous in just a matter of days. While good for U.S. bonds and to a lesser extent U.S. real estate and U.S. equities, should this conflict drag on, markets may experience continued draw-downs and in effect shake consumer confidence. Real estate has tangible qualities that make it attractive in this type of environment and may hold up better than other types of assets.  However, the odds are increasing that a recession may be on the way, so caution is warranted.  Also, lenders are slowly lowering rates even though our Government debt has dropped precipitously.  The overall market remains near impossible to handicap. 

Market Commentary 2/25/22

Russian Invasion Slows Pace Of Fed Tightening Plan

The Russian invasion into Ukraine sent global markets on a wild ride with globally traded public securities, bonds, commodities, and crypto trading.  Wednesday evening was a sad day as I witnessed the first invasion of Europe in my lifetime.  The last few years have certainly been challenging for everyone due to the pandemic. The destabilization of a European country will continue to create additional known and unknown risks throughout the world at a very delicate time. While our economy is doing well overall, it is also slowing as inflation inhibits consumer spending ability. The Russian invasion of Ukraine will add more pressure to food and oil prices. While we hope sanctions move Putin to negotiate, he is simply unpredictable.    

The U.S. being the safe haven in the world witnessed a quick drawdown on equities this Thursday morning, which turned into “a rip your face off” type of rally. The old trader’s adage of “buy on the sound of cannons” certainly played out.  Bond yields sank but then reversed higher and gold and silver traded down as well, which I found to be curious.  The reason bonds yields rose is due to unprecedented global inflation.  Ultimately, the bond markets quickly overcame their concern about what Putin may do to Ukraine and beyond.  Personally, I believe we have yet to see the worst of Putin’s intentions. There could be very troubling days ahead in the market.  Make no mistake, China is watching all of this very closely, as its own ambitions to take control of Taiwan cannot be forgotten. Additionally, the relationship between Russia and China has been growing more established over the last few years.

As the world has become more dangerous overnight, real estate should benefit as a less volatile asset to own.  Good solid real estate holding at a reasonable price will continue to be sought after.  Also, as many investors have had a great run in the equity portfolios, I am hearing anecdotally from several financial advisors that those investors with big gains are looking to cash out their winnings for either a new home or a cash flow producing property. 

The demand for U.S. bonds during more unstable periods should keep a lid on high bonds as yields may go. However, as inflation is running at the hottest rate in over 40 years, rates will need to rise (but probably not as much prior to the conflict).  This will be good for tech stocks who were very worried about the 10 year Treasury quickly moving north of 2.500%. While rates can move higher over time, the pace will be more gradual now.  Borrowers should take note that there is still time to lock in favorable interest rates. This opportunity could quickly change if there is a pullback by Russia over Ukraine. For the moment, this seems unlikely, but still cannot be totally discounted.