May 21, 2021
By Steve Blumenthal
“So my issue here is, in the future, as we go forward, if we look at
Federal spending as a % of GDP, the CBO is saying if the 10-year
Treasury goes to 4.9%, which is their normalized projection, the interest
expense alone will be close to 30% of GDP every year, that’s basically
what we just spent on the COVID emergency in the last year.
There is no way we can afford to have 30% of all government
outlays be toward interest expense, so what will happen is that the Fed
will have to monetize that. When they monetize it, I believe it will have
horrible implications for the US dollar.
– Stan Druckenmiller,
Former Chairman & President, Duquesne Capital
Everyone believes that the Fed has our backs. That they won’t let the stock market crash. That they won’t let the bond market crash. Hold interest rates at zero and buy $120 billion worth of mortgage, Treasury bonds, and a junk bond or two each month and—for now—everyone may be right. But for how long? Don’t know. When it comes to the future, in my view, Druckenmiller is right.
The Mauldin Strategic Investment Conference concluded last Friday. Mark Yusko started the day with a rapid-fire presentation on the markets and crypto, John Mauldin interviewed famed distressed securities investor Howard Marks, and Danielle DiMartino Booth interviewed William White and Richard Fisher. The day concluded with a panel discussion with William White, Richard Fisher, John Mauldin, and renowned investor Felix Zulauf.
For some background, William White joined the Bank for International Settlements in 1994 as a manager in the Monetary and Economic Department and was appointed Economic Adviser and Head of the Monetary and Economic Department (MED) in 1995. In that role, he oversaw the preparation of the prestigious BIS Annual Report and had overall responsibility for the department’s output of research, data, and information services, as well as the organization of meetings for central bank governors and staff around the world.
Richard Fisher was president and CEO of the Federal Reserve Bank of Dallas from 2005–2015. In this role, he served as a member of the Federal Open Market Committee (FOMC), the Federal Reserve’s principal monetary policymaking group. He also served as the chair of the Conference of Federal Reserve Bank Presidents, the body that oversees the shared operations of the 12 Federal Reserve Banks. For five years, he served as chair of the IT Oversight Committee for the 12 Federal Reserve banks, putting in place the first systemwide CIO structure.
Danielle DiMartino Booth is the founder of Money Strong, an economic consulting firm, and author of best-selling book, Fed Up. Previously, she worked for Richard Fisher at the Fed.
For me, the White and Fisher discussion, led by DiMartino Booth, stole the SIC2021 show. Why? Simply because it provided a crystal-clear window into what’s going on at the Fed. The grand finale was the White/Fisher/Mauldin/Felix Zulauf panel discussion. It was outstanding.
The collective message is that the Fed is, as my dad used to say, “stuck between a rock and a hard place.” A difficult situation in which they will have to choose between two equally unpleasant courses of action. White and Fisher confirmed this view. They also confirmed that the markets are far too big for the Fed to have our backs. As such, we should be open to the potential that “What everyone believes” is wrong.
Wall Street veteran Bob Farrell’s 10 rules on investing come to mind, particularly rule number nine.
“When all the experts and forecasts agree –– something else is going to happen.” When everyone is positioned on the same side of the trade, something else will happen.
I speak with many advisors and wealthy investors every day. My conclusion is that most everyone believes the Fed has our back. The insiders are telling us that view is wrong. Since I write on Fridays, I missed most of last week’s closing day presentations, but I did watch the video replays over the weekend. For me, it wasn’t work. I loved it.
I share the Druckenmiller quote again with you this week just as a simple reminder to not put your full faith and credit in the Fed. Inflation may be transitory or not, but faith in the Fed—in my view—will once again prove to be transitory. More on the Fed next week, when I share with you my notes from William White and Richard Fisher’s discussion.
This week, I thought I’d share with you a short bullet-point summary from several conference presentations I found valuable: Barry Habib and Ivy Zelman on the current state of the housing markets and Marin Katusa on opportunities in carbon credits, which we’ll all soon know a great deal about.
This week’s On My Radar:
- Real Estate, Carbon Credits, and Active Management
- Trade Signals – GMO’s 7-Year Asset Class Returns
- Personal Section – It’s All About the Fed
Real Estate, Carbon Credits, and Active Management
Barry Habib and Ivy Zelman presented on Real Estate during this year’s SIC. It was timely, as the market is absolutely on fire. My friend Barry is CEO of MBS Highway. He and his team help mortgage originators better serve their clients. No one knows more about how interest rate policy affects the housing market than Barry.
Ivy is the CEO of Zelman & Associates, the leading housing research firm working with institutional and private equity investors, home builders, and managers of companies that depend on the housing sector.
Here are a few takeaways:
- We all know that we’ve got tons of debt, which brings future purchases forward—and it does create a lot of economic activity today. And as we know, inflation drives interest rates. So, we believe that the level of debt that’s out there, contrary to what most people think, will actually contain interest rates, and not drive interest rates higher.
- We think that this flurry of economic activity that comes from the stimulus will be ephemeral, and we think that it will wear off. GDP growth will slow by the fourth quarter.
