Market Rising: Is peak inflation behind us? CPI suggests so
But the Real Estate market threatens to drag us down
Wednesday, August 10th, 2022
The Market soared today on news that inflation decelerated in July, perhaps signaling that peak inflation is behind us and that the Federal Reserve's policies are working. All significant market indexes rose:
The S&P 500 increased by +2.13%
The Dow rose by +1.63%
The NASDAQ jumped by +2.89%
The Russell 2000 climbed by +2.95%
Is peak inflation behind us?
After a few down days as investors anticipated today's inflation report, the Market jumped on news that we may have just passed the worst of inflation. The US Census Bureau reported that July's Consumer Price Index, a popular inflation gauge, was 8.5% higher than the previous year.
Although this number is still mind-boggling, considering we've had stable inflation of around 2-3% over the past 40 years, it was lower than June's blistering 9.1% price growth rate. It's important to note that economists have been mistaken about peak inflation in the past, such as in April vs. March.
Nevertheless, Wall Street cheered on the number, as it came in -0.2% below the expected value of 8.7%, perhaps signaling that the worst of inflation may be behind us. More strikingly, July marked the first month since the post-Pandemic reopening of the economy, where overall inflation was flat compared to the preceding month—a clear reason for optimism.
The decreasing cost of gasoline over the past month and a half has drastically helped slow the overall inflation rate. However, the prices of many items remain elevated from a year ago and are still rising, with food prices, rent, and cost of services all notching 4-5% price growth month-to-month over June.
Nevertheless, the softer reading is a welcome breather for stocks, as Wall Street now believes that the Federal Reserve's (“the Fed”) monetary tightening policies are starting to have their desired effect. If inflation continues to cool, the Fed could hold back on its more drastic moves, such as raising rates by another 0.75% in September, in exchange for a more palatable hike.
As a result of easing pressure on the Fed, the stock market continues a rally that started in mid-July, with tech stocks and even meme stocks bouncing off their lows. Yet, despite a brightening outlook for the Market, investors in the US Real Estate markets are starting to raise alarm bells over a darkening forecast.
Softening Real Estate: A Real Problem?
The Pandemic Real Estate bubble has popped, causing a headache for homebuyers and builders alike.
During the Pandemic, trends in the real estate market affected almost everyone, whether through "work from home (WFH)" policies, soaring housing prices, or now rising rents. But what can get lost in the individual experience is that real estate is a complex industry that profoundly impacts the overall US economy.
By now, we all know how deeply the Pandemic impacted the residential real estate market. WFH policies and rock bottom mortgage rates drove workers into suburbs and rural areas, increasing housing prices and creating scarcity. The median home price nationwide has risen more than 33% to $440,000 since the start of the Pandemic through June 2022.
But as interest rates have started rising again this year, housing sales have begun to pull back, as the average 30-year mortgage rate has climbed nearly 3% since December 2020. For perspective, the monthly 30-year mortgage payment on a $440,000 house with 20% down has grown by more than $600 since December.
Rising rates have a real impact on housing affordability
As a result, housing transactions have started to cool, with the rolling 12-month number of existing home sales dropping by -21% in July versus January. New homebuilders have also seen would-be buyers exit the Market, with new home sales transactions falling by -40% from a year ago.
But over the past few years, homebuilders, which had sat out much of the 2010s still reeling from the 2008 housing crisis, ramped up the construction of new homes to try and catch a hot housing market. Now, with cooling demand and increased supply, the US housing market sits on its biggest inventory glut since 2010.
One might expect prices to fall at the same pace as the supply of homes outstrips demand. But housing prices have remained stubbornly high as existing homeowners wait for a better time to sell. This behavior is doubly true for speculators who bought into the bubble and can't afford to drop prices.
Additionally, new home builders have seen costs increase with labor and materials soaring due to inflation. Not wanting to sell at a loss, homebuilders are starting to pause home construction and keep inventory off the housing market. We're left in a situation where sellers don't want to decrease their prices despite lower demand.
Resultantly, would-be homebuyers are re-entering the rental market, where rents have increased by 15% nationwide over the past year. All these drivers sum to a housing affordability crisis, where rent has become a central driver of inflation.
Why does this matter?
Beyond the obvious impact on consumers, the current real estate market has broader economic effects on corporations and real estate developers. With fewer homes sold, there is also lower demand for goods such as new sofas and TVs, affecting retailers. Consumer preferences have shifted away from durable goods, causing inventories to bloat.
Walmart’s inventory bloats as consumer preferences change
Meanwhile, demand for mortgages has plummeted, hurting banks and lenders and forcing them to lay off thousands of employees. At the same time, there is also a growing real estate developer debt problem, which overhangs the industry.
Homebuilders, which took on a lot of debt to build or purchase homes, now struggle to make payments and must restructure their loans in a higher interest rate environment.
Mounting debt has also hampered commercial real estate developers, which continue to see high vacancies post-Pandemic as companies shift to hybrid work environments. As retailers and offices are slow to return, the lack of tenants has heavily impacted the cash flow needed to service outstanding loans.
The amount of bank-held commercial real estate debt has grown to $2.7 trillion at the end of 2021, eclipsing the $1.9 trillion held in 2008 before the real estate market collapse. And while we don't find ourselves in the same toxic financial situation that fueled the housing market rise of the 2000s and precipitated the global financial crisis, debt levels are rising to dangerous levels.
Taken in its entirety, the low-interest rate environment that fueled the housing bubble of the past two years is starting to swing the other way. And the other side isn't pretty in that homeowners and developers are reluctant to sell at a discount while facing mounting debt, and would-be home buyers find themselves stuck in an increasingly unaffordable rental market.
And while no real estate market is in perfect equilibrium, the extremes of housing supply and demand can have a reverberating effect on the overall US economy, which is already under threat of a downturn. If the economy does indeed fall into recession, a soured real estate market will exacerbate it—and that would be a real problem.
Stay frosty,
Alex with TAI