On investing during housing reflation in the US and the fiscal drag in Europe and North America
I have two topics I want to highlight this morning. First, there are the US housing inflation numbers from Case Shiller, which are at a 7-year high. Then there is the fiscal drag in the US, Denmark, the UK, the Euro Zone and Canada. What I see everywhere here is continued faith in monetary policy and a lack of faith in fiscal policy. And I believe this is important in terms of predicting policy and economic outcomes.
First let’s look at housing in the US. The larger composite-20 Case-Shiller house price index showed house prices up 10.9% year-on-year in the US. That is serious house price inflation. It well outstrips 1.1% CPI inflation from April 2012 to April 2013 for example.
Think about it this way: if you put 10% down on a house, you have just doubled your return in one year. If you get another 10% rise the next year, you have tripled your return. Because of mortgage financing, housing is by definition a leveraged investment that makes large inflation-adjusted gains intoxicating enough to induce a (re-)leveraging in the household sector. The Federal Reserve is concentrating on mortgage-backed securities to carry out its yield suppression policy, meaning it is trying to keep mortgage rates low. And by extension, the Fed is actively promoting household re-leveraging by trying to keep yields low, something that enables more leverage. The bottom line is that QE equals low mortgage rates which equals house price inflation which equals increased household leverage which equals greater household balance sheet fragility.
In the meantime, we know that there has been a fiscal drag in the US due to payroll tax increases and the sequester/fiscal cliff combination. State and local government job cuts have long acted as a drag on US growth and now federal job cuts are also doing. The state and local fiscal drag is the inevitable consequence of limited resources at the state and local level during an unprecedented decline in tax revenue coupled with increased outlays to deal with joblessness. This has receded. However, the fiscal drag will continue in my view because of the (inevitable) ideological opposition to longer-term large-scale deficit spending at the federal level.
Against this backdrop and in an environment of muted inflation and inflation expectations – and large-scale and long-term joblessness, the Federal Reserve has felt it must act with a bias toward job growth to fulfill its dual mandate of maintaining price stability and full employment. Having reduced the policy rate to zero percent, QE and similar unconventional tools have become standard fare in this effort. So the Fed is taking on a more activist role because of the drag that contractionary fiscal policy has created. I have made this argument repeatedly for the past couple of years.
But what I think should be clear is that this is also the same policy mix – of contractionary fiscal and reflationary monetary policy – everywhere in Europe and North America. The level of reflation and contraction varies but the mix is the same. For example, in Canada despite the Bank of Canada’s tightening bias, the BoC has held the policy rate at an easy 1% for nearly three years and this has stoked a large housing bubble, particularly in Vancouver and Toronto. Meanwhile, Canada’s own Parliamentary Budget Officer says the government’s fiscal stance will cost the economy tens of thousands of jobs.
In Denmark, the socialist and left-wing coalition government, has recently slashed its economic growth to an anemic 0.5%. Even so, the government has refused to reflate using fiscal policy. Instead, the Danish economy has relied on the central bank for reflation. Policy rates are at zero percent, which can help the legions of underwater Danish homeowners after an epic housing bust amidst problems from the largest household debt to GDP ratio in the industrialized world. The central bank has even instituted a tax on deposits at the central bank (aka negative interest rates) to keep the Danish krona from appreciating vis-a-vis the euro – though this has not been reflationary.
In the UK, the mix is also similar, with the BoE having run multiple rounds of QE and the government having turned to austerity in its unsuccessful attempt to reduce deficits. Finally, we all know about the austerity in the euro zone. The ECB would argue it has supplied lots of liquidity to the euro zone banking system in order to counteract this fiscal drag.
In sum, the policy mix right across these countries is one of fiscal drag and monetary stimulus. My view here is that the train of events in economic policy suggests two things about the policy makers’ play. First, despite all evidence to date that low to negative real interest rates created an environment which invited high levels of leverage in places as disparate as the US, the UK, Britain, Denmark, the Netherlands, Latvia, Ireland, and Spain, policy makers around the world see low or negative real interest rates as a solution to private debt problems and economic malaise rather than a problem. In the US, where the reflation of house prices is most advanced in all markets, house price inflation is cheered as an engine of economic growth.
Second, despite the outcry from Keynesians and others who see expansionary fiscal policy as a good thing at this point in the economic cycle, in all of these countries, there is no political appetite for more fiscal expansion. In fact, the winds seem to be blowing toward contraction to varying degrees. Yes, the Reinhart-Rogoff debates have triggered a re-think of the pace of contraction. However, the desire to keep fiscal policy in check is very much still at the forefront of policy thinking.
The question is what this means for the economy. My view is that it means we will continue to see a dichotomy between asset market inflation and real economy stagnation. The transmission mechanism of fiscal policy is via the addition or subtraction of net financial assets to the private sector via deficit spending or net fiscal tightening. This is what I would call ‘money printing’ or ‘money withdrawal’ i.e. a net add to or subtraction from the private sector of financial assets and a corresponding increase or decrease in public debt. Monetary policy is not about adding or subtracting assets to the private sector. Except in the case of interest rate policy, it is more about transforming the types and quality of financial assets freely available for purchase or sale in the private sector. Therefore, as such, non-interest rate monetary policy is mostly a purely distributional tool. This is why we should expect a continued dichotomy between asset market performance and real economy performance.
Eventually, however, this dichotomy cannot hold and the economic fundamentals must reassert themselves as real interest rates rise and/or nominal interest and discount rates stop falling. The question goes to a. when does this happen? and b. will the economy be in a good enough state to make the asset market/real economy mean reversion more about improving real economy fundamentals than declining asset market fundamentals? This is a very big question that will decide which investors outperform during this economic cycle. And while I believe the evidence tilts toward asset price deflation, I am willing to entertain the idea that we will instead see (continued) real economy recovery.
For now, asset prices should continue to rise. Once the leveraged bets on housing, high yield and leveraged loans start to sour, we will have a better idea of what the medium-term holds.
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