Steno's Signals: What to Make of the Real Estate Rebound

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1:24Real estate is rebounding while inflation is veining. Is risk back on? That's the question of today's edition of StenoSignals. My name is Andreas Dino. It's great to be back on air after a few weeks off air with StenoSignals. And we have plenty of stuff to discuss today, not least in relation to the housing data that we've received from the US over the past week, paired with news on inflation. I actually think those two themes tie very well together. So let's have a look at the details of the housing market right now and why we also see positive spillovers to commercial real estate. This week, we received news from the print on housing starts in the US.

2:07And as far as I remember, this is one of the biggest positive surprises in a long while for housing starts in the US. It printed way above consensus, meaning that the new starts of home building is basically rebounding to an extent not expected by economists nor any other pundits out there. And this is, of course, of relevance in an economy that has been slowing since housing is a great part of the U.S. economy. And when housing starts rebound, it is typically a sign that the economy is not doing as poorly as expected. So, of course, the market also reacted to this. And the Federal Reserve is now expected to hike in July based, among other things, on this print from housing starts.

2:59And it was a major surprise to many. And I think it is a symptom of a broader trend in real estate over the past, say, three, four months here. If we look at the supply in real estate, we now have a situation with gaining supply again, meaning that it is easier for demand to outpace supply than it was just a few months ago. And I think we're back to a discussion on what I call the golden handcuff syndrome. A lot of people are stuck with 30-year fixed mortgages at, say, 3 % from the pandemic. And now that mortgages are printing at rather 7.5 % or thereabout, there are simply no reasons to move unless you're forced to, meaning that the supply in the housing market will stay extremely tight until the labor market deteriorates.

3:50And we're still probably at least a few months, maybe even a few quarters away from that point. So the housing market supply will remain very tight, meaning that the demand, even at interest rates of, say, seven to seven and a half in the mortgage space, will continue to sort of support a decent market functioning and a price action that is much better than feared. And if we look at pending home sales relative to the real estate price index, we also see how pending home sales is relatively low, meaning that the transaction volume is still low simply as a consequence of a lack of supply. And I think it's very hard to change that situation unless the pass-through from interest rates from the Federal Reserve to the real estate market becomes clearer.

4:38And as of now, at least when we look at residential real estate, it will take quite a long time before the actual pass-through from monetary policy will sort of make its way through the residential real estate sector. But if we look at the real estate sector in a broader setting, including commercial real estate, I'd say that we still have less clear trends, at least seen from a positive perspective, in the commercial real estate sector. The reason is that the average duration of loans in commercial real estate is much less mature than what's the case in residential real estate. So simply the duration is shorter on average.

5:24And that also means that the spillover from monetary policy to commercial real estate is clearer. Alongside that, we obviously have the work from remote trend still ongoing. The latest data I've seen from San Francisco is outright at the small. 30 to 40 % of the volume of calls made, for example, downtown in San Fran relative to pre-pandemic levels. So it basically means that the work from remote trend has remained intact even after the reopening of the U.S. economy. And there are more or less no signs of a true return to pre-pandemic trends. And if we look at the price trends in the commercial real estate space, it is very visible that the office space is the subsector hit the worst as a consequence of this work from remote trend.

6:11We know that a lot of refinancing of loans in commercial real estates will happen over the next, say, 12 to 18 months, meaning that the pass-through from interest rates will be a lot clearer in this particular part of the real estate sector, making me a lot more worried about commercial real estate than residential real estate at this juncture. But it's not all rosy. If we look at delinquency rates in the US, they are on the rise. And this is typically something that we see, I'd say, in between 6, 9, 12 months ahead of the recession, that delinquency rates start to rise as a consequence of interest rates on the rise and so on and so forth.

6:56So there is a pass-through from the fiscal and monetary policy setup currently. But it just takes a while longer than usual in residential real estate since a lot of people locked in those 30-year fixed mortgages during the pandemic, making it a long journey to sort of put the residential real estate under pressure compared to commercial real estate. And if we look at the price trends in Resi real estate, we've actually seen a rebound in sharp contrast to what essentially everybody expected just a few months back. Both on the West Coast and on the East Coast, we've seen a steadying of the ship, so to speak.

7:38And especially on the West Coast, it is a game changer that we've seen a rebound in house price trends. And hopefully, for the sake of the commercial real estate owners, we will see spillovers to commercial real estate from this as well. So far, it is not as evident, but it is also evident just not to the same extent across hotels, retail, et cetera. But residential real estate is rebounding. That is safe to say. And I mean, the mere fact that we went from, say, 7 % mortgage rates to 6 % in the early parts of the year actually allowed some mortgage applications to resurface. And I think that's, we basically see the repercussions of that already now price-wise across the landscape.

