The Real Pain From Rate Hikes May Still Be on the Way

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1:27Hello and welcome to another episode of The Odd Lots. podcast. I'm Joe Weisenthal. And I'm Tracy Allaway. Tracy, we've been on the road a lot lately. I know. It's been nonstop trips. Let's see. We did Jackson Hole and then we went to California at Huntington Beach. And now we're in Austin, Texas, your hometown. Have you enjoyed Austin so far? Oh, I love it. Okay. I mean, I'm not going to lie. Large parts of it do remind me of Dallas. What? But controversial opinion, but it has its own thing going to like amazing bars, restaurants, shops. We went cowboy boot shopping at Allen Boots. We've had some amazing Tex-Mex, really excellent barbecue at Terry Black's.

2:10It's been good. Yeah, we were in Jackson Hole. We did a lot of episodes in Jackson Hole, but a lot of them were sort of like these sort of like longer running, like academic questions that a lot of the episodes that we did. We didn't really do too much there on like, okay, but like what's happening right now in the economy with like monetary policy, the impact of the Fed rate hikes, things like that, even though that's sort of on a lot of people's minds. Yeah. Funnily enough, at a macroeconomic conference, the real economy wasn't the first topic of conversation. Although that's a little bit unfair because they did talk about supply chains and things like that.

2:44But you're right. We haven't done a current state of the economy episode for a while, although we've touched on it in various ways. One of the more recent ones was when we spoke to Wayne Dahl from Oak Tree about the credit market. And a big topic of conversation in there was why haven't we seen more of an impact from this historic pace of rate hikes on the real economy? Yeah. It feels like this is still this looming question. And until we have a sort of better idea of what's going on here, I think there's like a sense of unease. And even Ed Jackson Hole at Powell's speech, even with the improvement in inflation from last year, there is this still underlying sense of unease, which is partly driven by the fact that we've seen improvement, but it's like we can't quite explain why, because drawing that line between the rate hikes to the improvement in inflation is hard to draw.

3:42you would expect that, okay, if unemployment had been rising significantly, it's like, okay, well, we can tell the traditional monetary policy story. Phillips curve is alive and well. Yes, we can't quite tell that story. And then maybe it has something to do with the terming out of the debt that we talked about, Wayne Dahl. And then if that's the case, well, what does that mean then? Are we still going to feel the impact? So it's like, there's improvement, but there's like sense of unease underneath. Absolutely. But the most simple explanation for what's been going on is, yes, we had a massive terming out of debt on the corporate side and arguably on some individuals as well, homeowners, for instance.

4:19And that's provided a cushion between 2021, 2020, 2022 and where we are now. but it can only last for so long. And you're sort of getting back to the traditional long and variable lags argument. Maybe this is just the longest lag that we've seen in many, many years. So we did actually have this conversation at Jackson Hole. We just didn't get it on the record. Oh yeah, you're right. We did actually talk about all this at Jackson Hole. We just never recorded an episode. But the person who we spoke to in Jackson Hole in Wyoming last month, happens to be based here in Austin, Texas. So we are like, in a way, we're going to like pick up the Jackson Hole series with someone who happens to be here in Texas.

5:06I like how we've gone to Austin to record an episode with someone we talked to in Wyoming. So I'm very excited. We're going to explore these topics and more further. I'm very excited about our guest. Second time, I believe her appearance on Odd Lots, we're going to be speaking with Julia Coronado. She is the founder, CEO, and president of Macro Policy Perspectives. She is also a clinical assistant professor at the University of Texas on business and economics. So Julia, thank you so much for joining us. It is my absolute pleasure to be here with you. Really simple question actually to start. Oh, wait, can I just say, Julia is the first OddLots guest who has ever brought us breakfast tacos.

5:46Yes. Hey. Which now, if you're listening and you want to come on the odd lots, this is now the expectation. Bring food. Bring breakfast tacos. But Julia, so great to chat with you. Actually, just real quick, what do you do at Macro Policy Perspectives? So Macro Policy Perspectives is a macro forecasting firm. So we work mostly with money managers, people that are managing portfolios, and we provide them a perspective on the U.S. economy, we're US focused, but globally oriented and very markets oriented. So we work with money managers to help them understand this crazy world. So speaking of crazy world, and we'll get to all the debt stuff.

6:26Tracy and I, the other night, we actually spoke to a group of students here at the business school at McCombs. And we were chatting about various things. And one of the students said something interesting. They're like, oh, you know, they're talking about CMBS. and they're like, oh, you know, it's hard to know what's in some of the, they're very smart kids. They said hard to know what are some in some of these assets that people are buying. And what if you're buying stuff that's like Austin, downtown Austin real estate, and there's huge vacancies. Isn't that true? Like, it seems like this town is booming.

