Stocks closed mixed Friday to start the second quarter. The S&P closed down close to 5% in the first quarter rallying hard in the last three weeks to cut losses for the quarter by more than 50%.
As we start the second quarter, growth is starting to decline from the torrid pace of 2021 as government and central bank subsidies fade. At the same time inflation is near a peak, the highest level in 4 decades. There are several reasons for the inflation including supply shortages and sanctions related to the Ukraine war, but the primary cause is simply too much demand. Inflation is a symptom of the imbalance of supply and demand. With unemployment down to 3.6% and two jobs available for every American out of work, clearly the only way labor imbalances are destined to be corrected are with higher wages and fewer job openings. Excessive demand for semiconductors has led to supply shortages. Supply shortages have limited the number of cars available for sale. That has boosted new car prices and led to a surge in used car sales. The story repeats itself all over the business world. Too much demand and not enough supply.
Today, I want to concentrate on just one sector, housing. During my entire Wall Street career, I have followed the housing industry. There have been multiple periods of feast and famine. We all vividly remember the housing bust during the first decade of the 21st Century. That led not only to a collapse of housing demand, but such an enormous wave of foreclosures that the whole financial structure of our economy almost collapsed. Now we face a period where housing prices have taken off once again. Is this the second coming of what we saw two decades ago?
History teaches us lessons but it rarely replicates in the same way. What we are seeing today is not a replica of what began 20 years ago. Mortgages today are properly structured. Lending standards are much tighter. No one is cajoling a Wal-Mart assistant manager to buy a megamansion. That doesn’t mean there isn’t a down cycle in front of us. It does mean that we aren’t going to end up with a massive wave of foreclosures either.
So, let me start with a few facts. Demographics today are much more favorable for the housing market than they were 20 years ago. Millennials are building families and want to move into houses rather than continue to live in a one- or two-bedroom apartment. Empty nesters are eager to move out of large homes into lifestyle communities that fit their active retirement needs. The housing debacle of 2005-2010 left many stuck in place, without money to move. New home construction decreased to a snail’s place. That continued for at least five years. Thus, as demand returned to normal, there was inadequate inventory to support rising demand. But in the spring of 2021, houses went to market and sold literally overnight with no inspection or conditions. Price predictably shot up. There is no better cure for supply/demand imbalances than rising prices.
That leads to a second fact. Houses don’t appreciate. A house is a physical structure that only depreciates in value. One can slow the rate of depreciation through proper maintenance but, in the long run, most homes rarely last 50 years or longer without a major overhaul. It’s the land underneath the home that appreciates. Homes located in desirable communities sell for as much as 100% or more compared to the exact home in a less desirable location. In a country as vast as the United States there is no shortage of land, but there is a shortage of land in the most desirable locations. Thus, today, while the average home price is up 20% from last year, some communities are seeing increases of 50% or more while some are seeing no appreciation at all.
With the Fed now increasing interest rates pushing the cost of a mortgage higher, shouldn’t prices stop going up? On the surface, yes, but there are mitigating factors. The first is the fear of missing out. Those who have waited a year now see prices up 20%. If they wait another year, will that home cost 20% more yet again? Second, for decades, homes were viewed as a good investment. Buy a house for $300,000 with 20% down and, within a year, if the home rises 20% in value, one would double one’s investment. $60,000 down would now translate into an equity of $120,000.
When will this all stop? I don’t know. I do know that if one views the trend in real estate values over many decades, the values increase either in line or slightly below the pace of inflation. Remember, a depreciable asset sits on top of that piece of land that rises in value. What you don’t see today is a lot of flipping (buy a house pre-construction and then selling it at closing), but you do see institutional investors buying homes to rent, and you are seeing a surge in second home demand (e.g., the Jersey Shore). So, there are speculative aspects appearing. That doesn’t mean that calamity a la 2008 is about to reappear. Nor does it tell you when the frenzy to buy runs its course, but it does mean that the market is getting overheated, that 20%+ increases won’t persist. Ultimately, higher prices and higher lending rates will ultimately slow demand. Does that mean prices will tumble? Not necessarily given the good demographics, but it does mean that at some point, probably over the next year or two, higher costs will reduce demand and induce more current owners to put up their homes for sale bringing some level of stability back to the market.
I use housing to make a point, not belabor one. We are already seeing higher prices elsewhere begin to take their tolls. Restaurant activity is slowing. Retailers are starting to see slower traffic. Americans have an estimated $1-4 trillion in savings that will keep demand solid for a while, certainly for the rest of this year and maybe into next, but we don’t have infinite reserves.
The faster the Fed moves rates higher, the faster demand will fall. That’s not a guess; it’s a given. If the Fed reduces its balance sheet by $1 trillion or more, it will suck some of that excess cash out of the system. Less reserves will mean more caution. More caution will also reduce demand. Less demand will relax supply chain snarls. Traffic gridlocked at rush hour normalizes once fewer people are on the road. Less demand will enable supply chains to get back to normal. Car dealers still can’t get enough inventory. I suspect they won’t be saying the same a year from now and those frothy used car prices will come back down once dealer lots are filled with new cars for sale.
The bottom line is that the Fed will win its battle with inflation. What we don’t know is when and whether victory can be achieved without creating a recession. We are probably at peak inflation today. It took us a few years to get here. It won’t be solved in a few months. Wages and rents are going to continue to rise for a while. For many industries, that means the price increases you see today are going to stick. Those workers who two years ago were getting $10 an hour and now getting $15+ are not going to work for $10 again unless there is massive unemployment. No one is talking about that, but we can’t cure inflation in a world where there are two jobs available for every unemployed worker. For close to 3 decades, employers had the upper hand. Many Americans saw little or no improvement in their living standards. That is changing. The employee now has the upper hand and is likely to retain it for some time. Eventually, companies will have to absorb some of their cost increases, impacting margins and future hiring plans. Higher labor costs will require higher prices in the interim. We will all pay more for what we need. The excess that funds our discretionary purchases, including our vacations, may be at some risk down the road.
What’s playing out in housing, is playing out in the supermarket, at the office, essentially everywhere. Governments around the world have let inflation become pervasive. It will take several years to fix. As investors, that suggests it’s better to be a lender than a borrower. It suggests businesses that enhance productivity will gain as will those that give the consumer a better value. The world is being turned a bit upside down. It will affect everything we do and how we invest. That is not to say that companies that benefited before can’t continue to benefit. Innovation still matters as does superior execution, but change requires us to adapt both in our daily lives and in our approach to investments.
The stock market panicked in January and February as it came to grips with inflation. Did it overreact? March told us it might have, but the story’s end is still to be told. The Fed still wants us all to believe it can lick inflation and keep employment high at the same time. Somehow, supply chain issues will heal themselves. Few buy the fairy tale, at least not completely. The fact is no one knows what rate is the exact level to even supply and demand. Raise rates too slowly and inflation not only endures but becomes embedded. Raise them too quickly and you invite recession. Go back to housing. If prices stop rising, that would be helpful. If they turn around and tumble, that would introduce a whole other set of issues. It’s like sitting on a seesaw with both sides balanced in the air.
So the story’s end hasn’t been written. As it unfolds, markets will react. In the meantime, the best path is to lean in the direction of companies less impacted by inflation, less dependent on labor costs, with sound balance sheets and management teams that have proven the ability to adapt quickly. Bond durations should be kept short.
Today Robert Downey Jr. is 57.
James M. Meyer, CFA 610-260-2220