Mark Luschini, Chief Investment Strategist
The housing market has slowed measurably as affordability declines—a consequence of rising prices and the spike in mortgage rates. In the case of the latter, high inflation and the Federal Reserve’s rate hikes designed to thwart its advance are the culprits. Housing activity and home prices are important indicators of the broad economy, as well as homeowners’ wealth associated with it.
We have frequently expressed our view that, generally speaking, households are in healthy financial shape, nourished by a robust labor market and a formidable supply of pandemic savings. The dramatic rise in home prices was also a sizeable input to lifting household net worth to record levels at the end of last year. Collectively, these factors served as powerful tailwinds for consumption to overcome slowing economic activity. This activity was dragged lower by high inflation and the lack of a renewed round of fiscal transfers to bolster bank accounts.
Housing and Consumption
Housing has a discernable impact on spending via the wealth effect, so a sharp decline in home prices could prompt homeowners to retrench their spending impulse. Indeed, some put forward a theory that consumption may be more sensitive to falling home prices than rising ones. However, we don’t envision a replay of housing price drawdowns of the Great Financial Crisis. Although home price appreciation is in the process of decelerating, housing remains undersupplied and home prices should not fall precipitously if demand doesn’t collapse.
Consumers, flush with an abundance of excess savings they accumulated throughout 2020 and 2021, provide the foundation for our constructive long-term view on the economy and risk assets. While the wealth effect is real (household spending fluctuates with changes in net worth), consumer spending is predominantly a function of income. Therefore, job stability plays a non-trivial role in propelling domestic growth that is augmented by changes in net worth.
We recognize that nearly two-thirds of households own their home, and it is far and away the largest asset for many families. Stock ownership, for point of reference, is less than 50% of assets and a large concentration of common stockholders are among the wealthiest households. Put differently, fluctuations in the stock market mostly impact households with a low marginal propensity to consume but changes in home prices affect a much fuller sweep of the population. Consequently, a weakening labor market concurrent to price declines in the housing market would apply a lot of pressure on spending and economic activity.
We hear murmurs that we could see a replay of the housing bubble bursting similar to the 2008-2009 period, when price declines nationwide were around 40%. We think that is highly unlikely. Residential mortgage originations have been made under much stricter conditions, including stronger loan-to-value ratios and vastly better credit scores.
Additionally, housing is broadly undersupplied, and inventories of new and existing homes for sale are not shockingly high in the case of new homes and well below what is considered equilibrium levels for existing ones. Certainly, higher mortgage rates have put monthly payments out of reach for some aspiring buyers, sending them to the sidelines or to rental units. However, new supply remains constrained and, historically speaking, home prices tend to fall slowly when softening.
Even if the eventual magnitude of a decline in home prices is significant, such a decline will likely not be sudden. Homeowners that are not forced to sell due to pending foreclosures or some other negative impetus that isn’t currently evidencing itself in the data, can be patient if set on putting their home on the market. Softer pricing will incent turnover to slow, and the reduced supply should further help to mitigate the declines.
The rising risk of a recession cannot be ignored and among the possible economic outcomes we ponder for the U.S. economy over the coming year, we acknowledge the scenario of a severe and/or protracted contraction that would undermine the fundamental supports for housing, and thus the economy overall. We continue to urge near-term caution, as the uncertain macroeconomic and geopolitical landscape can agitate bouts of volatility across asset classes. However, we believe the eventual deceleration in inflation that leads to a more accommodative posture from monetary authorities will be a positive catalyst, providing risk assets a path to recover. Stay tuned.
Move Fast and Break Things
Guy LeBas, Chief Fixed Income Strategist
In our recent FOMC Commentary, Anatomy of a Policy Error, we joked about how the Federal Reserve adopted the tech adage “move fast and break things.” Facebook’s Mark Zuckerberg wrote that line in 2012 and the significance is clear: When there are benefits to rapid change, execute the change, and worry about the consequences later. That phrase seems like good advice for a startup, but it is bad advice for an established entity and downright horrible advice for the de facto managers of an entire economy. Yet, 10 years after Zuckerberg published that philosophy, the Federal Reserve seems to have adopted that approach.
Why Things are Breaking
In 2022, the Federal Reserve has tightened monetary policy by raising interest rates more rapidly than at any point in 40 years. In the six months since March 2022, those hikes have pushed overnight interest rates from 0% to 3.25%, and most likely to 4% by year’s end. They moved fast and, not surprisingly, things in financial markets are breaking. The exact cause of breakages is not Fed policy per se, but Fed policy creates the preconditions for said breakages in a few ways.
First is the U.S. dollar. In 2022, the dollar has been on a tear, rising +14% to +26% against major trading partners. Countries around the world need dollars for international trade and other balance of payment issues. When the Fed tightens monetary policy by moving fast (specifically faster than its neighbors), the dollar usually appreciates and problems tend to arise.
