The earnings announcements encouraged investors, stemmed the market correction, and left investors in a reasonably good mood. Results of the so-called Magnificent 7 generally met or exceeded expectations. One, Nvidia#, still has to report its earnings in May. These seven stocks are key because they account for roughly 30% of the value of the Standard & Poor’s 500.
As we look forward into the late spring and summer, interest rates, which had threatened to return to their October highs, are moderating a bit. For now, at least, the Fed has taken any possibility of another interest rate hike off the table, thereby anchoring short-term rates and limiting the threat of higher long-term rates. While the factors that set short and long rates are different, lower short-term rates will generally anchor how high long-term rates can go. In times when the yield curve is inverted, the impact can be even greater. With the threat of higher long-term rates receding, even as inflation remains persistent, equity investors turn to the earnings outlook for guidance. That remains upward sloping and will continue to as long as there is no recession.
With growth slowing as the impact of restrictive monetary policy continues, there is always the risk that slower growth slips into recession. Excluding the short-term impacts of trade and inventory adjustments, first quarter GDP slipped close to a full percentage point from the rate experienced in the second half of 2023. Management commentaries during earnings season from companies whose fortunes are tied to the strength of the overall economy generally described a quarter where growth slowed gradually from start to finish. But the pace of decline was moderate, and as mentioned earlier, few talked of actual recession in their individual crystal balls. Thus, there are good reasons for optimism.
The only gating factor to another vigorous advance is valuation. Stocks sell for 20-21 times forward earnings, a level inconsistent with long-term interest rates of 4-5%. History shows that discrepancy can last for months of even years. But not forever. Whether we face a sudden market correction of size or simply a slower pace of appreciation that lags the future growth in earnings is unknown. But for several years, even in the face of rising interest rates, stock prices have risen faster than earnings. They took a pause in 2022, but otherwise momentum and optimism have ruled. Time will tell how long that lasts.
Historically, real growth in this country has centered around 2%. It has been higher in recent years due to the recovery from the pandemic, extraordinary growth in fiscal spending, and a sharp increase in immigration. All three are unsustainable. The impact of the pandemic is largely over. Supply chain disruptions have been repaired. Deficits of $1,5-2.0 trillion are unsustainable. Over time, such extravagance will require borrowing levels that will force interest rates higher and higher, ultimately leading to a recession and subsequent restraints on government spending. Think Greece a little more than a decade ago. As for immigration, President Biden doesn’t have a focused plan to slow or stop the flow of migrants crossing our southern border. But public pressure to do something will only increase going forward. Politically, a sharp pivot to the left to appease progressives will almost certainly create some level of backlash from the political center critical to reelection. The flow isn’t likely to stop soon, but it will slow.
While immigration supports rising population growth, a declining birth rate does the opposite. The birth rate of 1.62 per family in 2023 was the lowest since 1979 at the peak of the inflation cycle of that era, and at the end of Jimmy Carter’s one-term Presidency. Simple math says a birth rate of significantly less than two won’t replace the two parents when they eventually pass. The rate has been in steady decline since 2007. Part is due to pure demographics. Part is that millennial families are having kids later in life. Post 2007, it was hard to get jobs and build up savings, the after-effect of the financial crisis that ensued.
Whatever the cause, there is a second derivative to the lower birth rate as it impacts the housing market. Economists like to pin the slowdown in demand on high interest rates. That, of course, is true. But it’s also true that a family unit of 2 or 3 has less reason to buy a large house than a family of 4 or more. This all collides with the idea that the American dream is for every family to own their own home. During George W. Bush’s presidency that was a strong theme. The push was so strong that demand was inflated by government actions, speculative financing, adjustable mortgage rates, and financing terms that allowed almost any working American to “buy” a home with a minimal downpayment. All this worked beautifully as long as home prices kept rising. Of course, the downside to leverage kicks in when the underlying asset, one’s home, declines in value. We all witnessed the mess that occurred starting in 2007.
To build a recovery, the government lowered interest rates to zero. In Europe and Japan rates went negative. The reaction was obvious. Home buyers arrived in droves and housing affordability reached levels not seen in decades. Mortgage rates fell as low as 3% or even lower in a few cases. These rates were locked in for 30 years. The surge in demand created a surge in prices as well.
