Viewpoints: January 2024

As the real estate industry moves towards a zero-carbon world understanding the challenges of this journey is crucial. Recent discussions on decarbonization, within the industry, in large part focused on retrofitting and estimation of the brown discount's size. All in all, it is apparent that the commercial real estate (CRE) industry is gearing up to commit significant funds to this initiative. However, challenges have emerged as the era of abundant, cheap money for European CRE investment funds has come to an end. Investors are now seeking better returns in asset classes beyond real estate, leading to increased bankruptcies and starting to significantly affect residential developers and construction companies. In addition, there are substantial challenges posed by the expected refinancing gap over the next five years. City University's "Europe CRE Lending Survey" estimates commercial real estate debt at €1.5 trillion. The AEW research indicates a financing gap of around €46 billion over the next three years, a substantial increase from their previous estimates. Meanwhile, PWC research estimated cumulative financing for the next four to five years to exceed €125 billion. Simultaneously, European CRE transaction volumes have come to a halt, adding another layer of uncertainty for CRE decarbonization spending as there is uncertainty in respect of future real estate assets values.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in December show continuing and slightly worsening softness. 30 states show declines from November, with Montana down 1.1 percent and Massachusetts off nearly .8 percent. Of the 20 states with increases, Minnesota led with a .7 percent rise. Over the 3 months ending in November, 24 states had no change (Hawai’i) or declines, with Montana down 2.5 percent, and West Virginia and Massachusetts both off by more than 1 percent. The indexes for both Minnesota and Nevada rose 1 percent over this period. Over the last 12 months Maryland was yet again on top, but its 5.6 percent increase was notably smaller than the last few months, and the same can be said of number 2 Vermont’s 5 percent gain. Montana was down 1.6 percent over the last year, and Arkansas and New Jersey both experienced declines.

The independently estimated national figures of growth over the last 3 months (.7 percent) seems higher than the state estimates would have suggested, but the 12-month figure (3.0 percent) looks to be roughly in line with the state numbers.

State labor markets were soft in December. No state reported a statistically significant or loss in payrolls. Most had modest point increases.

15 states had statistically significant increases in their unemployment rates in December, with the rates in Massachusetts and Rhode Island both up .3 percentage point. Minnesota’s rate fell by .2 percentage point. Nevada’s rate remained 5.4 percent, while California and DC were both at 5.1 percent. Illinois and New Jersey were also more than a point higher than the nation’s 3.7 percent. Alabama, Maryland, Nebraska, New Hampshire, North Dakota, South Dakota, and Vermont had rates under 2.7 percent, with Maryland and North Dakota at 1.9 percent.

Puerto Rico’s unemployment rate remained at 5.7 percent, and the island’s payrolls edged down 700.

The US has experienced two asset bubbles in the last twenty years, and a third one, bigger than the prior two, has been underway for a few years. Yet, unlike the previous two, which were a function of investor optimism about new technologies and easy credit conditions and the belief that housing prices never fall, the current asset cycle is a function of monetary policy.

The Federal Reserve's influence in the financial markets has grown substantially since the Great Financial Crisis. The increased influence stems primarily from their new financial tool, quantitative easing (QE), or the purchases of debt securities. QE lowers interest rates (making the future value of equities relative to interest-bearing securities more attractive) and increases the demand for risky assets (mainly equities) by removing the supply of safer debt securities.

The Fed never fully reversed its first QE program before another adverse event (i.e., the pandemic) triggered a second and even more extensive program. At its peak in 2022, the Fed's holding of debt securities topped $8.5 trillion, up from $3.8 trillion before the pandemic, and currently stands at $7.2 trillion. This has had a ratchet effect, lifting asset values far above fundamental values, and the positive impact remains in play.

Determining when asset values are running counter to underlying fundamentals is difficult. Yet, one can get perspective by comparing current valuations to past periods.

Since QE's second program in 2020, the market valuation of tangible and equity assets relative to GDP has increased from 2.5 to 3.3 times. The latest reading is for Q3 2023. Given the surge in equity prices in the fourth quarter, the ratio of assets to GDP could come close to its record high of 3.6 at the end of 2021. By comparison, this ratio peaked at 2.9 during the housing bubble and 2.4 in the tech bubble.

The prior two asset bubbles were pricked or unwound by market forces. The tech bubble burst when hundreds of new start-ups ran through their capital and failed to become profitable. The housing bubble burst when people had to refinance at higher mortgage rates, and speculators could not unload the homes they bought.

Critics of QE have always focused on its impact on reported inflation. QE does cause inflation, but not the one that shows up in the CPI or PPI. It is asset inflation, pure and simple. So, the Fed should study the impact of QE on its financial stability mandate, not its inflation and employment mandates.

