Which Mistake Would The Fed Prefer To Make?

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1:48Which mistake would the Fed prefer to make? Welcome to Real Vision Daily Briefing. It's Friday, April 21st, 2023. I'm Ash Bennington, joined today by one of our favorite guests, Harry Malandri, advisor for MI2 Partners. Harry, welcome back, man. Always a pleasure to be with you. It's great to be here. I'm shocked I'm one of your favorite guests, but I'll take that. I'll definitely take that. Well, you've earned it. Listen, the second half of the show today is just for Real Vision members, we should say. So if you don't want to miss it, you can sign up by using the link in the description or scan the QR code on the screen.

2:23Let's jump right into what's happening today. Harry, you know, we've been talking about this a lot at Real Vision. It feels like kind of a weird moment in markets, in macro. We alluded to it at the very top of the show with that question, which mistake would the Fed prefer to make? It does have this feeling like we're sort of perched between the Scylla and Charybdis here of rising inflation or inflation that still can't be contained. may be better said, and some of the risks that we're seeing in the banking sector, some of the retreat we're seeing in home prices, just a lot of stuff happening.

2:54Big picture, where are we? How do we frame it? How do we contextualize it for the viewers? So MI2, the way we're looking at it is, first of all, we have a rather bearish analysis of the real economy. For us, what we see is a classic inventory cycle that looks like it's running into a credit crunch and a construction cycle at the same time. I hesitate to use the word perfect storm because it's a bit of a cliche, but this doesn't look like it's going to be fun. Harry, let's break all of that down for our audience, many of whom are not familiar with thinking about inventory cycles per se as a way of understanding market dynamics.

3:35What does that mean first? What is an inventory cycle and where are we in it? And finally, why is it so important to understanding the overall picture of where we are from a macro perspective and its influence on markets? So, you know, you're asking me something so basic, it's hard to be sure my definition will meet the minimum requirement. But oscillations in the underlying level of activity in the economy can be amplified. And one of the obvious channels for that is the inventory channel. If you order a little bit too much inventory and if everyone does it all the way along the supply chain, pretty soon we have way too much of everything.

4:19And soon after that, the economy slows down because people cut production. So I gave you some slides and it's probably a good time to take a look at one of those slides. We have quite a few charts we could pull up, but this seems like the best one to illustrate why MI2 thinks we're about to hit an inventory cycle. And it's a chart of the ISM customer inventories versus the ISM manufacturing headline number. This is Institute of Supply Management that does these studies that give us a sense of what's happening in the economy. Boy, that's an unusual chart. Wow. So the red circles show you where the customer inventories flip above the manufacturing headline number.

5:09And the intuition is if you've stuffed your supply channels partly by oversupply and partly by a lower than anticipated demand, you tend to have to cut production soon afterwards. So either way, these circles tend to follow, tend to signal the start of an inventory cycle and a big cutback in manufacturing output. I can't quite read the x-axis, but it looks like a pretty sufficient time frame in years. I think it's probably about 20-year time horizon. And what's interesting to me is that we see the largest gap between those two indicators that we see on this chart. That's pretty striking. Yeah, you know, I think a lot of that is just the scale of some of these enormous moves we've had.

5:54But yeah, you know, I would hate to lean on any one indicator too hard. But if this one is showing that it looks like the underlying growth is slowing and, you know, that's happening against an unfortunate backdrop. So, as I said, it's not the only thing which points to a slowing economy. We also have a credit cycle. And I think with the credit cycle issue, I don't think anyone could have missed it. Like banks falling over, everyone tends to spot it when banks fall over. And it really isn't a great sign. There's an economist at BU called Paul Schmelzing, and we've used his work in the past. We love his stuff.

6:42He's responsible for things like 800 years worth of data. And I think one of his pieces was VAR, Volcker, and bond market reversals. Venetians, VAR, and Volcker, because he's using 800 years worth of data. So he recently did an analysis where they did a taxonomy, if you will, coding the financial shocks over the last couple of centuries, I think. And this policy mix we've just had, where you see substantial injection of reserves and deposit guarantees, that tends to be associated with something that subsequently is recognized as a systemic banking event. So, you know, it's definitely what we're seeing walks like a duck and it's quacking like a duck.

7:46And I think a lot of people are aware that the Fed, all it managed to really do was provide huge amounts of liquidity to banks that were struggling a bit with getting liquidity after they'd lost a lot of money on duration, among other positions. The liquidity they supply, furnish, doesn't eliminate the problem. It means that we don't have, they're not going to suddenly collapse because of deposits. We've already had quite a few banks that did that, that just collapsed because they ran out of deposits. But it does mean that we have capital impaired weaker regional banks at the moment in the US.

