Wednesday 24 October 2018

Macro and Credit - Ballyhoo

"Chaos is inherent in all compounded things. Strive on with diligence." - Buddha

Watching with interest recent market gyrations, with the intervention of China in the mix to calm down the turmoil in its equities market, when it came to selecting this week's title analogy, we decided to go for the word "Ballyhoo":
  1. : a noisy attention-getting demonstration or talk
  2. : flamboyant, exaggerated, or sensational promotion or publicity
  3. : excited commotion

A "Ballyhoo" is as well a "publicity, hype" from circus slang, "a short sample of a sideshow" used to lure customers (1901), which is of unknown origin. The word seems to have been in use in various colloquial senses in the 1890s.  In nautical lingo, ballahou or ballahoo (1867, perhaps 1836) was a sailor's contemptuous word for any vessel they disliked. There is as well a 2009 book entitled "Heroes and Ballyhoo" by Michael K. Bohn about sports stars during the period 1919-30s an "era of wonderful nonsense", when sport-crazed public demanded spectacles instead of just matches. Given this golden crazy age lasted 12 years long and many pundits are indicating that a recession in the United States could happen in the next two years, we are indeed wondering when this period of "irrational exuberance" to paraphrase former Fed supremo Alan Greenspan will end. On a side note, for sports fanatics out there, baseball legend Babe Ruth personified the Golden Age of the roaring "Ballyhoo" twenties, a close second was the boxer Jack Dempsey. 

In this week's conversation, we would like to look at housing as yet another sign that we think we have reached "peak" US economic activity.

  • Macro and Credit -  The real state of Real Estate in the US and the consequences
  • Final chart - Beware of the velocity in tightening conditions

  • Macro and Credit -  The real state of Real Estate in the US and consequences
Back in April 2012 we indicated the following relationship with the housing bubble: 
"The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fueling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008 at 11,440; with the index touching a low point of 680 in January 2012"  - source Macronomics, April 2012
- source Macrobond
The Baltic Dry Index, a gauge of rates to transport dry-bulk commodities including grains and coal by sea. Dry bulk cargo represents the largest part of the $380 billion shipping industry. Container shipping traffic is driven by consumer spending as it is dominated by consumer products. Container volumes to the United States are dependent on the housing market. Furniture and appliances are some of the top freight categories imported in both the United States but, in Europe as well from Asia. 

Any changes in consumer spending trends are depending on the health of the housing market:
- source Macrobond

With the Fed on its hiking mission, house affordability is being impacted through rising mortgage rates. Housing is getting more expensive in conjunction with labor shortages and rising costs linked to some extent to tariffs such as those on imported steel.

Basically it seems that the housing market in the United States seems to be stalling as affordability is becoming an issue:
- source Macrobond

Making a quick detour to shipping, there are as well signs that global trade is indeed cooling off. 

Another indicator other than the BDY is the Harpex Shipping Index. It is considered a good indicator of global economic fleet shipping activity since it tracks changes in freight rates for container ships over broad categories. It is slightly different than the BDY. Harpex weights average daily charter rates across eight size classes of vessels to formulate its index. A vessel containing dry bulk generally transports a single load type. Containers ship, by comparison, usually transport a wider variety of finished goods, which makers therefore the Harpex Shipping index a more accurate indicator for measuring global trade:
- source Macrobond

We can clearly see a deceleration in global trade happening at the moment thanks to this index.

But, let's return to US Housing. 

The housing market has clearly been the weak spot in the “strong economy” narrative. The Fed’s hiking path is leading to rising 30 year fixed mortgage rate towards 4.90%, the highest level touched since April 2011:
- graph source Macrobond

Single-family homebuilding is the largest share of the US housing market and fell by 0.9%. Housing affordability is becoming a challenge. 