- However, in the interim, expect a rocky road for the inflation numbers, as well as interest rates. Rates are likely to bump a little bit higher over the summer before resuming a downtrend.
- So, as we see inflation potentially rising over the summer, and while we agree that this will kind of peter out, we do think that over the summer months, we could see rates rise from their current low levels by about a half of a percent or so.
- Focus on the core rate of inflation because that is what the Fed is focused on. It strips out food and energy. I think we’re going to see a core rate of inflation at around two and a half, maybe higher, maybe two and three quarters percent.
- With current mortgage rates around 3% and core inflation at 1.6%, if we get 2.5% to 2.75% core, holding mortgage rates at 3% will be difficult. Expect a cruel summer for interest rates.
- However, we see it transitioning. We see it coming back. We see it backing down, and, hey, I’m going to put my neck out on the line like I’ve done before, and I’m going to say, “I think there will be either a recession or recessionary-like conditions 2022, 2023.” And I think that you may very well see a challenge of the all-time low in interest rates.
SB here: Put Barry in Dr. Lacy Hunt and David Rosenberg’s camp. Because of the massive size of outstanding debts, high rates will choke growth and slow the economy. The stimulus spending and all the printing/government bond issuance is transitory and so too will be their effects on the economy. By the way, I agree most with William White’s view that, in the short term, we’ll have inflation; in the medium term ,we’ll have deflation; and in the long term, we will have serious inflation. My gut says 2022 is looking like a probable recession target. Of course, much depends on unknowns such as infrastructure and other government goodies (when, size, etc.).
Back to Barry:
- The rules of supply and demand apply to the housing market. Demographics matter. The number of births spiked significantly 28, 29, 30, 31, 32 years ago. So, what does that tell us? What does that mean? It means that these people are coming, and they’re going to be coming in droves, and we think that that’s going to add to the demand side of the equation.
- On the supply side, builders did not get the memo about demographics.
Barry shared this chart, which shows household growth vs. annual completions (think new construction). In 2006, look at how much supply there was (gold bar) vs. demand (blue bar). Then compare it to the last few years:
- Housing inventory back in 2007 was 3.7 million homes strong. Today, we’ve got a million homes for sale. And if you take a look at the late ’80s, when we had a problem, there were also huge amounts of inventory. But here’s the way I’d like to look at it: In 2007, there were 116 million households. Today, there are 128 million households. So, let’s do the math. There are 12 million more households that are competing for three million fewer homes.
- Bottom line: Thanks to the classic laws of supply and demand, home values go up.
Barry said there is more equity value in homes today then in 2007. 87% of homes have at least 20% equity value (80% of the value is mortgaged). 37% of homes have no mortgage debt at all. This is not an underwater inflated housing market like ’07. Barry is bullish on the U.S. housing market.
- Just to give you some perspective, everyone and anyone who’s alive knows that the housing market’s red hot. But what I wanted to give you some perspective re: looking at the number of sales, what we call absorptions per community for builders.
- Over half of builders’ communities are actually limiting sales because they cannot keep up with demand, and their backlogs are getting very extended.
- Our forecast is that we’ll continue to see double-digit growth in ’21. And in ’22, we’ll still see very strong absolute growth, but we do know based on what’s in development and how much backlog and challenges and constraints there are, that it’s just not going to be possible for them to bring in more communities at a faster rate.
- So, the builders are very challenged to get their orders converted for their customers, and there’s a lot of frustration. In fact, many builders don’t even want to do dirt sales. They call it dirt sales because they write a contract, let’s say, for a half a million dollars. But then when that house closes, call it in 18 months from now, they’re going to have significant risk of their costs rising. And in fact, costs are rising at a spectacular rate. Talk about inflation. There’s inflation across the entire ecosystem.
On areas of potential focus, Ivy said:
- We’d be focused more on the tertiary markets. I think that direct investments with builders right now that are looking for less expensive capital than bank capital is a good opportunity. And I would say where they focus and where they should focus is in the areas in the country where household growth is the greatest.
- Target markets with the strongest household growth: DC, Utah, Texas, Nevada, Florida, Idaho, Arizona, North Dakota, Colorado, South Carolina.
- We are constructive on the Sun Belt multi-family markets, especially where there are suburban areas with little current supply.
Ivy added that she sees more multi-generational living ahead. Especially in more expensive coastal markets. Builders are focusing on that as a product offering. She believes home ownership overall is still affordable.
Barry sees a big trend in the use of reverse mortgages. This due to the appreciation in home equity values and need for income due to aging demographics. He said, “I completely agree that you will see more and more. It’s already happening, but it’s going to continue to accelerate.”
Mauldin Economics CEO Olivier Garret interviewed Marin Katusa, founder of Katusa Research and renowned speculator. Following are highlights:
Carbon credits will turn out to be the commodity of the 21st Century. Since 2018, the asset class has doubled Bitcoin and more than five times the 100% return in the Nasdaq.
Not a single research firm is factoring in the carbon offset costs that will impact corporations over the next five years.