Chart 1: BoJ Intervened After -30% YTD Decline in Yen vs. USD
In mid-September, the Bank of Japan (BoJ) was forced to intervene to keep its own currency from depreciating too severely. In late September, the Bank of England (BoE) was forced to put its balance sheet shrinkage on hold when a plunging pound, coupled with some fiscal missteps, caused UK borrowing rates to spike 1.25% in just three days. While neither the BoJ nor the BoE actions were directly the result of Fed policy, the Fed produced the preconditions for stuff to break by moving fast in the first place.
Second is intermediary risk taking. The financial markets rely on intermediaries, such as banks and broker/dealers, to act as shock absorbers. In fixed income, that means when the seller of a bond emerges, a bank will typically “warehouse” that bond temporarily while it looks to find a buyer. Market-making activity is crucial to healthy trading in Treasuries, corporates, and all sorts of bonds. When Fed policy is moving fast, however, there is a greater risk of sudden market swings, which means that market makers have to dial back willingness to warehouse risks (or demand more profit to do it). That rational decision then exacerbates the very volatility about which these market makers were most concerned. Again, the private market volatility is not precisely the result of Fed policy, but when the Fed moves fast, they tend to break intermediaries’ risk tolerances.
Third is external intervention. Typically, the Fed enjoys relative freedom from political interference. However, when they move fast, they tend to break this freedom, which comes with long-term consequences. Today, political bodies the world around are putting pressure on the Fed to stop moving so fast, with even the United Nations (UN) warning that the Fed should stop hiking rates to protect developing economies, which, so far as we can tell, is completely unprecedented. Of course, the UN itself is not going to directly affect the Fed’s ability to conduct monetary policy, but the UN statement is a symptom of the political pressure the Fed is facing from its rapid actions.
Chart 2: BoE Intervened in UK Bond Markets After 30yr UK Yields Spiked +1.25% in 3 Trading Days
Focus on Fed’s Pace
The Federal Reserve has many reasons to tighten policy. Chief among them is high and broadening sources of inflation in the U.S. (and also the global) economy. Raising interest rates slows economic growth, probably causes a recession, and thereby reduces inflation pressure. But the pace of rate hikes matters too. When the Fed moves so fast that the dollar appreciates sharply, intermediaries pull back, and political entities start interfering, and financial market stuff starts breaking. With any luck on the inflation front, that seems like a good sign that policymakers will at least ease off on the pace of moves, lest something even larger break.
To Tell The Truth
Gregory M. Drahuschak, Market Strategist
A month ago, Investment Perspectives asked whether September would be a month to remember or one to forget. As it turned out, for the wrong reason, the month will not soon be forgotten as the S&P 500 posted its third-worst loss for the month (-9.34%) since 1950 with only the September losses of 11.93% and 11.00%, respectively, in 1974 and 2002 worse. The loss this September was 2.5 times larger than the average loss when the S&P 500 had a loss in September.
Chart 3: 10 Worst Septembers for S&P 500
Stocks Grapple with Interest Rates, Inflation
The stock market struggled with the implication of what higher interest rates and a stubbornly high inflation rate might do to the domestic economy and how the rapidly rising value of the dollar might impact business for multinational U.S. companies.
In the midst of the market’s major concerns, however, corporate earnings expectations held up relatively well.
At the end of September, the 2022 earnings estimate was only 2.36% below its high and the 2023 estimate was only 4.39% from its high. Nonetheless, the S&P 500 is down 24.77% through the first nine months of 2022. The major question as the third-quarter earnings report period begins is whether the stock market has discounted the trajectory of corporate earnings for the next year and a half and how the market will capitalize the earnings drop stocks seem to be forecasting.
Any fundamental analysis of company results focuses on two key elements: revenues and earnings. At the same time, analysts recognize that of the two, only revenues are 100% reliable. Either something is sold, or it is not. Earnings can be adjusted by numerous factors.
A basic premise in technical analysis is that the price of a stock is the culmination of the collective intelligence of everyone buying or selling the stock.
You might not like what the stock price is saying, but assuming that you are correct and the market is wrong can lead to expensive disappointments.
As the corporate earnings report period begins this month, scrutinize the stocks you own for earnings, revenues, and other fundamental factors, but when you do this also open charts of the stocks. If what those charts display differs from what valuation metrics might suggest the stocks should be worth, remember the phrase “price is truth.”
Q4 2022 Begins
As the final quarter of 2022 begins, it is worth remembering the strongly positive market bias that in 14 of the 17 midterm election years since 1950 allowed the S&P 500 to end the quarter with a gain.
Deeply depressed sentiment and an oversold market condition combined with the election bias might be enough to allow the final quarter of the current midterm election year to produce a gain also.
Chart 4: S&P 500% Results—4th Quarter of Midterm Election Years
Of all the metrics investors adopt as valuation measures, the
venerable price-earnings ratio is the most debatable. The
urge to have a one-stop valuation method often leads to an
overly simplified use of P/E ratios.
For decades, a market P/E below 10 was considered
to represent solid value. For a long time, this was a fair
assessment but considering the composition of the market
today, a below-10 earnings multiple is extremely unlikely.
On the other end of valuation spectrum, a P/E well above
20 for many years was considered to represent an extremely
expensive market. The pervasive presence of technology in
many forms, however, could mean that many widely accepted
value metrics differ from what they once were.