At the same time, US housing prices are now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012:
- graph source Macrobond

On the subject of housing being a cause for concern, we read with interest Bank of America Merrill Lynch's US Economic Weekly note from the 19th of October entitled "Will housing hurt?":
"Will housing hurt?
  • We have made a number of changes to our housing forecasts to reveal a weaker trajectory of sales, starts and home prices amid rising rates.
  • We think home price appreciation is set to slow but not fall negative absent a recession in the overall economy.
  • Housing is no longer a tailwind for the economy, but the headwinds are blowing very gently.
Home prices: from boom to bust
Home prices nationally, as measured by the S&P CoreLogic Case-Shiller index are running at 6.0% yoy as of the latest data in July. Assuming some modest slowing into the end of the year, we believe we are on track for home prices to end up 5.0% this year, as measured by 4Q/4Q change. As we look ahead into next year, we expect the slowing in home prices to persist, leaving home price appreciation (HPA) of 3% at the end of 2019 (Chart 1).

Thereafter we expect home price appreciation to hold at that 3.0% pace in 2020.
Back to econ 101, home prices should be a function of housing supply and demand. As we argued in Home sales: the peak has been reached, we think existing home sales peaked at the very end of last year and have since been moving sideways in a choppy fashion. This is a function of affordability which has been challenged from rising mortgage rates and elevated home prices. Inventory levels have remained extremely low, but since we look for some continued growth in single family housing starts but little change in home sales, we could start to see the supply of homes increase. The modest shift in the demand curve and out of the supply curve naturally implies slower  home price appreciation. As Chart 2 shows home price appreciation typically peaks along with the peak in home sales.

With mortgage rates heading higher, the challenges with affordability will continue. As a simple rule of thumb based on the NAR’s affordability index, we find that a 50bp increase in mortgage rates would need about a 5.5% offsetting drop in home prices in order to keep affordability unchanged. Of course, this does not account for the rise in income which provides an additional modest offset. Plugging in forecasts for mortgage rates based on our rates strategy call for the 10 year to end this year at 3.25% and 3Q 2019 at 3.35% – which implies close to 5.15% and 5.25%, respectively, for the 30-year fixed-rate mortgage – we would see affordability continue to slip lower (Chart 3). 
While affordability would still be above the historical average, it would still be more challenging than the past several years.
Another important aspect when thinking about the trajectory of home prices is an idea called “mean reversion”. Home prices are ultimately anchored to a fair value which is a function of income growth. Based on the OECD’s methodology, we compare nominal Case-Shiller home prices with disposable income per capita, indexed to 100 in 1Q 2000 (Chart 4) which shows the overvaluation during the housing bubble given the irrational exuberance in the market and easy credit conditions.

The housing bust left prices to tumble back below fair value. Based on our calculation, prices are once again overvalued on a national level, albeit not nearly as much as during the bubble period. Over time the overvaluation can be solved in two ways: 1) home prices grow at a rate below income for a period of time to close the gap; 2) home prices decline to correct the valuation difference. The pull to fair value can be quite strong.
Regional realities
We have been discussing the national outlook for the housing market but the dynamics will vary on a regional basis. Focusing on the top 20 metropolitan statistical areas (MSAs), we find that all 20 are still witnessing positive YOY home price appreciation, ranging from a low of 2.8% in Washington DC to a high of 13.7% in Las Vegas.
Generally speaking the West Coast has seen stronger home price appreciation relative to other regions. This reflects the fact that the West has enjoyed robust economic growth, supported by the thriving tech sector, which has led to greater income and wealth creation. This subsequently feeds into housing demand and a bid on prices (Chart 5).

At the same time, the West has also suffered from greater building constraints and a more severe housing shortage, owing to restrictive land-use regulations and zoning laws. This has contributed to home prices well outpacing income growth. Unsurprisingly, a regional analysis of price/income ratios finds the greatest levels of overvaluation in  Western MSAs (Chart 6).