8:31Now, so the analogy is that the Fed resuscitated the patient but didn't cure the disease. Sorry, Ash. No, I was just going to ask you to talk a little bit and expand upon where we are right now in the credit cycle. Obviously, lots of folks have been following the news cycle very closely. Obviously, we see what happened with Silicon Valley Bank. We've seen some of these tremors happen throughout the system. There's been a lot of talk about a credit contraction, about some of the impact into firms not being able to get the credit that they may want or need. Let's talk a little bit about what's happening in the news cycle so people can contextualize this 800-year cycle in the context of what they're reading every day when they pick up the Wall Street Journal, because it is just an unremitting sort of stream of trepidation and doubt about what's going to happen in the future of credit.

9:16So you can tell that we're restricted in the amount of credit available. And that's not really a euro bond issue. If you look at Fortune 500 companies, there's trivially small widenings in spread product in corporate bonds. There's almost nothing there. Mortgage bonds are a little weaker, but where you see real problems is in CMBS. CMBS is showing all sorts of signs of weakness and limited demand, but also in in what's generally referred to as a shadow banking sectors. Can we define that and talk a little bit about what commercial mortgage-backed securities are and what their significance is in the system for folks who may not know?

10:08Sure. So when we originate debt secured by commercial real estate, that debt can be pooled and it tends to go into bond pools called CMBS. And the CMBS pools, they may have a huge number of different bonds in them, often specialized by sector. So you might see things like, what do you call them, malls in retail. You might see office CMBS. You'll get a huge amount of paper written on this. And this paper has been distributed into insurance companies. it's in the banking sector, it's in pension funds, it's everywhere. Sensible real estate investors don't like to leave too much equity in their deal.

11:04So as real estate values rallied and as yields came down, people kept on refinancing their deals and issuing more paper and extracting the equity from the deal. We're now in a place where a lot of that paper, because rates have gone up, We question the underlying value of these things. We question those collateral values partly because cap rates are now upside down with regard to funding rates, but also because we've had – sorry. Just a reminder, the Real Vision Daily Briefing is in partnership with the Gold Investment Letter, helping sophisticated investors successfully navigate capital markets and maximize profits in gold, silver, and mining stocks.

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13:21No, I was just going to say we should say that cap rates are an important component of understanding real estate investment. This is capitalization rate. It's very often the way that real estate investors price property and get a sense of how cheap or expensive it is. Yeah, I'm bound to misspeak because it's not really my home pitch. But the right way to think about cap rates is you've got a net operating income on your piece of real estate. And if you divide that by the purchase price, you get a cap rate. So how much does your piece of real estate yield after costs? And as I said, the odds of me misdefining that slightly are very high.

13:57No, that was perfect. How much does it yield in terms of costs? And then the reverse, how much does it cost in terms of yield? You can think of them as sort of - Exactly. So this is where we get to cross-compare cash flows. What we can do here is now take a look. If you've got a positive spread on the cap rate relative to your funding costs, there's a chance, and it is only a chance, by the way, that your piece of real estate will positively carry, that you'll make money after you finance it. um now you've got probably you haven't considered all of your costs in that but if you were you know a positively financing piece of real estate will give you net net cash flow after you pay off your your all your debt service now apart from refinancing the loan now uh what's been going on well uh we we built a lot of real estate uh we have a fair amount of real estate which is not, you know, no longer meeting the needs of business.

15:01So real estate, which maybe doesn't have class A air conditioning units, class A heating, class A wiring for data, ceiling heights, all sorts of things. We have legacy offices, which are just not as popular. Businesses want top quality space. And there's a fair amount of top quality space now that we fired so many people from the tech sector. So what does that mean? That means that rent's sliding. And as rents slide and vacancy rates increase, we get into this kind of vicious circle where it becomes hard to refinance real estate. Now, I don't want to spend too long on this because there's a lot to be said and there are specialists in the field.

15:46But let's just say that banks own a fair amount of real estate related debt. Insurance companies own a fair amount of real estate related debt. And municipalities are exposed to tax streams from real estate related assets. So all of those groups might be a little worried about the returns on their assets. Yeah. And obviously, it's worth mentioning that the position that we're in with commercial real estate right now, in addition to the cyclical factors that you're talking about here, which is this constant rolling between these different points in the cycle. We also have these secular factors, one-time factors, significant disruptions to the economy in terms of what's happened here with the COVID epidemic and the fact that, I don't know about most people out there listening, but I don't go into an office anymore.