- This will be a new item on financial balance sheets.
- ESG investing wave brings this forward.
Coming is the ability for the purchaser of a good to determine if they want to buy a product from a green manufacturer or from a heavy carbon emitting producer.
The world is moving to a 2050 carbon-neutral footprint. Europe has the most aggressive carbon-neutral goal. Currently, the world produces about 32 billion tons of CO2 per year. Think smokestacks at manufacturing plants, cars, trucks, air conditioning, etc. Anything that produces anything omits CO2 into the air.
If we do nothing, the dotted red line is where we are estimated to be in 2050. The black line is the Kyoto Protocol that they’re trying to get to. Carbon credits are a $16 trillion opportunity. The market is legitimate today, with verifications from firms such as PWC (PricewaterhouseCoopers, LLP) and all the big five accounting firms involved.
In America, there are 189 companies on the listed stock exchanges that said they have a target carbon reduction goal. In European listed markets, there are 268 companies with committed target reduction goals. Combined, this is a small number representing about 8% of all listed companies. Companies are just beginning to think about how to go carbon neutral. Herein lies the opportunity.
There are 2,410 companies in something called a Scope 1 category that have to report their target emissions. Only 8% have announced targets to reduce CO2 emissions but haven’t even begun to start to reduce.
There are 5,230 total companies in the US and Europe on the exchanges, with a market cap of more than $1 billion. Here is what Katusa believes:
- Over the next decade, accounting standards globally will incorporate CO2 emissions on the balance sheets as liabilities in some form.
- This will be used by ESG funds and green bond market (which will be the largest growing sector of the bond market) to track and rate coupons and flows of capital.
- Nobody is talking about this now—but they will in three to five years.
Here’s the bottom line: The cost of capital, driven by CO2 mandates and incented by markets will drive the value of the carbon credit market higher. ESG and sovereign wealth funds bring this forward faster.
There is a reward system in place. As my old friend Jim Ruff would say, “if you can’t measure it, you can’t manage it.” The advantages to a corporation’s bottom line in funding costs, etc. will become evident to all investors.
I’m going to spend a lot more time in this area. I’m not yet sure of the best way to play it, but it is one of the best-looking investment ideas that I personally gained from the conference. Stay tuned. More to come on this topic…
Trade Signals – GMO’s 7-Year Asset Class Returns
May 19, 2021
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Notable this week:
I normally post various valuation/forward return data in On My Radar. The SIC2021 conference has my mind spinning like a kid in a candy store, so the latest valuation data won’t make to OMR this month. And really, there is little changed in the story.
The broad stock market indexes are under early significant selling pressure, likely due to inflation concerns and associated Fed policy response (or lack thereof), the conflict in Israel, cryptocurrency concerns (i.e., Bitcoin slide). On the other hand, several major retailers and other consumer sector companies have reported solid earnings in the first quarter, as COVID-19 infection rates, hospitalizations, and deaths decline.
Yesterday, Ned Davis Research published a client research report reminding us that “[e]ven transitory inflation has slowed stock market rallies in the last 40 years of disinflation.”
The “Don’t Fight the Tape or the Fed” indicator improved to a “0” reading this week, which is slightly bullish for equities.
Trade Signals – Dashboard of Indicators follows next. Green continues to dominate the dashboard. Click HERE to go to the balance of Wednesday’s Trade Signals post.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Personal Note – It’s All About the Fed
If you have some extra down time, here are a few more links that may be of interest:
- More from the conference. George Friedman, Louis Gave, Emily de La Bruyere, and Mark Yusko: China Panel – SIC2021: “A Giant Consumptive Force,” by John Mauldin
- Not everyone at SIC2021 was bearish on equities. Howard Marks said he expects six to nine months of very good economic news, followed by “decent” growth for several years. He concluded by saying that equity prices are not in a bubble.
Marks is co-founder and co-chairman of Oaktree Capital Management, the largest distressed securities hedge fund in the business, managing $150 billion. He spoke on day three of the SIC2021. John Mauldin conducted the interview. Advisor Perspectives’ Robert Huebscher did an excellent job summarizing it here.
- YouTube interview: Danielle DiMartino Booth and William White. Former Central Banker Explains Alarming Debt Trap Facing America — Down the Middle, DiMartino Booth.
- If you missed last week’s OMR post: SIC2021 – Deflation? Inflation? Transitory? Define It? You can find it here.
Personally, I don’t agree with Marks that “equity prices are not in a bubble.” One could argue that when the cost of money is zero, the value of a company’s future cash flows is worth much more. And much more is showing up in the record high equity valuations we see today. The problem is that, for every basis point the 10-year Treasury rises, it changes the way you discount the value of future cash flows. As I wrote last week, inflation and rising interest rates are kryptonite to the bond and stock markets.
Thus, my obsession with the Fed and doing all I can to understand the behavioral dynamics inside it. I’m really looking forward to reviewing my White/Fisher/Mauldin/Zulauf notes. I’ll share them with you next week.
Wishing you a great week,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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