Conversely, the Midwest cities were generally undervalued.
The higher prices rise in overvalued regions, the harder they may fall. So outright price declines could be seen as demand pulls back, though as discussed earlier we think this is less likely for aggregate national prices. Meanwhile, more affordable areas should continue to see price gains assuming healthy regional economic growth.
Sales and starts are a bit weaker
While existing home sales have peaked and will continue to hold around 5.5 million through next year, we see further upside for new home sales, albeit only modest. We forecast new home sales to edge up to 665K next year from our forecast of 640K this year, which is up from 612K last year. Why would new home sales increase while existing home sales move sideways? The recovery in new home sales was much slower since builders were hesitant to add supply to a challenged market, particularly in the early stages of the recovery.
We have revised down our forecast for starts this year and next. We expect 1.260 million starts this year and 1.30 million next year. The gain will be entirely in single family construction as multifamily has little upside.
- source Bank of America Merrill Lynch 
While we expect single family starts to edge higher – consistent with continued elevated levels of NAHB homebuilder sentiment and low levels of inventory – we think builders will be cautious in the face of rising mortgage rates." - source Bank of America Merrill Lynch
Unfortunately we do not share Bank of America Merrill Lynch's optimistic view. That would not make us "perma-bears" but we do not fall easily prey to "Ballyhoo" games namely sensational promotion.

No offense to Bank of America Merrill Lynch but, Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street

If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:
- graph source Macrobond

Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Many pundits are predicting a recession in the US economy in the next two years.

As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up and when during the summer the house of sticks of the macro tourist carry pigs blew up (Turkey, Argentina, etc.). We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount to track going forward as the credit noose tightens.

Furthermore, it’s isn’t only residential housing which is a concern, in recent years Commercial Real Estate prices have gone through the proverbial “roof”:
- graph source Macrobond 
We think that "housing is no longer a tailwind for the economy" and that "headwinds are blowing very gently" is in this case a "Ballyhoo".

If one looks at US Homebuilders index versus the S&P500 that cyclicals matter when it comes to assessing the rising probabilities of a US recession:
- graph source Macrobond

This is telling you that housing activity is leading overall economic activity, housing being a sensitive cyclical sector. We have reached "peak" everything when it comes to US economic activity. It might be very well all downhill from there. We are already seeing signs in Europe with the latest PMIs of global trade deceleration, and not only from shipping mentioned above.

Also, if one looks at the S&P500 versus US Regional banks, one could conclude that "misery loves company":
- graph source Macrobond

The Regional Banks index has fallen 16.58% from its high back in early June and has fallen 7.05% since the start of October. Bank OZK’s stock dropped nearly 24% on the 19th of October after Commercial Real Estate (CRE) write-offs. The Arkansas-based bank is one of the largest condo construction lenders in Miami, NYC and LA. You would be wise thinking about selling your condo in Miami according to Main Street's predictive history.

As indicated by Bank of America Merrill Lynch in their weekly Securitized Products Strategy weekly note from the 22nd of October, bank stocks and MBS basis have a strong relationship since 2015:
"How Q3 bank earnings inform us
Domestic bank demand is key to agency MBS valuations; one simple relationship we have ascribed to is the strong relationship between bank equity valuations and the current coupon mortgage basis. Even recently, lower bank stock valuations have coincided with the basis widening. The underlying logic tying these two together is the outlook for bank balance sheets, reflected in stock prices, suggesting a technical backdrop for bank demand for agency MBS.
Many individual moving parts, however, come into play on the various pieces of bank balance sheets. For example, theory suggests deposits are impacted by the Fed’s balance sheet runoff. Appetite for securities relies on tolerance for capital volatility related to AOCI (all other comprehensive income), which changes with rate views and duration appetite. Finally, loans funded vary based on credit risk appetite and industry competitiveness, such as non-bank participation and accessibility to the high grade, high yield markets. These moving parts change, dampening or expanding bank demand for securities. We leverage the 3Q18 earnings call transcripts of the largest banks to extract takeaways on driving factors influencing these trends.
Lower tolerance for incurring AOCI risks – Tax reform, lower tax rates specifically, has reduced bank tolerance for incurring AOCI risks. AOCI losses have led to a larger tax deductible historically than what the current lower tax regime offers. The outlook for higher rates this year, and the potential for even higher rates ahead, has dampened enthusiasm for banks to take duration risk.
Cash is king, a compelling alternative, only getting better– Cash yielding 2+% compared to a post-crisis era of offering nothing raises the bar for investing in securities and taking on duration risk. Projecting returns on cash, along the forward path, only further stands to enhance the appeal of this strategy. Indeed, this is how the Fed’s tightening of policy works its way through banking channels, essentially raising the risk-free rate!
Yes, higher base case NIMs, but a few IF’s echoed – The selloff in rates highlights better NIM opportunities presented today, as deposit rates undershoot model forecasts. However, it is far from being just this simple. Convexity concerns and volatility ahead pose risks, along various forward paths. The outlook for loan growth, hinging on whether the economy keeps expanding, dictates securities demand, be it for HQLA/LCR reasons or for NIM/earnings.
The big question is can the US economy continue to expand as such a pace when housing is already struggling and even if FICO scores get lowered to facilitate credit card use by a pressurized US consumer?

