Viewpoints

State labor markets were generally mixed to improved in January. Eight states had statistically significant gains in payrolls. New York led in absolute numbers (59,300) and percentage (.6) terms, while three of its neighbors (Massachusetts, New Jersey, and Vermont). Only a small handful report point declines, none statistically significant.

4 states had statistically significant increases in their unemployment rates in January, while 2 had significant declines. None of these movements were larger than .2 percentage point. The highest unemployment rates were in Nevada (5.3%), California (5.2%) and DC (5.0%). Illinois and New Jersey were also more than a point higher than the nation’s 3.7 percent. Alabama, Maryland, Minnesota, Nebraska, New Hampshire, North Dakota, South Dakota, and Vermont had rates of 2.7 percent or lower, with North Dakota at 1.9 percent.

Puerto Rico’s unemployment rate remained at 5.7 percent, while the island’s payrolls rose 6,000—likely a statistically significant increase.

China’s National Peoples’ Congress (NPC) meeting kicked off today with Premier Li’s announcing its first Government Work Report. It’s definitely an interesting day for all China watchers and investors, as we are all looking for clues in China’s upcoming plans to prop up an economy that is grappling with deflation, a property market slump, heightened debt levels and low level of foreign direct investment. Before the meeting, many market participants are looking for bazooka-style stimulus or long-term structural reforms, however, the annual NPC is not really a platform for these policy announcements. Instead, we get a flurry of economic and budget targets, and a to-do-list for this coming year. In a nutshell, there is nothing juicy or new in this government report – with a couple of exceptions – it appears that China is still using old tools to fix the current economic problems.

Let’s start with the targets, a couple of highlights. The 5% GDP growth target was in line with market expectations, and consistent with early growth targets released by the local governments. In my view, it is an aggressive target to achieve compared with last year’s, because 2023 growth target benefits from the low base in the year before when the economy was mired in zero Covid policy. By contrast, the base effects this year is unfavourable. Also, it is more difficult to hit target this year without any forms of fiscal and monetary support, given the deepening property market slump and lingering local government debt problems. The Chinese government realised the hurdles and hinted at further targeted stimulus, as Premier Li said in his speech “It is not easy for us to realise these targets. We need policy support and joint efforts from all fronts.”

Interestingly, the unusual issuance of RMB 1tn central government bonds is a nice addition to the fiscal impulse from the local government special bonds quotas of RMB 3.9tn for 2024. This is the fourth time in the last 26 years to issue such sovereign bonds, the last couple of times it happened was in 2020 and 2023, to fund Covid-related expenses and post-disastrous reconstruction in north-eastern China after a major flood. We expected the central government to share the credit burden with the local governments going forward, because the hands of provincial authorities are tied. Local governments get a significant share of income from land sales to developers, but this is getting difficult on the back of tumbling demand for housing. Therefore, it makes sense for the central government to step in and allocate resources back to provinces, probably on more favourable debt servicing terms given its higher credibility and lower indebtedness.

Property sector, which accounts for over 25% of the economy, saw no new concrete measures mentioned in this report. The NDRC did say they will try to address the root causes of the property malaise and mounting debt problems, but they stop short of spelling out what the solutions are. The crux of the property problem remains low level of confidence of prospective homebuyers, leading to a collapsed in demand for off-plan new housing. Homebuyers would rather sit on the sideline, worrying that troubled developers will not have sufficient funding to complete the projects. This in turn reduces the cashflow of property developers, including heathier ones. And the negative feedback loop repeats itself.

But note a glimmer of hope that President Xi’s property slogan “housing is for living in, not speculation” is omitted in the policy wordings this time, suggesting that authorities are more determined to prop up the property market. Before this, mixed signals were sent to the market when property measures were relaxed, reducing the efficacy of the stimulus.

Thus far, the government implemented a slew of measures to support the ailing real estate market, such as slashing the 5-year LPR, increasing the PSL funding, lowering the LTV requirements for first-time buyers and buy-to-let investors, also encouraging banks to lend more to white-listed property projects selected by local governments. Unfortunately, none of them had material impact on lifting sentiment or breaking the negative feedback loop. Rather, we continue to hear news in recent weeks about investors filing a lawsuit against Country Garden and Vanke delaying its debt repayments, further denting buyers’ confidence.

In all, this is a fiscally expansionary budget, and it should cushion the economy currently in deflationary mode. The 5% growth target is only achievable with a strong dose of stimulus, so expect more targeting measures to be deployed. The Chinese authorities are still aiming for quality development over sheer growth, but structural changes for “new productive forces” and consumption to take hold won’t happen overnight, more stimulus measures are therefore needed in the interim period. But the lack of creative policymaking in Zhongnanhai to bridge this gap suggests that China may still be using old tools for new problems. We are not looking for sizable credit-fuelled stimulus in the past which would normally result in unproductive capacity, but timely and well-packaged policies that can address deficiency more quickly and broadly would vastly improve the recovery experience.