But all good things come to an end. When inflation took off after the pandemic, central banks were forced to raise rates. That slowed demand for housing. But it also ended up reducing supply. Potential sellers were kept on the sidelines given the negative impact of selling a home backed by a 3% mortgage to buy another with a 7% one. Lower supply and lower demand reduced activity but, at least to date, not price. People locked out of the housing market are still locked out. Housing is much less affordable today than it was just a few years ago. The dream of everyone owning their own home never really went away. With rates too high, what was the government fix going to be? Government mortgage issuers and consolidators could ask for lower down payments, and they do. The latest in the bag of tricks is to allow Federal agencies like Freddie Mac to guarantee second mortgages. Rather than being forced to replace an entire mortgage when refinancing, borrowers could retain their low interest rate first mortgage and take a second mortgage only paying the higher rate on the additional borrowing.
The risks here are obvious. A second mortgage is akin to a home equity or consumer loan. The proceeds could be used to maintain, improve or enlarge one’s home. But it also can be used to buy Taylor Swift tickets. Or to swap a 20%+ debt (one’s credit card balance) for an 8% debt, the rate on a second mortgage. All this amounts to financial engineering to support more leverage and more borrowing to buttress GDP growth. Hey, it’s an election year. Why not?
I understand the dream of living in a nice suburban home. Seniors will remember as kids watching “Ozzie and Harriet” or “Father Knows Best”. Dad worked, mom stayed home, and the kids lived an idyllic life save for a few squabbles that carried each weekly episode. That dream carried forward into the 70s with “Happy Days”. Different times. Same scenario. Dad worked, mom was the dutiful housewife, and the kids had fun. Of course, none of these shows ever talked about meeting a mortgage payment. In fact, we didn’t know whether the house was owned or rented. We just assumed it was owned.
Today, families have a choice to own or rent. The economics of that choice are simple and drive part of the decision to own or rent. A second factor is lifestyle. Space, education choices, etc. A third factor in the equation is whether the value of the home is going to rise or fall in the future. If consensus believes values are too high today and ready for a tumble, why buy now? Conversely if one only remembers a period of rising home prices, then owning is preferred. But whether you own a house or rent the same house, the ultimate decision is one of economics. The current costs of occupancy can be compared easily. The future value is speculative.
While prices of houses have generally risen since World War II save the period during and immediately after the Great Recession, studies have shown over much longer periods that home values increase at a pace consistent with inflation. In fact, a home is a house on a piece of land. The house itself almost never appreciates, just as it is extremely rare to sell a used car for more than one paid for it when it was new. Houses age just as cars do. They need more upkeep and require more repairs. All the appreciation is in the value of the land. If the land is half the worth of the home when purchased (it could be more or less depending on location), it’s value would have to increase at twice the rate of inflation assuming that the value of the structure remains the same. This is all a bit of a convoluted discussion but the point is that adding leverage to home financing is an accident waiting to happen, a bad idea.
The reality is that with smaller family units, the demand for smaller homes will increase while the demand for McMansions will decrease. Empty nesters also want to leave the 4-bedroom house for a smaller home in an appropriate lifestyle community. Our government can provide risky incentives trying to recreate “Ozzie and Harriet”, but that was yesterday’s world, not tomorrow’s. Central banks’ actions over the past decade have helped, but they have created unintended consequences. Government actions are always reactions to events of the past. The American dream of tomorrow won’t be the same as the dreams of yesterday. Free markets are much more capable of adjusting than manufactured incentives resulting from government actions. Artificially high or low interest rates work for a while, not indefinitely. Our tax code is riddled with incentives and then counter incentives to offset. We see today the impact of EV tax credits. They may induce one to buy an electric vehicle but they sour future demand if the existing infrastructure can’t support a positive experience. Green initiatives to shift away from foreign fuels are admirable, but the shift is disruptive if done too quickly. Solar and wind can never supply base load needs. Americans are still scared of the nuclear alternative. Natural gas isn’t perfect, but it’s a lot better than coal or fuel oil, a logical step in the right direction although not a final solution.
Regulations are needed to insure good behavior. When is too much? We know it when the negative impact shows. Then we adjust. In the case of insured second mortgages, there is simply too much history that tells us this is a bad idea. Ditto any form of price controls. They simply don’t work even when the temptation to use them is obvious. In an election year, it’s tempting for incumbents to add some economic juice. But, frankly, it’s too late now. Americans vote with their wallet. It is unlikely the picture painted six months from now will be impacted by anything done today. For four years, we have been hearing about reshoring, tax incentives for new semiconductor plants, and a trillion dollars to support infrastructure improvements. With all that, in 3 ½ years, our economy has added a grand total of 20,000 manufacturing jobs. Politicians want us to listen to the words. The truth is we react, and vote, based on what we see in the real world.
Actor George Clooney turns 63 today, former British Prime Minister Tony Blair turns 71, and baseball great Willie Mays is 93 today.
James M. Meyer, CFA 610-260-2220