There are indeed some implications down the line as highlighted by Bryce Coward from Knowledge Leaders Capital in his blog post from the 19th of October entitled "More evidence of a slowing housing market, and its implications":
"The slowdown housing activity leads overall economic activity by eighteen months. Housing, being one the most cyclically sensitive sectors of the economy, often feels the impact of higher rates well before other areas. This alone implies a peaking of economic activity right about now, leading to persistently slower growth rates through Q1 2020. 

Not coincidentally, a peaking of economic activity about now is also consistent with the 1.2% fiscal stimulus boost we’re getting in 2018. Incremental stimulus for 2019 drops to .4%, with the potential of that entire stimulus being negated by dead weight losses from tariffs, but that is a topic for another day." - source Knowledge Leaders Capital
This ties up nicely we think with Main Street sanguine view of the housing market, namely that it's less and less the time to buy a house and more and more the case of selling a house as per the previous credit cycle call Main Street made. The credit cycle is no doubt turning regardless of the "Ballyhoo" put forward by some pundits.

Sure overall, the latest quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points towards gradual tightening of financial conditions overall, yet the recent move based on the sensitivities of major market variables points towards an accelerating trend as per our final chart.

  • Final chart - Beware of the velocity in tightening conditions
Our final chart comes from Morgan Stanley US Economics note from the 11th of October and indicates how using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions:
"An updated view on financial conditions indices shows a mixed picture, with the
Chicago Fed’s FCI actually easing further in the week ending October 5, while other alternative financial conditions metrics show a more considerable tightening in recent days.
The Chicago Fed updated its weekly FCI this morning. The latest update covers through last Friday, October 5, so it’s quite lagged. Somewhat surprisingly, the index eased 0.026 points – the largest one-week easing since the week ending August 10 and the 13th consecutive week of easing for the index.

The index now stands at a level of -0.76, a low since July 2015, driven by lower readings on the risk, credit, and leverage subcomponents. 49 underlying indicators tightened in the last week and 56 loosened – some of the biggest contributions to easier conditions were the Markit IG 5-yr senior CDS index, HY 5-year senior CDS index, and the 3-month TED spread.
An alternative metric that we look at for a more real-time look at financial conditions has shown a greater tightening in financial conditions so far this week. This metric tracks financial conditions based on the sensitivities of major market variables in the Fed’s FRB/US macro model, and we express it in a fed funds rate equivalent.

By this approach, financial conditions have tightened about 10bp from last Friday and about 50bp from the end of September. That compares with the experience from early February this year when financial conditions tightened about 80bp over a two week period." - source Morgan Stanley
Is this velocity seen in greater tightening of financial conditions a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions, or is it simply a case of "Ballyhoo" at play? We wonder...

"Civilization begins with order, grows with liberty and dies with chaos." - Will Durant, American historian

Stay tuned!

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