8:22In terms of the commercial real estate sector, I mean, it's structurally speaking over the next, say one or two years, I've remained very skeptical that this is a sector that will perform once all of the refinancing of loans will feed through the system. So who are the backholders of the exposures in commercial real estate space. If you look at the chart here, the dark blue colored area at the bottom shows the percentage of the exposure towards commercial real estate loans held by banks. And smaller regional banks actually make up a large portion of that banking exposure. So this is something to watch still when it comes to the banking sector in the US and also exposures in particular in regionals.

9:09I would be surprised if this is already a story of the past, given the amount of refinancing that we have just ahead of us in the commercial real estate space. And bear in mind that this is an issue for mainly regional banks, not to the same extent, at least not from a relative perspective for larger banks. So why does this rebound, both in sentiment among home builders and the actual rebound in price action in real estate, carry spillovers to the inflation picture? Or rather, maybe vice versa, why is the inflation picture relevant for this discussion? Well, if we look at what I call the circle of life, it's sort of a wheel of the overall inflation picture in the economy that I've created.

9:58I think that we see signs now of a clear decline in prices of what I will call input costs for construction companies. Right about every commodity relevant to the real estate sector has dropped in price over the past 9 to 12 months. We see an outright decline in commodities as a consequence of a decline in the amount of money in circulation, basically. And when we see a decline in the commodity space, it typically spills over to what I call input prices in the producer leg of the inflation equation. And once input prices start to decline, we should also expect output prices to decline. So the price of the house when you get the keys is simply lower than it was three, six months ago.

10:51And that is of relevance also for the discussion on consumer price inflation. When input costs drop, we know that is a certainty already now. We see it month after month in the US number, but also elsewhere around the globe, especially in Canada. We know that output costs ultimately drop. And then the company will have to either increase or decrease margins from there to ultimately get to the selling price, the so-called consumer price index. And given the very elevated margins that we saw through 22, my bet would not be that they will be able to at least increase margins in the current environment at this juncture in the global cycle.

11:31And if so, then this drop in commodity prices through input prices via output prices will ultimately spill over to consumer prices, even if margins are kept roughly unchanged. Just a quick moment to remind you, today's Real Vision Daily Briefing is sponsored by CraneShares. Learn about their KRBN ETF at craneshares.com forward slash KRBN. Now back to today's analysis.

12:03And therefore, given what we see in producer prices this week, we've seen a sharp decline in May in Canada. We've seen a sharp decline in May in the U.K. We've seen a sharp decline in producer prices in Germany in May, and we've also seen a decline in the US through May, falling prices. So it makes me optimistic on behalf of the inflation cycle, say, three, four, five, six months down the road. But given the amount of action that we've seen from central banks this week, it is not something that they're willing to admit to yet. That is also safe to say. So let's look at this inflation cycle in a sort of a real life example.

12:38I'd like to use the UK as the example, given that the Bank of England hiked by 50 basis points today, topping market expectations and also partly shocking markets with a much more aggressive approach. If we look at the circle of life, the green line shows the ongoing growth or decline in the amount of money available for the real economy in the UK. We now stare directly into the decline phase of the overall money growth. Typically, what happens after a while is that it's built over to commodities, then to producer prices, as you can see on the input side, producer prices on the output side, and then ultimately the consumer price index.

13:20And it is actually ranked from left to right, given the sort of line of events in the lifecycle of inflation. So I'm starting to convince myself that the signals that we get from the producer leg of the equation are as firm as they get, basically, given the current development in price pressures and commodities. And it's all driven by money, essentially. And that is also what I try to showcase in this wheel of inflation, that once there is a decline in the overall amount of money and credit available to the economy, it typically means that you should expect this to spill over. And on the next chart here, I have sort of a table that aggregates money growth across various jurisdictions.

14:07And we have the money in outright decline in both China, the US, Europe, and also the United Kingdom. So, I mean, it is a general trend across the entire global macro landscape that the growth in money is now declining on a month-on-month basis. basis. And I think we should expect this to slowly but surely pass through this life cycle of inflation and ultimately reach consumer prices. So now I'm asking a question that I will probably get a lot of questions on after asking it, because could this essentially lead to deflation in 2024? I wouldn't rule it out, at least, given that we see price declines in the producer leg of the price equation.

