Inflation Is Ugly - The Good News?
Shelter Continues to Decline
Consumer Price Index - September 2023
The Bureau of labor statistics released CPI numbers for September 2023.
September 2023 Headline CPI: 3.7%
September 2023 Core CPI: 4.1%
The Break Down:
Note: “The index for shelter was the largest contributor to the monthly all items increase, accounting for over half of the increase.”
Since June 2022 we have seen CPI continue to decelerate from 9.1% to 3.7% as of September 2023. Individual categories such as Food at Home, Energy, Gasoline, New Vehicles and Apparel have significantly rolled over since their 2022 highs.
The laggard - Shelter, But Why?
Order of Liquidity
Real Estate is usually the last asset class to correct in response to a rising interest rate environment. The full effects of rising interest rates take longer to impact valuations of commercial and residential property due to the relative illiquidity of the asset class.
As a quick example please refer to equities.
The S&P 500 and particularly high beta growth stocks were the fastest to reprice to the rising rate environment.
Stocks are extremely liquid and have a fast reaction to rising rates.
The above picture depicts a chart of the NASDAQ Composite, notice the steep declines almost immediately after the Federal Reserve started raising rates in March 2022.
Some individual stocks declined upwards of 90% throughout 2022, repricing for a higher interest rate environment.
Why is this?
Professional investors care about determining the present value of a company’s future cashflows.
Watch: Bill Ackman: Free Cashflow is All You Should Care About
When interest rates are artificially suppressed for long periods of time, stocks tend to go through a multiple expansion.
When rates are low, the present value of a company’s future cash flows are worth more and when interest rates start moving higher, the present value of the company’s future cashflows decline.
Thus the market needs to “re-price” the asset, and being that equities are extremely liquid, the repricing tends to happen very fast.
The discount rate reduces future cash flows, so the higher the discount rate, the lower the present value of the future cash flows. A lower discount rate leads to a higher present value.
Shelter Costs Will Continue to Decline
Expect shelter costs and real estate assets in general to decline in price.
I am not calling for a crash, but a normal correction that happens during every business cycle throughout history.
How the cycle plays out:
Interest Rates Move Higher
Transactions Decelerate Sharply
Price Declines to Adjust for New Rate Environment
Deal Flow Picks Up
Lets look at some visuals:
Pictured above is a chart of Total Existing Home Sales from the National Association of Realtors.
Notice from pandemic lows there was an explosion of transaction volume spurred by extreme fiscal and monetary stimulus. (Easy Money)
The transition from quantitative easing to quantitative tightening almost immediately impacted sales volumes and we have been in steep decline ever since.
The picture above depicts Median Price of Existing Home Sales
We are seeing declines in sales transactions and and increase in transaction price.
A clear divergence that can persist for a while but the divergence will close in time.
The market is at the point where cost of living has never been more expensive because the cost of money i.e. interest rates are high and prices have yet to adjust to the higher rate environment.
Data From BLS CPI
March 2023 seems to have marked the top in the cycle for shelter costs.
Shelter recorded 8.3% in March 2023 and has declined for 6 consecutive months.
March 2023 - 8.3%
April 2023 - 8.1%
May 2023 - 8.0%
June 2023 - 7.8%
July 2023 - 7.7%
August - 7.3%
September - 7.2%
The table above depicts a clear visual representation of the lagged effect for shelter in relation to headline CPI.
Conclusion: Real Estate being less liquid, takes longer to reprice.
Commercial Real Estate
The probability of steeper price declines in commercial real estate in comparison to residential are high.
$1.5 trillion worth of commercial real estate loans will mature over the next 3 years.
With vacancy increasing across the country, commercial operators will be in a position of declining rent rolls and increasing costs.
The above is a visual of the Federal Funds Rate.
As the wave of debt comes due for refinancing, the cost of money has increased significantly.
This should create a generational opportunity over the next 24 months, unfortunately at a very serious cost.
Will Rates Come Down?
It is unlikely that the Federal Reserve will start to cut interest rates anytime soon.
Federal Reserve Chair Jerome Powell has been very clear that the goal of the Federal Reserve is to bring inflation back down to their 2% mandated target.
After todays CPI report coming in higher than expected, we can anticipate rates remain higher for longer.
The shelter component makes up roughly 40% of Core CPI and as we have discussed, shelter is a laggard.
Until we see shelter return under 4%, Headline and Core CPI will remain above the Federal Reserves 2% target.
The Good News
Savers are once again being rewarded in this country.
After a decade of suppressed interest rates , savers are able to generate a real rate of return, risk free.
US 6-mo bill is yielding over 5.5%.
US 30-YR is yielding 4.855%.
As bond prices go down rates go up, as bond prices go up rates go down.
The Ishares 20+ Year Treasury Bond ETF is trading at levels last seen during the great financial crisis of 08-09.
I am not one to catch a falling knife, but institutional players are likely accumulating and increasing exposure to bond funds after significant declines fueled by a tightening cycle.
Updates
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