6:57Is actually underneath the facade here in Austin, like some problems brewing? It depends. There's a debate. The commercial real estate crowd is inherently optimistic, glass half hole type of people. I think you have to be to take that kind of risk. And they've been printing money for a decade, right? Austin has been booming. All of their developments exceed expectations. And so it's been a great run. But yes, there is an overhang. So you see the cranes all around you, but a lot of these buildings are empty. So we have very high vacancy rates, very high rates of subleasing, which is another indication that Google or Meta builds a building but then they don't need it.

7:39And so they sublease a lot of the space. And depending on how you look at it, the estimates of the pipeline under construction as a percent of the existing inventory is by far the highest in the nation and at record highs by many measures. So we've got a lot of supply both in offices and in multifamily that are coming to market in the next 12 to 18 months. And rates are high. Vacancies are high. Probably the assumptions that went into these projects at the beginning are not going to materialize. So the question is, does that mean just reduced profits or does that mean outright defaults, delinquencies, and some distress?

8:22Right. This was going to be my next question, which is how does distress in commercial real estate actually feed through into the wider economy? Because you see different types of arguments, you see a more optimistic scenario, which is, well, yes, there are pockets of stress, but not everything is dire at the moment. Yes, downtown offices are probably the most affected, but maybe a multi-use building in the suburbs with doctor's offices and little shops, probably not as huge a deal. And then the dire scenario that you see every once in a while is that we are going to get a bunch of defaults eventually, and that will impact the banks, presumably, and they're going to have to cut back on lending.

9:06So how are you viewing the actual impact of CRE destruction? That is extraordinarily difficult to get a clear idea of or put good parameters around because CRE is inherently idiosyncratic. Every project is different. The financing of each of these projects come in layers and are sourced differently. So it's really hard to get kind of a macro framing of how much potential distress. I would categorize the banking channel as one that could go nonlinear in the sense that we could see more bank failures. Or it could be just a macroeconomic channel of a headwind. Right now, the unemployment rate in Texas is underperforming.

9:52It's risen more than the national average. That's unusual for Texas. Some of that is the tech layoffs, which are part of what's behind some of the vacancies. So as these projects roll off, you're going to see less jobs. You know, people in the real estate industry and the construction industry are seeing layoffs here, maybe not everywhere, but certainly here. So you'll just see some regular old garden variety economic headwinds, even if it's not, you know, some sort of crisis. It's yet to be felt. And therein are the lags in monetary policy. So I want to get into, obviously, this whole lags debate.

10:31But before we do, you mentioned the developers of various sorts in Austin have been printing money. You mentioned all the cranes. We don't really see many cranes in New York because I guess it's a city. We forgot how to build for various reasons. Well, also, even if they were there, they're up pretty high, right? They're up really high. You kind of got to look for them. Right. Because the one thing they do build are those super tall buildings. The tall, skinny cigarette buildings. Yeah, but Austin is not alone. I mean, is this a broader Sunbelt story? And can you talk about how much of these developments have a sort of, okay, we're building this for Google, or we're building this for Meta or whatever, versus we're building this and it's the Sunbelt and someone is eventually going to rent it, but we'll build it without even knowing who.

11:17Yeah, there is a lot more build it and they will come activity in the Sunbelt that doesn't exist in New York. In New York, before you build a Hudson Yards, you've got several anchor tenants lined up. That is not the case here. You can actually, a lot of these developments, you know, the Google and the meta buildings are an exception, but there are a lot of developments around town that are built on spec. And is it broader than Austin? Yes. There's a number of cities. Austin is by far got the biggest overhang, but Dallas has a pretty big overhang. Denver, Boise, there are, there are a number of the sunbelt boom towns, the COVID boom towns in the West where you can build, where it's relatively more straightforward to get from concept to groundbreaking.

12:05And I would say it is a sunbelt slash COVID boom town phenomenon, mostly in the West and the South and the Southeast.

12:22Thank you.

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14:04Member FINRA and SIPC. Crypto trading provided by ZeroHash. Complete disclosures available at public.com slash disclosures. Can we get Jackson Hole-ish for a moment? But going back to the way monetary policy is supposed to work, when you hike interest rates, you are supposed to be deterring some speculative, frothy activity. So in a sense, how expected is this development for policymakers? I mean, you were in Wyoming. You were talking to loads of people. When you talk to them about what's going on in the Sun Belt construction may be slowing in places like Austin. What do they say and what do they think?

14:46That's a great framing. There's a range of views, obviously. And yes, this is an intended channel to the extent that people took risks that turn out not to be, you know, viable or have a lower rate of return than they anticipated. That's just, you know, that's life in the big city, right? It's just part of taking risk is you realize sometimes some losses as well as some gains. So this is an intended channel of policy. The debate is more around, have we seen all that we've seen and therefore we need to do more to slow the economy? Or are a lot of the effects of this still, do they still lie ahead of us?

