Turning the Ship
(1) The Government’s Pickle.
(2) So far, no change in demand.
(3) No sharp supply changes, either.
No one starts taking drugs with the intent to become an addict. Over time, habitual use of a stimulant leads to diminishing marginal returns for the user which encourages further abuse to get the same high. If that drug is abused for a long enough duration, the body will develop a chemical dependency that requires continual abuse just to feel “normal.” When the drug is removed from the system, the body goes through extremely uncomfortable withdrawal. If you think our economy is going to go through anything dissimilar, you are mistaken.
The Government’s Pickle
When an economy is recessing (read: sick), there are certain amounts of cheap money (read: drugs) that are good for the system. Problems develop when drugs are still administered even after the patients have recovered and that’s exactly how our economy got to this point in time. There’s no way President Trump could have predicted the COVID-19 pandemic when he passed his tax cuts, and it doesn’t matter — this legislation (in my opinion) was one of the worst things that happened to our economy in recent history and it’s finally playing out. Here’s why:
1) Passing tax cuts that benefit wealthy individuals (estate taxes, QBI, lower marginal rates, etc.) creates a lot of cash.
2) When interest rates are <2% and inflation is >2% (negative real interest rates), unlike less fortunate people who use tax cuts to fund their lives, rich people invest it.
3) No matter the channel (public or private), increased investment increases prices and return requirements.
4) Higher prices leads to higher return requirements which, in turn, forces investment managers and corporate executives to invest in more projects.
5) New investments require new resources (people & goods). Keep in mind the goods also require people for production.
6) At the time these tax cuts were passed, unemployment was only ______% which is effectively “maximum employment” for the US economy.
7) When you’re already at full employment and there’s a huge slug of new demand for labor as a result of increased investment, you get wage inflation. (Have you seen salaries in the tech space lately…?)
8) Wage inflation increases discretionary spending…
9) Which leads to more demand for goods…
10) Which leads to more demand for labor to make those goods…
11) And the inflation cycle continues until it can’t anymore.
The pandemic only exacerbated economic issues that were already brewing. Both the Trump and Biden administrations share blame for taking the path of printing money first and asking questions later. Replacing income for workers while everything was shut down led to higher free cash flows for the American consumer and created an increase in spending. At the same time, many companies that should have gone bankrupt were given exceptional accommodation which kept labor from recycling into the market to satisfy increased demand in other sectors. As a result, supply-chain issues were exacerbated which only increased inflation pressures on consumer goods. Simultaneously, low-interest rates for an extended period as a result of Fed accommodation further incentivized investment in long-term capital projects and an already sizzling real estate market which resulted in dramatically higher real estate costs across the board -- both for construction and existing products across all asset classes.
With the Fed’s new course of increasing rates, companies are now facing a new triple-threat: (1) costs of labor have skyrocketed (salaries, benefits, turnover, etc.), (2) costs of financing are materially higher, and (3) buildings that manufacturers need to make goods are significantly more expensive. While a company can try to increase prices to cover these higher costs, that is not always an option. Additionally, if the cost of commodities continues to increase, it will only increase the pressure on the Fed to act more aggressively which makes (2) and (3) a bigger problem than it already is today.
The acknowledgment of inflationary pressures by the Fed is a good thing in the long run and it will cause significant pain in the short & medium term as the second and third-order effects of Quantitative Tightening (or QT) are untested. Here’s just one thought experiment… Before QT was recently announced, Quantitative Easing (or QE) was one of the “exceptional tools” the Fed deployed during the financial crisis in order to help encourage long-term investment; it’s also become the drug on which we’ve depended to fund our lives.
Since the concept was introduced in 2008/2009, the US Fed has accumulated nearly 40% of all outstanding US government debt onto its balance sheet. The Fed isn’t legally allowed to lose money, so think of this arrangement as a short-term loan between the Fed and Congress that effectively “prints money” but only for a period of time. The Fed bought bonds from the US treasury and at some point, the US treasury will have to make the Fed whole. The benefit of this series of transactions, at the time, is that it provided a ceiling on long-term interest rates that facilitated long-term investment by companies and lowered the debt service costs of the US government; we borrow money to cover annual budget deficits which increases the amount of interest the government has to pay on its debt. This was all fine until inflation started to rear its ugly head and caused the Fed to change course.
Just as the QE drug was helpful when we were sick, the problem is two-fold for the US government now that we are experiencing significant side effects (inflation). The first problem for the government is that Treasury now needs to find a new buyer for its debt at a time when that debt is starting to become less valuable. (They could solve this problem by increasing Tier One capital requirements at banks/insurance companies but this will also decrease the velocity of money and slow down the economy.) The problem will become even bigger over the next several months given the Fed’s recent announcement that they will start selling $60 billion/month of their portfolio and then accelerate that figure to $90 billion/month this summer. Now, instead of the Fed acting as a stabilizing force for the bond market, it will become destabilizing when it starts to compete with Treasury in the bond markets.
