Residential fixed investment weighs on growth
The below graph reflects ongoing cycles and trends in fixed investment in the U.S. economy, as well as several economic crises. The yellow line reflects the vagaries of residential fixed investment: how hard it is to be a large mortgage lender, or perhaps how well the U.S. banking system, as well as U.S. economy is regulated. No wonder the government is debating the shutdown of the Government sponsored Entities (GSE’s) of Fannie Mae and Freddie Mac. Residential investment goes through terrible swings in volatility and appears to be a pro-cyclical menace to the U.S. economy, much like a modern-day economic Frankenstein’s monster. Yet, prior to the November mid-term elections, don’t expect Republicans to support the current bill to do away with the GSE’s. This article considers the importance of investment, including residential investment, in the support of U.S. consumption data and the implications for investors.
For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
The U.S. residential real estate market: Too big to fail
At the end of the day, it’s unlikely that the government will cede control of the housing market to too-big-to-fail or regulate banks. After all, nothing supports the middle class consumption data better than a stable and rising house price, much like nothing supports upper-class consumption like strong stock prices. Housing is middle America’s investment portfolio. Period. And as goes the housing market, so goes middle class consumption. Simply put, housing market prices are too central to the stability of the U.S. economy and its government to be left to the willy-nilly forces of free market economics and major U.S. banks—no matter what Larry Kudlow says. This is why the housing-dependent middle class is reluctant to cede control of their only asset to privately owned banks. Individuals seem to trust the government more than the private sector when it comes to ensuring honest underwriting standards as well as adherence to foreclosure policies and procedures.
Residential investment: What went wrong
The above graph reflects the difficulty in managing the U.S. residential real estate market. It would seem that both regulators and credit rating agencies were lulled into a false sense of complacency, as housing data was less volatile from 1990 through 2007. With such stability in prices, and housing bouncing along at a steady 5% of GDP, what could possibly go wrong? Given that housing was so stable, it was clearly in the public’s best interest to lever up—debt finance more and more of this wonderful wealth-creating machine. Enter the subprime mortgage era and adjustable-rate mortgages. As usual, what can go wrong eventually did go wrong.
The multibillion-dollar settlements that big banks have made with the U.S. government since the subprime crisis aren’t new news, though they’re a horrible reminder of what disaster can occur when big banks even operate under regulatory guidance. Far too many ninja loans (no income, no job) were originated, which occurred with such frequency as to ultimately destroy the integrity of the mortgage pools in which they were placed, securitized, and sold to old widows, orphans, PIMCO, and Iceland.
Great idea, opportunistic execution
It would appear that the big banks, in all their earnestness to get America’s poor into their own home, went a bit too far in this endeavor. The fallout of this failed execution wrecked it for everybody. The positive economic externalities associated with homeownership versus the slum lord option for America’s poor are easy to identify. Yet low-income lending has been weak, as the banking industry has been in the leverage penalty box since the crisis, sparring with regulators over what constitutes equity, and what constitutes debt. In the meanwhile, the price of stocks and bonds are 20% above pre-crisis peaks, while the average house price is 20% below pre-crisis peaks. The middle class portfolio is going nowhere, and the housing market still suffers from extensive shadow inventory overhang.
Why consumption languishes
As we noted in the prior article of this series, lower-income Americans have been hit hard since 2008. Not only have their real wages fallen for years, but their home values are still quite low. This is what has cooled the growth rate in consumption. This has been a terrible economic dynamic. However, as the economy recovers and middle America is finally starting to see real wage gains after years of financial duress, it would appear that growth is on the way. High earners have benefitted from high prices in stocks and bonds. Overall investment is picking up, though housing is still the laggard—just like middle class consumption data.
To see how overall investment—with the exception of the housing sector—is recovering, please see the next article in this series.
For a historical overview on fixed investment in the USA, please see Greenspan’s lament: The lack of fixed investment in the U.S.
Equity outlook: Cautious on China’s rate collapse and Russia
Tensions in Ukraine have led to a 20% sudden drop in the Russian stock market. China’s Shanghai composite index is also down 20% from its 12-month peak. The VIX volatility index in the USA has risen from its 15% lows earlier in the year to near 17.0% currently. This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is quite normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in the U.S. markets is driven by the tensions in Ukraine and evidence of some deterioration and oversupply in China.
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting Trust product investors take the losses on this 10.% coal company loan, it might appear the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk—just as Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers–structured investment products. This should keep the speculative investment climate a bit cooler in China.
China’s short-term interest rates plummet
While the allowed defaults in China should cool speculative investing, the China Central Bank has also been careful with interest rates in order to rein in speculative lending. The summer of last year saw the seven-day benchmark lending rate spike over 10.0%, with a run to near 9.0% at the end of 2013. Currently, the seven-day repo rate is at 2.50%. With the specter of shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured ultra-low interest rates. Cautious investors could see this as a somewhat extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be quite nervous about potential credit market contagion.
Given China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvement in the current economic recovery.
For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).