In this second installment of "What the Hec'onomy. Deciphering what is going on in the economy and markets" we will examine what the impact of rate hikes have been to date as well as other market forces at work in the economy.
The Residential Real Estate Market
Let us start by looking at the residential real estate market. If you were a homeowner with a mortgage during the close to zero interest rate era, it is likely that you would have taken advantage of refinancing your home when 15- and 30-year fixed mortgage rates were in the 1.7-3.25% range. At today’s mortgage rates of 6-8% you are less likely to move if you do not have to for work or other pressing reasons. For homeowners in this category, mortgage related costs have not gone up, which means that their overall purchasing power has been less impacted.
Add to this scenario, a shortage in housing inventory to the tune of five million homes, it does not take much demand for housing prices to remain steady or in an upward trend. It is also worth noting that the last 11 times the fed raised interest rates since 1955, during 10 of those times, home prices went up. The 11th instance resulted in a negligible decline in values of just 1%.
With supply side home builder material prices falling, builders are more than willing to meet demand. Add to this, a plentiful supply of home buyers who are not wanting to miss out and who remain undeterred by current rates given the strong economy, wage push inflation and easy access to credit, the retail real estate market remains robust.
The consumer is still not buckling in the face of interest rate hikes to date. For example, consumer non-housing debt which was $2.6tn in Q2, 2007 prior to the great recession is approximately $4.7tn today.
With GNP at 5% and a robust residential real estate market, let us examine the industrial real estate side of the equation.
Industrial and Commercial Real Estate Markets
The Inflation Reduction Act and The CHIPS Act has accelerated hundreds of billions going into shoring up the US Semiconductor manufacturing capacity so that the USA can become less reliant on international partners and corresponding geo-political risks that can impact supply of critical components to infrastructure and security. Likewise, billions are being spent on incentivizing the transition to green and cleaner technology to build a more carbon neutral footprint and correct the calamitous global warming trend.
State level governments are also competing with one another by offering huge corporate tax breaks to the tune of $24 billion in 2022 which is three times higher than 2021. That trend is likely to continue in the coming years. US. Manufacturing Facility Construction in the US is at 60-year highs. Between January and June 2023 construction for new manufacturing plants was $196 billion. The computer and electronics industry announced $100bn in new construction plans in the 2nd quarter of 2023, up 10x from same quarter two years ago.
Not all commercial real estate is doing well. The commercial office real estate space is languishing post COVID due to the rise in the work-from-home trend. This issue is systemic to a cultural change in how we work and is unlikely to change back to pre-COVID times. Lower occupancy rates mean lower revenue and valuations. That could be problematic when loans come due to be refinanced in a higher rate environment. A mid to long-term solution to addressing this is to convert excess office capacity to residential housing – where there is an inventory shortage – to restore supply/demand equilibrium and support to the local economy and businesses that have relied on office workers.
Foreign Investment & The Financial Impact of Two Wars
Foreign investment in the US is also growing: This was at approximately $5.3 trillion in 2022, up $216 billion from 2021.
Overall, the economy is seeing large investment and stimulus impacting land prices, employment and demand for goods and services across major regional hubs.
We would also be remiss not to mention the US support of two wars with billions and potentially trillions being added to the national debt. Afghanistan cost the US over 8 trillion dollars. Aside from adding to the burgeoning national debt, now over $30 Trillion, it adds liquidity into the economy fueling the industrial war complex and all associated industries and regional economies.
So, while the mainstream media has been focused on a “soft-landing” or “imminent recession” the economy is in large part healthy and strong. Eventually, as night follows day, the economic cycle will produce a recession, but for some time now the press has been barking up the wrong tree.
So, what do the credit markets have to say?
The CREDIT VIX was launched recently by CBOE Global markets to measure the confidence levels of bond investors. The indicators show that volatility has fallen since Mid-2022.
Companies are managing debt as the economy is doing well and the credit market is robust.
The inverting yield curve – the harbinger of a recession to come – is simply not showing the signs of that happening anytime soon, so the market response is: “sell long term bonds and buy short term bonds” as growth is not showing any signs of slowing, and interest rates are not going to come down anytime soon, given the Fed’s inflation mandate and strong GDP numbers.
In addition to the known $700billion+ unrealized bond losses being held by banks on their balance sheets, other lesser known but not insubstantial risks also lurk beneath the banking surface which were articulated well in an article by Arthur Hayes. During the close to zero interest rate era both pension and insurance funds were faced with the challenge of finding reliable yield to pay out benefits to their constituents. The oasis for finding yield were banks’ fixed income desks and the creative solution/product ended up being an interest rate option (callable note structure) which allowed pension and insurance funds to sell an interest-rate option and receive a premium (yield) in return. As a result of selling trillions of these products worldwide, the TBTF (too big to fail) banks now find themselves sitting on substantial losses as rising interest rates have worked against them, and hedging losses has continued to stack losses.
The size of the problem is not altogether known as these instruments are traded on a bilateral basis off-exchange. As a result, it is not altogether clear what level of interest rates and continued stacking of hedges could cause a systemic failure and at what banks. We can add the esoteric, mostly undisclosed, and gargantuan world of derivatives, a burgeoning national debt that is set to increase by 1-2 trillion every year for the next twelve years and rising interest payments on said debt to this complex equation as well. The US macro-economic picture is entering unfamiliar territory which is hardly ever written about or discussed by the mainstream media. The pattern of spiraling national debt by a leading power in which the financing of wars played a major part has plenty of precedent throughout history. All ended badly.
In summary, a sustained period of close to zero interest rates followed by a rapid rise in interest rates created both known and unknown systemic banking and economic risk that the Federal Reserve is tasked to manage. How well this has been managed is questionable as fed policy has been a significant contributor to both inflation and many of the systemic risks in the finance sector and overall economy. COVID provided the crisis and catalyst resulting in supply chain bottlenecks, supply side inflation, corporate price hikes and the work from home trend and the Fed provided everything else.
If GDP numbers remain strong, rents are less likely to fall and the Fed's 2% per annum inflation target may prove to be elusive. As mentioned, out of the eleven times the Fed raised interest rates since 1955, real estate prices rose in ten of these instances. If GDP numbers remain strong, hard asset appreciation is more likely to continue than not. As the cycle of price appreciation continues, it will reach an unsustainable point at which point the bubble will burst and the economic cycle will shift into a recession. Inflation and GDP will fall and a new re-set point will emerge along with a new rate-cut cycle.
The exact timing and way this will play out is unknown. At this juncture with GDP at 5% last quarter and all the economic incentives at work as described in this article, we are still in the growth stage of the economic cycle which is likely to get stronger as we head into 2024/5.