15:26And I think that's where there's a range of views. I really respect and like to hear the views of Chris Waller, Governor Waller, but he tends to be of the view that the lags are shorter because of forward guidance, because the Fed is very transparent, that markets react almost instantaneously well before they actually raise rates, and therefore it's all priced in. I think if we think about a credit channel, and it's something we didn't really have last time, right? The credit channel was crisis. We didn't have this elongated kind of tighter credit. How does it feed through into the economy? And because of the refunding that you touched on with your other episode, the lags are probably longer.

16:10And this is something that if you talk to European central bankers, they think of the lags as being longer because of fixed rate financing and more of that, and that it's going to take some time for financing to roll over and to feel the effects and employment and activity. And so you have to know that what you've done already is going to keep being a restraining force going forward. So I'm more in the lags are longer camp because of this than the lags are all behind us camp. Joe, this kind of reminds me of some of the discussion around inflation, just the idea that it's been decades since anyone has really had to deal with higher inflation and we're not sure how to deal with it.

16:50This idea that like, well, maybe it's been decades since we've had a sharp change in monetary policy propagated out into the economy and we don't really get how it works. And the last example was so extreme in 2008. I love the way you put that, which is that we think of 2008 as a credit crisis. Yes. But the actual mechanism by which the economy slowed down was not per se the contraction of credit, but oh my God, the world is falling apart and everyone just slams the brake at once. They They slammed the brake on hiring. They slammed the brake on new development, et cetera, which is not really what people have in mind with this idea that we're just going to pull back on credit and slow things down.

17:30This is the key dynamic we want to talk about. But the realized disinflation that we've seen so far. So at one point, I think we were looking around 9%. Maybe we're closer, like 3-something percent now. But as I said in the intro, no one really knows why exactly. And unemployment didn't rise like the way many economists would expect. What's your story basically for the last 12 months of fairly nice disinflation? So we are big believers in sectoral analysis, micro to macro, right? So what's going on? Look sector by sector. What's going on in the dynamics of how concentrated is a sector? How are the profits panning out?

18:12How is consumer price sensitivity in that sector? and then building, you know, running the top down macro models, but also building that outlook from the bottom up. And the bottom up is, you know, on the one hand, it led us to be falsely in the transitory camp early. But then we pivoted because the reason it failed was we had more supply chain frictions. We had more waves of COVID. We had Malaysian chip factory shutdowns. We had all kinds of Russia, Ukraine, Russia, Ukraine, these frictions and challenges sand in the gears that kept inflation. Meanwhile, also like very strong demand support, very price insensitive demand.

18:54When we look out at the dynamics so far, I mean, some of it, yes, when you look at cars, for example, which has been such a key part of the inflation, and now it's been a key story, higher rates, lower demand for cars, more price sensitive demand for cars, but also improving supply chains, improving inventories, available chips. So it's both a supply and a policy story tangled up together, hard to disentangle. But it's definitely a key part of the disinflation. And if you don't think in those terms, if you're just thinking, OK, economic growth equals inflation, which is kind of what Powell did at the press conference, then you're going to be untrusting.

19:46You're going to be skeptical, part of which is perfectly healthy, but also maybe too skeptical. They're extreme. They have very pessimistic inflation assumptions for the remainder of the year in their forecast. They definitely seem to be leaning on we maybe need to do more. And we see a lot of good things happening in inflation dynamics. One of the things we look at, for example, is the diffusion. How many prices are increasing versus decreasing? That tells you, if you look at the 70s, that was 100%. Every single price was going up every single month, quarter, year. All wages were going up. That's not what's happening now.

20:27Some prices are falling. Airfares go up and down depending on consumer demand. Capacity there has totally normalized. Auto sales similarly up and down. So I think we're seeing a much more dynamic, healthy pricing dynamic, which gives us more optimism that this lower regime can have some staying power and you don't need to hammer the economy. I mean, we had several cycles over the last 30 years where we had growth and no inflation. But because of the PTSD from the pandemic, there's this equating of growth with inflation almost amongst. And what was surprising about the meeting, the September FOMC meeting to me, was how unanimous it seems to be.

21:14everybody's forecasts kind of showed a higher funds rate and everybody raised their 2024 inflation forecast or a lot of people did. There isn't a lot of sectoral inflationists in on the FOMC. And and I think that gives them a very rigid view of how things are playing out. This was going to be exactly my next question. Actually, you mentioned Powell's speech, which was very macro and sort of traditional FOMC speech-ish. But Christine Lagarde of the ECB gave basically the opposite speech, talking about like we are in this weird period where it feels like the real economy, supply chain constraints, fiscal is more in control than monetary policy, and it poses new challenges to economists.

