I apologize that my thoughts for this month’s article are somewhat scattered. This is partially due to everything going on with Altus itself. The ongoing capital raise and two projects in which we are pretty bullish have resulted in a reduction in time available to spend to fully flesh out my thoughts. But it is also due to economic data that seems so disjointed and providing so little clarity around the direction of the world’s economies, various securities markets, etc. Among everything else, I spent three days in Dallas this month at an investment conference. It was an entertaining (at least for wonks like me) and enlightening experience.
- The ten-year treasury has been moving down consistently since the beginning of the year and has completely fallen off the table over the last week or so. Rates are as low as they were all the way back in July/August of 2017 and a whopping 1.05% below where they were as recently as last fall. To paint a clearer picture of the magnitude of the move, this is a relative change in rates of 32.5%. This indicates that the bond market has greatly reduced their expectation of inflation over the next ten years, and most likely along with it, their expectation of economic growth.
- As discussed in this space previously, interest rates are inverted. WAAAAY inverted. And have been for some time. Not all recessions have been preceded by yield curve inversions, but since 1921 all yield curve inversions have resulted in recessions. There have been seventeen recessions since 1921 and all have followed yield curve flattenings. Does this mean for sure we will have a recession over the next 12–24 months? No. As the investment world is constantly disclosing, past results are not indicative of future performance. However, when something has this high of a correlation it makes sense to take notice.
- Unemployment is at record lows. This is good news, right? It is good news for today, but it is another leading indicator of a coming economic slowdown, almost by definition. Economic growth happens either through growth of the workforce or improvements in production efficiency. Production efficiency is positive but not dramatically so. This means economic growth is dependent on the growth of the work force. But if the work force is fully employed, then there is no more room for growth.
- Interestingly, even with some recession indicators flashing red and the Fed having exercised a level of quantitative tightening, there is still substantial amount of uninvested money in the economy. There is also a shortage of housing in many US markets. Cap rates, on which real estate prices are based, largely follow interest rates, though the spreads expand and contract at various times. If interest rates are following and there is still a ton of liquidity looking for a home, then cap rates will also logically fall. Cap rates and real estate prices move in opposite directions. Lower cap rates mean higher prices. We could quite easily have a situation where the economy is slowing but real estate prices are increasing. At least for certain asset classes whose operating income is not as directly tied to economic performance. Also interesting in this analysis is that the cap rate and interest rate spread (as measured on Class A apartments in primary markets) is relatively healthy. Joe Anthony, head of JP Morgan’s Real Estate Asset Management Group, calculates the spread at 228 basis points. By comparison, it was negative in 2006.
- Other Real Estate fun facts:
- According to Barry Habib (and I have seen this data presented by others as well), home prices are not correlated to recessions. Five out of the last 6 recessions have not caused home prices to drop. It could be argued that the sixth recession was caused by dropping home prices. With millennials median age now reaching 33, which is the prime home buying age, he believes there is another 6+ years of solid home buying numbers ahead of us. Habib was recently named the top Real Estate forecaster by Zillow and has been awarded with the Crystal Ball Award for the most accurate real estate forecasts out of 150 of the top economists in the US.
- However, there is a large mismatch of the homes that are needed, what is available in the open market as baby boomers downsize, and what most home builders are equipped to build. This could lead to falling prices in certain areas (like expensive zip codes in Connecticut for instance); and strengthening homes sales and prices in entry level houses due to lack of supply. This is, in fact, what is happening with the median home price recently. Softness in the median home price is not due to prices dropping overall, but rather more sales at the lower end of the spectrum.
- John Burns calculates that the renter pool is going to grow by 6% through 2025 and the entry level buyer pool is going to grow by 11%. These are good numbers for apartment owners and entry level builders. The real opportunity may be in cracking the code of investment product that services retirees, which will increase by 34% over that same period, a staggering amount.
- Loan to values in homes are as low as they have ever been. Please note that this is a different measurement than loan to values in new purchases, which are relatively high with increasing housing prices. Underwriting standards are roughly where they were in 2002, which was as loose as they had ever been up until that point, but still far below how loose they were leading up the 2008 correction.
- Total profits in the US economy have been flat over the last several years. Earnings have looked better because of share buy backs. But share buy backs and growth in corporate debt are almost perfectly inversely correlated. This means that expected EPS growth, as extrapolated from the last several years, is likely overstated.
More tidbits: these are more philosophical takeaways from the conference:
- Inflation in the US was likely suppressed by shale oil boom. This would offset inflation in other areas of the economy. Matched with flat real wage growth, this may be leading to some of the social upheaval we have been seeing.
- The US dollar strength has also tempered inflation, while also holding down oil prices. This is not a virtuous cycle if you want inflation. A weaker USD, combined with higher oil prices (demand still growing, Venezuela and Iran supply reducing), may create inflation even in this late cycle. This is a different take on it than many people are forecasting over the next several years, hence the collapse of the ten-year bond yields. I try not to make projections, and while I understand this logic around the dollar strength and oil prices, the argument for low inflation seems more solid to me. Granted, I also thought there was a strong argument for inflation due to the quantitative easing actions taken by the various central banks, and I was obviously wrong on that one.
- Several presenters think MMT (modern monetary theory, otherwise known as magic money tree) is not going away any time soon because of where we are within the generational and societal cycles. It should be pointed out that MMT is not really a new theory, just a new name on an old theory. It has been tried multiple times throughout history, and all of them have ended very poorly. Details of those attempts can be found in the book “This Time is Different” which has been discussed in previous Insights.
- Presenters from several different disciplines felt that we are moving into an extended period of societal volatility. This is not just in the US, but across the world. We have discussed this in previous Insights but that was largely prior to the current trade wars and China becoming more and more assertive/aggressive in their territorial/military ambitions. A couple presenters from China don’t think the trade issue will be resolved soon, and if it is, it will be a temporary resolution. They also felt there is a strong likelihood of military conflict between China and the US over the next decade, though it will likely be through proxies as opposed to directly between the two countries as superpowers.
- As an aside, another presenter made the case that protectionist policies are not correlated with economic growth; and pointed to several time periods through US history where the US was highly protectionist but also experienced high economic growth rates.
- Felix Zulouf: The time to buy index funds is over. Market volatility and mostly sideways movement over the next several years will reward stock pickers and market timers over index fund buy and holders. Central banks haven’t lost control of the markets. Rather their control of the markets will grow. But their control of economy will fall (we have already largely seen this with the weak effect QE had on the economy).
- Woody Brock: The current economy is not a true capitalist economy and has been taken over by cronyism. This is quantifiably evident with the percentage of income going to labor versus capital. Historically labor has averaged 65% of income, but since the 1980s that share has dropped to 60%. This is evidence of inefficiency within the markets. Since the 1660s when the role of capital was first introduced into economics (capitalism), living standards have improved 35x. Despite the widening income gap, relatively speaking, the rich were better off in 1660s than they are now.
- Several presenters mentioned that universities are stifling diversity and blocking upward mobility. This is a shift from where they were throughout the mid to late 1900s, and more akin to how universities operated in the early 1900s and backwards.
- Jared Dillian, ex Lehmen trader: Wall Street traders are not investing their own investment accounts in the stock market. They are heavy in cash and real estate.
I could go on, but this is probably getting a little long in the tooth. Interesting times. Interesting times.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.