16:37And there are lots of folks who are like me. When you see that decrease in demand and the supply remains constant, obviously these buildings are durable assets. They don't go away when you have a real estate cycle, when you have a change to the economy. So what you have is prices declining as a consequence of this sort of one-time secular event that has had an enormous impact on the global economy here in the United States and abroad. Exactly. And I'm not talking to you from an office either. It might look like I am, but that's a pretty unconvincing backdrop. You did a great job with your home office, Thank you.

17:13That's very impressive. Yeah, I've got to hide the foosball table. It's apparently not something you're meant to have, but it's really popular. Let me ask you this. Is that Midtown East? Is that the city building? I think it – yeah, absolutely. I think we're looking out over Queens with our backdrop. What's really strange is we're facing the opposite direction, right? Because I'm looking at you toward New Jersey, and Queens is behind me here on the Upper East Side. So it's like everything's flipped. Yeah, exactly. Exactly. So we can see that regional banks have a problem brewing, and that's worse when we think about the deposit situation.

17:53I read earlier today that$4.7 trillion worth of non-interest bearing deposits had been modelled as having a seven-year duration. Well, let's put it this way. You have a large deposit in a regional bank. It's your upside to keep it there. Not very much. What's your downside? Well, if it's not federally deposit guaranteed, your downside is the entire deposit. So naturally, we've seen deposits bleed out of the banking system. And I would argue there's nothing. People are not stupid enough to leave money in unguaranteed bank accounts, having seen what they saw with SVB Bank, Signature Bank, and so forth.

18:39So that bleed, it's just inconceivable to me that it will not continue unless the government, unless the authorities choose to guarantee every bank account, which there are really good reasons why they don't want to do that. It's effectively a form of socialization of a banking system. And we need a banking system which is a private sector entity. We don't want a socialized banking system. Perry, is the perception that large money-centered banks here in the United States, the Wells Fargo's, JPM's, Bank of America's of the world are essentially implicitly guaranteed? Well, that is a perception and that has been the reality.

19:19And the authorities refer to them as systemically important banks. So what you don't want is that the people who had their deposits in SVB Bank were very lucky that that bank was considered systemically important. And we should perhaps ask a few more questions about how that determination happened. And the bank itself had lobbied very aggressively to be considered not systemically important, which is a burden. So there's a whole series of things one might ask quite pointed questions about. But right now we're focused on this issue about whether or not the credit disaster that we almost had is over.

19:59And I would argue it's inconceivable to me that it is over, simply because you can't unsee a series of bank failures. Right. And if you know that you have an unlimited downside on a risk with very limited upside, why would you take that? And what's worse is now think about it. So imagine that you're a regional bank and you had assumed you had a block of non-interest paying deposits that you could use and lean on for your funding and that kept your funding costs low. Well, your funding costs have just gone up massively. So you've got a sustainability problem. You've got a problem in sustaining your business model.

20:44You've got a problem in sustaining your profitability. and there are really good reasons why you'll be in defense mode going forward. And not just you, I would suggest everything in the shadow banking sector is also in defense mode. People having seen this kind of event will be quite cautious in rolling over existing risks. Harry, it's so interesting that you should make that point because it's precisely what Andreas Steno-Larsen was talking about in his most recent Steno's Signals, the big discrepancy between East and West aired yesterday on Real Vision on 420. I want to take a look at this clip because it really makes precisely the same point that you're making right now.

21:26Let's take a look at it. So what we saw in March and April was this uptake in emergency lending from banks at the Federal Reserve. So the lender of last resort stepped in with emergency liquidity when it was needed. And typically what we see after a short while is that banks faced with liquidity issues and deposit flights tend to take very conservative decisions on their credit policies. And we have gathered evidence also over the past couple of weeks of very conservative decision-making among large banks in the US, both for consumer credit, auto credit, and home credit. So I think the evidence is slowly but surely building now that the credit contraction will eventually unfold in the US after a time lag since the credit decisions are now very conservative in banks.

22:23Also small and medium-sized companies, they tell us now in surveys that the availability of loans is less good than it was just a month or two ago. So that is ultimately what happens once liquidity stress hits financial markets. And therefore, when we look a bit ahead, I think the banking sentiment and the banking crisis is likely to worsen. Okay, so obviously, some bearish views from Andreas Stenos-Larsen, talking about this challenge where you essentially have this risk, a heightened risk of credit contraction going forward after they have access to emergency liquidity. It's an interesting concept.