22:05How well-equipped do you think economists are to start looking at individual industries or looking at specific sectors, as you just pointed out, versus the sort of macroeconomic theory that many of them have been trained on. There's a lot of good economists, ourselves included, I would say, that are doing this kind of work. So Alan Detmeister at UBS, Skanda Armanath at Employ America, Omer Sharif, Mike Conskall at Roosevelt. I love that most of these are all thoughts guests. We've never had Alan Detmeister. We should have them. We should. You definitely should. Yeah, yeah, yeah. It's the who's who of all that.

22:42But there's, and you know, we engage in this conversation, in this debate, you know, in social media, and there's lots of great exchanges and analysis, the seller's inflation. Your point about the ECB is a great one. Seller's inflation, let's set aside the loaded term greedflation, but the idea of profit margins. We have purposely avoided saying greedflation. We tried to coin the term excuseflation, which did some people have been using it. But I think sellers or profit led inflation. Yeah, profit led inflation. And if you look at, say, Lagarde's press conference, she breaks down what's been happening in inflation in terms of what's driven by the labor market and what's driven by profits.

23:23Like as a matter of accounting, you know, there's plenty of ECB officials that are sort of well versed in. Yes, there's the labor market and then there's the product side. There's the profit side, the industry side. It has to do with concentration and common shocks, et cetera. So it's not like it's a radical theory. It's not like there's no work out there. It's just like there's nobody on the FOMC that embraces this very overtly. And so, again, I just think there's a common framework at the Fed that is, you know, it's an important framework. it's a useful framework but it's not the only framework and you need to have i would say it's better to have as many possible perspectives and points of view to understand these dynamics you know inflation went up more than even the macro models suggested and at a timing that does not align with the macro models so when you have an error on your model as a forecaster you look forward and think hmm that error might reverse at some point i might get downside surprises standard forecasting i'm not saying anything radical now of course it's not the central bank's job to err on the side of optimism when they're above their target but you know you can you can talk i i don't understand like powell had several opportunities at the press conference there was three or four questions.

24:52Actually, Craig Torres of Bloomberg asked an excellent question about the nuances of higher rates and supply side led inflation in real estate. And Powell just won't go there. He just doesn't want to go to the supply side and talk about those. I mean, he did, to be fair, he did say we understood that fading pandemic frictions are part of the story. But again, I think they just are very shell-shocked by what they've been through in the last couple of years and are still erring on the pessimistic side. You know, one other thing in that Lagarde speech specifically that you mentioned, this idea of like the price insensitive demand and the big source of that is the investment that's happening in like green transition and energy infrastructure.

25:39And that's going to happen regardless. We could have a recession, we could have a boom. We know governments are going to spend a lot on this. They're going to subsidize a lot. And of course, we talk about that all the time on odd lots. And yeah, this is an interesting dynamic. There's a lot of spending that's going to happen regardless of where we are in the cycle. I want to get deeper into the lags debate because I have this like sort of like weird sympathy for the priced in. Everything's always priced in. Everything's always priced in. Yeah, it's all priced in. Yeah, that's what we saw after the FOMC meeting, right?

26:08It was all priced in. day one. And so like, okay, that's the Waller view as you characterize it. Like, why isn't it all priced? What is the case for like, why? Like, all right, even if we know that rate hikes are coming, they telegraph it. We're in an age of very aggressively clear forward guidance. The dots didn't used to exist. That's a modern innovation in central banking. So like, let's talk theoretically and then like, let's get more concrete. What is the case for why it wouldn't all just be priced in and why people don't adjust their behavior the moment the central banks give their indication of where rates are going?

26:44Yeah. The way I think about it is I break it into two channels. There's the capital markets channel and then there's the credit channel. And the capital markets channel, exactly as you describe, the Fed telegraphs its intentions, its perspective on the balance of risks and capital markets price it in. But there's the credit channel side where you've got this fixed rate financing for a couple of years and you've got time and there's legitimate uncertainty about where we're going to be in a year, in two years. And if you are, again, commercial real estate is a perfect example because they are glass half full kind of people.

27:27And there's been a real conversation. And, you know, I talked to a lot of people in the real estate industry. There's a real sense that, you know, if we hold on long enough, rates are going to go back down. And so I'm not going to mark my losses. I'm not going to scale back my project. I'm going to maybe slow walk that project and not be in a hurry because I think if I come to market in a year or two years and I need to roll over my financing, I'll get better terms then. And that's not irrational but it does mean that you know if they're wrong which you know the market has moved one of the things that's happened since the last fomc meeting in july is that markets did move to higher for longer pricing real rates are up 50 basis points and so we have yet to feel the effect of that last leg of increase in real rates.