14:57If margins are kept on tack, that could lead to price declines in the consumer part of the equation. And that is, at least on paper, a deflation scenario defined, right? If we look at the development in M2, so the broad money base in the US versus the CPI, there has historically been a lag of, say, in between one and a half and two years between the decline in money and the subsequent decline in prices. So that means that 2024 is one to watch for when it comes to price action, since there is an outright risk of falling prices. And you could actually welcome such a scenario at this juncture. Not if you have a lot of debt, but if you haven't, then falling prices would be clearly a win-win scenario.

15:47And it's actually the same in Europe if we look at the developments in M2 relative to the consumer price index in Europe, there's this time lag of, say, in between 18 and 24 months between the decline and the money growth until we actually see a broad-based deceleration and decline in the overall consumer price index. And I mean, given this historical correlation, I'm tempted to say that we will be surprised on the low side on inflation next year. But it just takes a while before it makes it through the entire system. First, a decline in money, then a decline in commodity prices, then a decline in input prices, then a decline in output prices, and ultimately a decline in consumer prices.

16:34So we need to be patient. And that is also why central banks have lost patience. Let's look at a few charts on why I find this pattern to be historically very stubborn. If we look at commodities relative to producer prices, we have a very strong relationship between commodity prices dropping and producer prices dropping ultimately. And that is the juncture we are at right now. Commodity prices have been falling over the course of the past two, three quarters, and they've now led producer prices into negative territory, as you can see from the chart here. This is US data, by the way. Is the PPI, so the producer price index, then a good leading indicator for consumer prices?

17:20Well, let's take the Canadian case first. If we look at Canadian producer prices relative to Canadian consumer prices, we actually have a chart that looks as deflationary as it can, I think, in Canada, given that we now have an outright decline both on a monthly and a yearly basis in producer prices. And typically, it spills over all the way through the inflation equation to consumer prices with a time lag of, say, 5 % to 6%. And the same is the case in the UK. They've used the most recent very poor CPI report from the UK as an excuse to hike by 50 basic points today. I get why they do it. And I probably also think it's the right move.

18:06But if they look a bit ahead and look at producer prices in the UK, they actually have a pretty decent leading indicator for the consumer prices in between five and six months down the road. And I think that's at least of relevance to the discussion on fixed income and interest rate markets right now, that central banks, they kind of fear trusting this framework that I'm currently laying out. basically as they've been wrong and right about everything since 2020. So I think the appetite to try and forecast what's ahead is extremely low at central banks right now. And that also means that they can hike interest rates even though they're well aware that the disinflation or maybe even the deflation is very present in earlier stages of the inflation cycle than in consumer prices.

18:53And ultimately, what I wanted to show here before we get to the questions is a couple of charts on the inflation outlook relative to the most updated projections that we have from central banks. Because I find that to be the ultimate question to answer, both when it comes to the commercial real estate market, the real estate market overall, but also the road ahead for fixed income. will central banks be surprised on the low side of their inflation expectations or on the high side? And they've been surprised basically on a running basis for maybe one and a half years now on the high side of their expectations.

19:34But if we look at producer prices, so an early leg in this inflation cycle relative to their consumer price index forecast, let's take the US as an example first. Then I would actually say that we have a pretty decent risk reward and maybe even a relatively high probability of betting on central banks now being surprised on the low side of their expectations. So the pink vertical line is the 2023 year-end forecast for the CPI in the US made by the Fed. and as you can see from the PPI on the chart in the lighter blue, there is a pretty decent chance that we will get below that point in the consumer price index already before year end.

20:18And that will allow the Federal Reserve to be positively surprised, you might argue. If we look at the same equation in Europe, I think it looks even clearer. The European Central Bank updated its inflation projections just last week, and they now expect European core inflation to print on average at 5.1 % through the year. And the dark blue line here is the core PPI, so the producer price index without energy and food costs. And it looks relatively clear to me that we will have surprise on the low side. And we essentially, and now I sound a bit too cog to what's fair, we essentially already know that if the typical patterns unfold through the cycle of inflation.

21:09This was sort of a short introduction to a broader framework I've made on inflation. I've labeled it the circle of life and inflation. And I actually think that if we track the developments in some of the earlier parts of this chain, we will be able to pinpoint where the inflation developments further down the road is headed. And I finally think that there is a decent chance that central banks will be surprised on the low side, even though they've been constantly surprised on the high side of expectations when it comes to inflation over the past one and a half years here. I will conclude my early remarks here with a big question mark, but also a very interesting chart in relation to this.