THE FOLLOWING is what keeps me awake at night... The US had a decade to get its fiscal house in order, but instead, we chose to borrow more money to fund deficits because the Fed made money so cheap. Now, we have a very, very limited amount of time to resolve our budget issues before the market will force the US government to divert funds away from entitlement programs/defense and into debt service. If we want to avoid cutting programs, then taxes will have to go up, but neither of those options are going to be pleasant, especially for a Baby Boomer generation on the verge of retirement with a disproportionate amount of voting power. What makes this scenario potentially worse is that all of this will happen even if the economy doesn’t enter a recession!! If the economy recesses, then it will only exacerbate the need to increase taxes which will further hurt prospects for growth.
Nice rant, Jared. So what?
First, wages will not go down anytime soon. Boomers are leaving the workforce and will need to be replaced by someone or something; additionally, their increased longevity will increase demand for goods and labor which will maintain demand for human capital well into the future -- and also keep inflation running hot. Real estate is going to stay expensive and probably become less affordable in the future. Without new tradesmen entering the labor market, replacement costs for real estate will stay exceptionally high and provide support for pricing no matter how expensive financing*** becomes. Companies are going to have to make the choice to increase prices for their goods or lower expenses to stay profitable. If they can’t increase prices and need to cut costs, jobs will be lost***** in favor of software or robots. Whether it happens now or later, the government will need to increase tax revenues to cover higher debt service costs and maintenance of Boomer entitlement programs -- this will definitely hit aggregate consumer spending.
This all won’t play out over the summer. First, no politician wants to talk about raising taxes on the campaign trail and this isn’t an important enough issue in the face of Roe and other social issues. Additionally, China’s Communist Party is having its elections this fall and that is a HUGE incentive for Xi Jinping to maintain a feeling of normalcy even while you’re starting to hear about their commercial property bubble bursting and revolt against their COVID policies. So, go out and enjoy your summer. Play a lot of golf, take a vacation, buy a house if you can, but don’t deploy a ton of investment capital. I think you’re going to have a much better entry point in 6-12 months.
*** Unless something drastic happens, the trend is reverting back to what we saw before WWII when you had to be upper-middle-class to be wealthy enough to afford real estate... How many “middle class” Denverites make enough (~$150,000) to afford the median home in Denver right now? By the way, you can break the student loan cycle and simultaneously solve the affordable housing crisis by incentivizing a lot of young men and women to go to a trade school for secondary education.
***** That’s not a joke. If you’re looking for long-term equity investments, I think companies specializing in robotics and automation are going to be a no-brainer for the next 10-20 years after we cycle through the next 12-24 months of volatility.
So far, No Change in Demand
Let’s check in on our table summarizing what’s happening in Denver’s real estate market right now.
Data taken from REColorado on May 6, 2022.
Over the last year, we’ve seen the pace of the market slow down less than the pace of new listings which is why prices for homes skyrocketed in Denver. Last month was no exception. In the first four months of 2022, approximately 8,000 units (detached and attached single-family) went under contract. That number is in between what the market displayed in 2020/2021 but right in line with the 8,200 units that went under contract in 2019.
What we’ve experienced so far this year is extremely impressive when you factor that the average price of a sold unit in our market area in 2019 was $490,000 and interest rates were around 3-3.5%; now, the average price of a sold unit is $700,000 and the cost of financing is much closer to 5%. I recognize a lot of “cash” has moved to Colorado over the last few years and that’s helped provide a significant lift to prices; anecdotally, it’s not unusual anymore to meet a client moving to Denver from NY, FL, TX, IL, or CA that is looking to purchase a million-dollar home for cash. I’m struggling with who the next buyer will be, though… If you assume that a majority of those who could relocate to a new area already did so during the pandemic, then I’m not sure from where the new influx of buyers will come who can afford these higher prices once we cycle through the existing demand in town.
No Sharp Supply Changes, Either.
Just as we continue to see similar market behaviors on the demand side, they continue on the supply side. And, the more that I’ve given it thought, I’m not sure it’s going to change anytime soon. Even with everyone moving here and all the new units that have been built over the last three years, we are still seeing drastically lower per capita listing rates. In 2019, 9,800 new listings hit our market area in the first four months of the year, and this year that number was 8,900 (down ~10%).
There are A LOT of Coloradans who are now “stuck” in their homes — a confluence of factors including rising home prices, higher interest rates vs. existing debt, and less workforce mobility (why leave CO if you can work remote?) means fewer homes will go on the market in general. Assume you bought your home in 2019 for $500,000 and are paying 3% interest on a $400,000 mortgage. Even if there weren’t transaction costs and you were able to roll all your equity into your next deal, you’d start out paying an additional $8,000 in interest every year just based on the interest rate moves this year. If you’re still working, maybe you got a raise that would allow you to qualify for another loan, but the odds are that you’re already spending a chunk of that money on other aspects of your life. Additionally, many older homeowners on fixed incomes can’t absorb the increased mortgage costs and can’t put additional equity into a new home given their retirement needs. Furthermore, they are taking advantage of equity positions through reverse mortgages so they can stay in their homes rather than cash the equity out at once.
It seems we are already in the “new normal” for Denver’s real estate market.