Understanding the cost associated with reducing the carbon footprint of buildings is crucial for the CRE industry's decarbonization efforts which however pose a difficult challenge. The European Commission and the European Environment Agency do not always add towards better understanding as their explanations of the CRE industry decarbonization targets can differ, while allowing only an indirect perception of associated costs. More concrete estimates, such as those from Oxford Economics one, suggest that the cost of decarbonization to extend the existing building life, by up to 25 years is approximately 30% of the buildings' capital values. However, this estimation is somewhat ambiguous, as the dynamics governing real estate values and costs associated with building decarbonization differ. The Deutsche Bank research paper associates the cost of decarbonization of its CRE portfolio mainly with retrofitting expenses aiming to reduce energy usage per square meter of buildings. The paper indicates that the cost of retrofitting Deutsche Bank’s existing residential real estate portfolio to the currently adequate Energy Performance Certificate (ECP) is estimated at around €80 Billion, while retrofitting its commercial real estate portfolio costs is at least ten times more. In this case uncertainty related to decarbonization costs estimates arise due to the changing nature of regulatory framework. For example, German form of ECP (Energieeinsparverordnung – EnEV) was introduced in 2002 and then amended in 2007, 2009, 2014, 2017, 2023, each time bringing more stringent regulations that were becoming more expensive to implement. The Catella Residential Investment Managament research paper estimates that the cost of decarbonizing typical residential dwellings in EU could be in the range of €25,000 to €40,000. This implies that the cost of decarbonizing the existing residential stock in the EU could be in a range €6 - €10 trillion. Expressed as a percentage, this accounts for approximately 65% of the annual EU28 GDP, as shown in the table.

In the last twenty-five years, asset price cycles have become more dominant in business cycle analysis, and in doing so, asset inflation cycles have become the modern-day form of inflation. Their importance has become so critical that they have become an explicit part of monetary policy via its new tool, quantitative purchases, whose primary purpose is to increase asset prices/values. With the Federal Reserve now a key player, do asset price cycles still exhibit similar boom and bust patterns as was the case in the past? Or can monetary policy permanently elevate asset prices above and beyond economic and financial fundamentals?

Asset Price Cycles

Several theories help to explain why asset price cycles have become more significant and more volatile over the past twenty-five years.

First, monetary policymakers changed its operating framework in the mid-to-late 1990s, just before the asset price tech bubble. Policymakers abandoned the money supply and credit anchors and started to track real official interest (i.e., Fed Funds level less consumer price index). That created an informal price-targeting policy regime, which years later became formal and removed a policy framework that responded to financial conditions and imbalances that could trigger future inflation or economic problems. Ever since the change in its framework, policymakers have refused to use official rates to dampen speculative and significant asset price cycles.

Second, in the late 1990s, BLS removed the house price signal (i.e., it stopped surveying owner homes for the rent calculation) from its measure of consumer price inflation. That change further broke the link between real estate and consumer price inflation and changed the correlation between real estate and equity prices to positive from negative. So, real and financial asset price cycles became mutually inclusive, which was the opposite of what was usually the case in previous cycles.

Third, globalization (i.e., the ability to import cheap goods) played a role in the US inflation cycle as it helped dampen goods price inflation. With monetary policy shifted exclusively to reported inflation and less to financial conditions, tame consumer price inflation contributed to investors speculating, and often winning that monetary policy will remain easy regardless of asset inflation.

Asset price cycles do not generate public outcry as general inflation cycles, even though history shows they can be equally destructive and destabilizing. That could be because asset price upswings can generate substantial wealth gains while general inflation penalizes everyone. Yet, policymakers have a mandate for financial stability, so they must stand up against the crowd even if it's politically unpopular.

Asset price imbalances or bubbles are hard to detect in real-time and can last long. Yet, one can gain perspective by comparing current market valuations of real and financial assets to past periods of boom and bust.

During the tech bubble, the market value of the real estate and equities on household balance sheets to nominal GDP spiked to a record 2.5 times, falling back to below two during the bust (see chart). The housing bubble helped fuel a more significant spike in market valuations to roughly three times GDP, and again, history repeated itself, as it often does in finance, with market valuation falling back to below two.

The Fed's QE 1 program helped asset prices recover ground lost during the Great Financial Recession, and QE 2 has pushed asset values to GDP to a new record high. Based on Q4 changes in asset prices and GDP, the ratio is estimated at 3.5, just shy of the record high at the end of 2021. If history were to repeat itself, it would take a 35% to 40% decline in both real estate and equity values to match the fall in the Asset/GDP ratio following the tech and housing bubbles. That is not a forecast but an illustration of how far current valuation have deviated from trend. Liquid assets correct sooner and more sharply than real assets so the equity and real estate declines, if they do occur, would not be proportional.

Can monetary policy permanently increase the nominal values of real and financial assets with its new policy tool (QE)? Monetary policy can make things look better and last longer, and QE has done that. But to permanently increase the earnings power and asset valuations is not something monetary policy can do. Every excessive asset and non-asset price cycle in history eventually broke for one reason or another. The current cycle should be no different.

Policymakers are debating when to reduce official rates because general inflation has slowed. Reducing official rates would be a significant policy mistake because of the price imbalance in the asset markets. Instead, policymakers should comprehensively review their policies because the economy's performance, evident with the strong job and wage gains in January, says the total stance of monetary policy remains too easy. In doing the review policymakers will learn that their new tool of quantitative purchases offsets a significant chunk of their official rate policy. In the current climate, it makes more sense to accelerate the reduction of the Fed's balance sheet than to lower official rates.

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.