21:56Should we assume that the Federal Reserve has already paused the hiking cycle? Not only skipped the meeting, but paused the hiking cycle from here. It's debatable. Then I would argue that the lower inflation paired with current positioning, paired with the possibility of at least a sentiment rebound in commercial real estate and real estate, should lead to risk on for, say, the next one or two months. Typically, what we observe in markets such as the S &P 500 100 days after the pause in the hiking cycle, is that the S &P 500 rallies. It typically drops again, but it rallies right on the back of that pause.

22:41So should this be a pause? I'm not overly convinced, but should it be a pause, then positioning is very wrong-footed here, and we should expect risk assets to perform over the coming one or two months. I'll take a few questions now we have a question coming in from Will he's asking me hi Andreas the key difference of opinion between Raul and Julian Brickton is that Raul thinks the recession was already priced in whereas Julian thinks it's yet to come and risk assets will fall in Q3, Q4 where do you stand? as of now I stand in Raul's camp I think positioning is extremely negative if housing rebounds as we have early very early evidence of.

23:25We should probably expect the recession talk to be postponed, say, another quarter, maybe even two. And that is of relevance for the current positioning in equity space where most real money players, be it pension funds, asset managers, or the likes, remain underweight equities relative to benchmarks. I also have sympathy for Julian's view. I just think that the ultimate recession is being postponed. Once again, due to this temporary tailwind to the real estate market from falling commodity prices and a pickup in sentiment due to falling inflation. We have a question on crude oil in relation to this discussion on inflation and the housing market.

24:10Sandy asking, what's the outlook for crude here? And I mean, we currently have a very clear talk of war ongoing between especially Saudi Arabia and speculators. If we look at managed money, so essentially hedge funds and CTAs, and their current net speculative position in crude, it is about as pessimistic as it can be. And typically, you want to fade such extremes. The reason why I'm hesitant to do so right now is that this is a clear, I say, empirical test of classic game theoretical theory. If you look at the speculators right now and their positioning, if you ask me clearly, this sign to try and force OPEC Plus into noncompliance.

24:59They've sniffed out disagreements within the OPEC Plus group. And if they managed to bring down the price even further here, countries like the United Arab Emirates, some of the African countries, Nigeria, Angola could be tempted to try and prop up production in non-compliance with the supply deal that was struck with OPEC+. So I think that is why speculators are as aggressive as they are right now. They're trying to force a reaction in the supply space. And currently, they have the upper hand. So I'm actually leaning in the opposite direction. Question from David. Employment is still high in the US and in the EU too.

25:43How can there be any deflation with such a high employment number? Impossible. Inflation will shoot up again. And it's, of course, an extremely relevant point. As long as wage inflation is as high as it is currently, we will not see the sticky components of the consumer basket dropping in price. And wages, to me, they form a part of what I call the margins in the lifecycle of inflation. And interestingly, what typically happens is when inflation drops in headline terms due to commodities and food, some of the traded stuff on exchanges, right? We see a decline in headline inflation relative to wages that will remain higher, at least on a growth basis.

26:33when real wages increase so you get a larger spending power it basically also means that the average selling price from a company declines relative to the um sorry relative to uh the um margin right and that is of relevance for the margin outlook for companies or the profit outlook rather, meaning that when we have an increase in real wages, we actually see a decline in profits and margins, typically. That inverse relationship is extremely neat since 2019, but it works over longer time frames as well. So when you actually increase the purchasing power of consumers, if they don't go out and spend that immediately, companies will have to lay off people as a consequence of squeezed margins.

27:25And I actually think that we're staring into that maybe, say, six, nine months down the road. Wages will remain sticky through the second half of the year, and then they will drop back materially into 2024, if you ask me. I will leave it there for today. Thank you very much for the questions. The intention is to be back every single Thursday with StenoSignals here. And if you like what you've seen today, we have an exclusive offer for you today. We run our life portfolio at Steno Research, and we also put money behind our ideas. We've, for example, expressed ourselves in a couple of real estate positions over the past few weeks.

28:06So an exclusive offer for you out there. You can get 40 % off your purchase at stenoresearch.com if you visit realvision.com. That will guide you directly to the subscription page. And this is an exclusive offer for the community here. I'd like to remind you that this is a window into my thinking, into my methodologies. I cannot guarantee you that you have the same risk appetite or the same risk horizon as me. But what I can guarantee you is that we will be back week in and week out with the latest from global macro and how to trade it. Thank you very much for watching. Thanks for joining us, everyone.

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