Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery” ― Charles Dickens, David Copperfield.
The much-anticipated June CPI report showed inflation to be a bit lower than expected before the bell last Wednesday. The headline reading was of a 3% year-over-year rise in inflation. This was the smallest year-over-year gain in prices in 27 months. Investors got more proof that inflation continues to slow on Thursday when the June PPI report came in lower than expected, with “core” PPI edging up only 2.4%, close to the Federal Reserve’s official target for inflation of two percent.
These softer than expected readings have fueled hopes that the Federal Reserve is on the cusp of achieving an almost mystical “soft landing” and that the coming 25 bps hike from the central bank later this month will be the last one for this monetary cycle. For the week, the S&P 500 (SP500) added 2.4%, the Dow (DJI) 2.3% and the Nasdaq (COMP.IND) gained 3.3%.
I wish I could buy into this scenario that the rally in equities would continue. Unfortunately, I can’t for two simple reasons. First, my faith in the Federal Reserve is much lower than evidently is that of the market. After all, this is the same cast of characters that let money supply rise 40% in the aftermath of the pandemic lock-downs. Combined with massive spending from Congress, this ignited the largest wave of inflation since the early 80s. They then sat on their hands for a year believing inflation was “temporary” and “transitory” before going on the most aggressive monetary tightening cycle since Paul Volcker.
The last time Fed Funds broached the five percent level was back in 2007, when Fed Chairman Ben Bernanke was assuring the markets that the subprime crisis was “contained.” We all remember how that turned out and as Mark Twain famously quipped “History never repeats itself, but it does often rhyme.”
The second reason for my skepticism on equities is that investors seem to be forgetting monetary policy always acts with a long lag. It is usually 18 months for a rate move by the Federal Reserve to be fully felt across the economy.
Investors don’t seem to be factoring in the longer-term impacts of higher rates on the economy as well as the markets. One of the more interesting takes I have seen on this recently is from the high yield credit strategy head of Bank of America. He notes that global interest rates have moved from one percent in 2021 to approximately four percent. Because most of that debt has not rolled over yet, the blended interest rate on that global debt is around 1.5%. If the remaining global debt has to eventually reset at four percent, this would result in some $8 trillion in additional annual interest costs.
To put that in perspective, the GDP of the largest economy in Europe, Germany, has an annual GDP of just over $4 trillion. The GDP of the United Kingdom is just under $3.3 trillion, and that of Japan is just over $4.2 trillion. Does anyone think the markets/economy are ready to handle anywhere close to that additional annual interest expense?
Few sectors of the economy will be more negatively impacted from the increasing impacts of higher interest rates than commercial real estate {CRE}. The last financial crisis in 2008/2009 was triggered by the collapse of the residential housing market. The next financial challenge will likely be caused by the implosion in commercial real estate values and a spike in default rates.
We have already seen lenders “turn in the keys” to the two largest hotels (by key count) in San Francisco, along with the largest commercial mall in the city by the bay. This will be an increasingly common occurrence in coming quarters. This could result in more regional banks going bust as we saw earlier in the year as the regional banking system holds about 70% of overall commercial mortgage back securities or CMBS. According to Trepp, the delinquency rate for office loans packaged into CMBS reached 4.5% in June from just 1.6% at the end of 2022.
Some $270 billion in commercial real estate loans need to be rolled over before the end of this year. Some $1.5 trillion of these CRE loans need to be refinanced over the next three years. Approximately one third of which are on office properties whose values continue to fall as vacancy rates have hit over 20% in NYC and D.C. and are still higher in Los Angeles and San Francisco where they sit at record highs. I expect to see more and more and headlines like this one in the coming months.
The Public Hotel on the Lower East Side of Manhattan is headed to foreclosure auction next month after its owners, Ian Schrager and Steve Witkoff, defaulted on an $85 million loan with Värde Partners.”
A recent report by McKinsey & Co. noted that because of the explosion of the virtual workforce and hybrid work:
“As much as 40 percent of the core of retail and office corridors in the nation’s cities could be rendered obsolete. An estimated $800 billion worth of real estate could be wiped out.”
As the debacle in commercial real estate plays out in the coming quarters, the delinquency rate for CMBS is likely to rise quickly into double figures. The corresponding spike in write-offs across the regional banking sector will likely set off a “credit crunch” that will tip the economy into recession within 12 months.
This likely scenario is simply not priced into the current markets. To me, the biggest investing no-brainer right now are short term Treasury bills while waiting for rationality to come back to the markets as well as lower entry points. They pay just north of five percent annual yields, offer a positive after-inflation return, and are considered risk-free. Approximately half of my portfolio is made up of these instruments currently.
Just over 40% of my portfolio are around holdings with great balance sheets like Exelixis (EXEL) and Valero (VLO) within covered call positions for the additional downside risk mitigation. The rest is made up of cash and very small bets on overvalued stocks in the market via out of the money bear put spreads. I outlined one of these trades around Apple (AAPL) recently.
As I have highlighted above, the risk to equities seems fully tilted to the downside at current trading levels. Investors should act accordingly.
The ideas of debtor and creditor as to what constitutes a good time never coincide.”― P.G. Wodehouse.
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