23:03Harry, what did you think about it? How does it jibe with your view or not? So I totally agree with Andreas in this case. I think that the Fed supplied all the liquidity the regional banks might need. The big banks didn't need it because they are systemically important. Everyone understands that they won't be allowed to fail. The scenario is unacceptable. But the regional banks are now looking at closer regulation. They're looking at more expensive capital, more expensive deposits. If rates stay where they are, they will slowly realise the capital losses that they would show if they marked their duration positions to market.

23:40So we will need rates to come down for all the regional banks. Well, not all, but a fair number of regional banks will be questionable. And the market will go on a seek and destroy mission for weaker banks. Hence the incentive to stop lending and shore up capital positions. You guys have come across the joke about bears, haven't you? You know, being chased by a bear. I know precisely the joke. so two guys uh come across a bear in the in the woods and one guy drops to his knees and starts praying and the other guy starts lacing up his book his boots and the gentleman who's dropped to his knees and praying saying oh for goodness sakes you don't really think you can outrun a bear and his friend says oh no i don't think i can outrun a bear at all however i think i can outrun you and this is the logic of the situation we find ourselves in now with the banking system weaker banks will be in trouble.

24:37So if you can put yourself to be in a stronger position than other regional banks by maybe cutting your lending or maybe shifting your portfolio around to have better, shorter duration bonds, more liquidity, then you can outrun, you can't run the market, but you can outrun the weaker banks until the Fed changes its mind. And I think that guarantees that the weakness in the regional banks will remain. And what that really means is we have a situation where there's not really a good reason to lend, to do CRE lending, commercial real estate lending. It's not really a great reason to do residential lending either, except for the fact that a lot of residential lending comes from federal agencies.

25:23But that lending is slower. You have to dot I's and cross T's. And you don't transact huge portfolios. You certainly don't transact shopping malls, generally speaking. You're talking about the GSEs here, yeah, Fannie and Freddie? Yes, exactly. So the agencies will continue to lend. So for conforming mortgages, we'll see that business continue. It'll slow down overall, though. And generally speaking now, we're going to reward banks that don't lend. And that's a problem. we're going to see less real estate investment. And so GDP growth will weaken. Harry, what does this portend more broadly for equity markets, for fixed income as we look?

26:11Obviously, this sense of trying to search for direction, kind of a stagnant period right now in the S &P. How do you feel this carries over to equities? So it's a really good question here. which is we've got quite a bearish view. We can see that we're in a bearish situation for the construction, for cyclical construction. We have an inventory cycle, which is bearish. So why are equities so damn strong? And I can posit some arguments. I can't prove it. But one of the arguments I'd make isn't really made by me. It's made by a guy called Warren Mosler. He would point out to you that fiscal policy is more stimulative than it looks because higher rates with high debt to GDP levels are producing an awful lot of interest income for people who are now invested in government bonds or deposits or whatever, guarantee deposits.

27:21So the amount of interest income, it's a very backward-looking number that's produced on the Fred series. But this thing, it looks like an exponential chart. We're seeing something like$865 billion annual rate of interest expense in the federal budget. That's a stimulative – in the flow of funds analysis, it's a kind of stimulus. Now, the counterargument to that is it's hardly a progressive stimulus. So you're basically putting huge amounts of money into wealthier – into the portfolios of people who would normally spend on assets. They don't consume that money. So it's a relative – Right. This is an important point here.

28:08I just want to double-click on it because I think it's so important. Now, obviously, from one perspective, people will talk about the economic inequality issue, which is certainly the case. But macro economists will look at this and say exactly what you just did, which is the difference between marginal propensity to save versus marginal propensity to consume. When a large portion of return goes into the hands of those who consume very little of their next marginal dollar earned, in other words, the next dollar they earn, what winds up happening is you don't have the kind of stimulative effect to growth.

28:39Whereas if you put it in the hands of working people, working people have unsatisfied needs. They get a little bit more money. They want to go out and spend it. They want to buy a bigger house, maybe start a small business, all of these kinds of things. When it's going to people who are essentially making money, I guess the old-fashioned word is the rentier class, making money on rents and basically clipping coupons from bonds, what winds up happening is it goes back into assets. And you have this pro-cyclical effect where you get even more asset price inflation as a consequence of that earning.