Yet, how does an asset bubble burst when a non-market buyer like the Federal Reserve drives it? The 500 basis point increase in official rates would have had a much more significant and sustained negative impact on equity and housing markets if QE did not exist on the scale it does.

Monetary policy can make things appear better or run longer. Still, even though there is no law of gravity in finance, recent history does show financial euphoria not grounded in solid economic fundamentals is not sustainable. The significant over-valuation of tangible and financial assets poses a substantial risk to the economy, and history says it's not if but when it will unwind.

Before he took over hosting The Tonight Show” in September 1962, Johnny Carson hosted an afternoon quiz television show called “Who Do You Trust” (originally titled “Do You Trust Your Wife”). I used to watch it when I came home from school before digging into my homework. Looking at the revisions to the monthly report of nonfarm payroll employment, the show’s title gained more relevance to me now. Billions of dollars, maybe trillions, of transactions in financial instruments take place in reaction to the first estimate of the change in nonfarm payrolls on the day each month that the Bureau of Labor Statistics (BLS) releases its report. That first estimate of the monthly change in nonfarm payrolls gets revised in each of the following two months. But those revisions, although sometimes mentioned by the mainstream financial media, tend to be put aside in the frenzy of trading that takes place in the nanosecond after the BLS releases its monthly report of the Employment Situation.

I decided to take a look at how much the monthly changes in total nonfarm payrolls get revised from their preliminary estimate to their “final” estimate two months later. (I put quotation marks around final because there are of course, subsequent benchmark revisions.) Plotted in Chart 1 are the BLS first estimates for monthly changes in total nonfarm payrolls (the red bars) and its third estimates (the blue bars). (Ignore the November and December 2023 data points inasmuch as the BLS has not yet reported its final estimates for the changes in nonfarm payrolls for these months.) Plotted in Chart 2 are the monthly differences in changes in total nonfarm payrolls between the third estimate by the BLS and its first estimate. Notice that in the 10 months ended October 2023, there is only one month, July 2023, in which the third estimate is greater than the first estimate. Plotted in Chart 3 are the 10-month cumulative totals in the monthly differences between the third estimates of the changes in total nonfarm payrolls and the first estimates. Attention should be focused on the last data point, October 2023, which reads minus 417 thousand. So, in the first 10 months of 2023, the cumulative total of monthly changes in nonfarm payrolls was 417 thousand less when the third estimate of the monthly change in nonfarm payrolls is compared with the first estimate. But these 417 thousand jobs that got revised away probably had no effect on the analyses of the state of the US labor market made by the talking heads on CNBC and Bloomberg when the November and December 2023 first estimates of changes in nonfarm payrolls were reported by the BLS.

Pent-up demand and record monetary and fiscal stimulus drove' inflation's first act. Inflation's second act will revolve around higher house prices, partly driven by record financial wealth and higher wages. Inflation's second act may not run as hot as the first, but it will only be broken with a monetary response.

Statistically, reported inflation has been decelerating, but actual inflation, especially core inflation, has risen again. House price inflation, which is not part of the official price index, has rebounded over the past five months and stands nearly 5% higher than year-ago levels, according to the Cass-Shiller home price index.

The government measure of consumer prices does not include house prices but instead uses an imputed rent measure as a substitute or proxy. But that is not a measure of inflation. For one, it's not an actual price; secondly, no homeowners have ever experienced or paid that inflation. To be accurate and timely, inflation measurement must use transactional prices that people confront in the marketplace. One of the reasons the spike in core inflation in recent years was not as disorderly as previous periods of similar inflation was because two-thirds of households, or homeowners, never felt or experienced it.

House price inflation could run hot for many months. Household's direct holdings of equities relative to real estate stand at close to their highest level recorded during the tech boom. Back then, there was massive portfolio reshuffling away from equities and toward tangible assets, and it should happen again, especially given the sharp drop in borrowing costs in recent months.

The second act of the inflation cycle will also include significant wage increases. In Q4, UPS workers won the most lucrative wage and benefits package in history, lifting wages immediately by roughly 10%. UAW won an 11% wage increase in year one and additional gains over the contract's life. That triggered a flurry of wage increases at non-union companies; for example, Volkswagen raised pay by 11% at its Tennessee plant, Nissan increased wages by 10%, Honda an 11% increase, Toyota by 9%, Tesla hiked wages by 9% at its battery plant, and Hyundai said it would lift wages by 25% over a series of years. Also, Congress recently approved a 5.2% pay increase for federal workers, the most significant annual increase in forty years.

The large and broad wage increases indicate at least a 5% increase in the employment cost index (ECI) in 2024. Since the ECI series started in 1983, there have been only three years in which the annual increase topped 5%, the last being 1990. 2024 should be the fourth; at some point during the year, the Fed will realize a 5% increase in employee costs is inconsistent with a 2% inflation target.

Inflation's second act may not run as hot as the first, but it will be hard to break without a monetary policy response.