Podcast

Dreamstime

Wolf Richter: The Era Of The Fed "Put" Is Over

It now wants lower asset prices (just not too fast)
Monday, April 2, 2018, 3:39 PM

To all those investors expecting the Fed to step in to backstop the recent weakness seen in the stock market, Wolf Richter warns: The cavalry isn't coming.

After years of force-feeding too much liquidity into world markets, the central banking cartel is now aware of the Franken-markets it has created. And now with a new head at the US Federal Reserve, and soon at the ECB, central bankers have shifted their priority from supporting asset prices to now actively engineering lower prices.

They just don't want prices to drop too far too fast.

Of course, the big question is: how much control do they really have? The situation may very quickly get out of their hands.

But the big takeaway is to expect lower prices across the board for nearly every "risk on" asset: stocks (including and especially the FANGS), corporate bonds and real estate. The Fed is working to reduce investor exuberance -- and as many bloodied contrarian investors will warn you -- Don't fight the Fed:

Now we're in an environment where we have an Everything Bubble, and even though there's still a few central bankers out there that say that they can't see the bubble, others have now acknowledged it. Of course they don’t call it a "bubble"; they say that prices are "elevated". So they're seeing this. In my opinion, a lot of the responses from the Fed are not really about inflation; they're really about trying to avoid the asset bubble from getting any bigger. They're trying to avoid a deflation of that asset bubble that could be very messy for the financial system.

Which is why they're now tightening. Even though inflation by their measure is still relatively low and below target. And so they're really not targeting inflation; I think they're targeting asset prices. They're trying to put a stop to the Everything Bubble out of fear that it might bring the financial system down again if this goes any further.

There's debt behind this asset bubble, and this leverage is what's risky. So I think the Fed is clearly, this time, on the side of targeting assets bubbles. Investors are asking if the stock market drops, if the Dow drops a thousand or two thousand or five thousand points, is the Fed going to step in and put a stop to it? And my gut feeling is, no, they won't. They will let this run unless credit freezes up. They're trying to bring these asset prices down somewhat. I think that's the environment we're in. We have bubbles everywhere, and now we have Central Banks trying to somehow save the system with minimum damage.

Of course we only have the central banks to blame for this situation. They wanted every investor to go way out on the risk branch, and pension funds have done that. And now, the price to be paid for that will be tremendous.  Most of these insolvent pension funds are state and municipal funds, so taxpayers may be at least partially responsible for picking that up.

This same will probably be true with corporate pension funds. We are seing companies that are going bankrupt, such as Remington, you know, they're guaranteed to some extent by the Federal government and that, too, in the end, is probably going to require that the taxpayer will have to step in.

And as for the pain that rising interest rates will create, this is just the beginning. This has just started. After almost a decade of 0% interest rate policy we don't know anymore what it's like to look at many years of rising interest rates. Money will get a lot more expensive for a lot of companies. And those that have to roll over their debt, even if they're not on LIBOR, if they have fixed rate debt they'll have to roll that over eventually. And when they roll that over, they go from, you know, from a 4% percent coupon to maybe a 6% percent, 7% percent or 8% percent coupon.

As for housing, I think what we'll see is not a dramatic selloff of double digit percentages that we had last time. I think we'll see a long, drawn-out, much more difficult process. At first, it won't even look like a sellout. I think on housing on a national basis, housing will continue to look strong even though the selloff will start in particular cities. You will have some cities that are turning around, but overall, nationwide the numbers are still stable. And so the Fed won't even be worried about it because they're looking at the nationwide numbers, and they're saying, "Oh, it's still okay, it's just declining a little bit" or it's "plateauing" whereas house pricing may be coming down pretty sharply in some of the most bubbly cities.

Transcript: 

Chris: Welcome, everyone, to this Peak Prosperity podcast. I am your host, Chris Martenson, and it is March 28th, 2018. Now, in case you haven't been paying close attention, there are warning signs everywhere suddenly emerging suggesting that the stock and bond markets have finally begun their long-awaited corrections. But, have they? Look, we've been here before only to have Central Bankers ride in with another flood of money that only bought them two things. First, more time. I admit, that's worked longer than I ever thought. Second, even larger bubbles in the form of ridiculously high asset prices.

As we enter the late stages of the third massive Central Bank inspired bubble-set in fifteen years – by the way, there are precious few voices that have been steadfastly pointing out, all along the way, just how idiotic all of this is – and did I say third bubble? You know, hmm, I actually meant global interconnected set of bubbles. Period. You know, plural here.

Today, we're going to discuss macroeconomics, real estate bubble dynamics, debts and deficits, with someone I've been reading for years, Wolf Richter, proprietor of wolfstreet.com. Wolf lives in San Francisco. He has over twenty years of C-level operations experience, including turn arounds and a VC [PH] funded started up. He has a B.A., and M.B.A., and an M.A. And my subscribers also know him as a regular guest on our Off the Cuff podcast. Here is Wolf. Welcome to the show.

Wolf Richter: Thanks for having me, Chris.

Chris: Well, congratulations on your blog, wolfstreet.com. I see that you're attracting a larger and larger following as well. You should because your writing and analysis are really first rate, Wolf.

Wolf Richter: Thank you. We're having a lot of fun looking at dynamics out there.

Chris: Well, Wolf, I see bubbles everywhere, and I believe – my belief system – that they are Central Bank driven and inspired, and you heard my intro. Further, I believe that Central Banks bought time at a terrible cost. The bubbles burst; when they burst it's going to massive. Wolf, what are your thoughts here?

Wolf Richter: Yeah. Central Banks have one particular feature that almost no one else has and that is they cannot see bubbles. At least they claim they cannot see bubbles. And even though everybody else can see them, they cannot. And even if they could see them, they say they couldn't do anything about them. So they do their monetary policies without actually looking at the side effects of those. There's people out there that say that bubbles is what Central Banks are trying to create. I'm not sure that's true. I know that they want to create asset price inflation, but not necessarily bubbles because bubbles are very dangerous to the financial system and Central Banks, as guardians to the financial system, know that.

So I don’t think they want to create bubbles necessarily, but they certainly don’t want to do anything to prick them. Now we're in an environment where we have an everything bubble, and even though there's still a few Central Bankers out there that say that they can't see the bubble, others have now – don’t call it bubbles – but they say the prices are "elevated". And so they're seeing this. And a lot of the responses from the Fed, I think, are not really about inflation. They're really about trying to avoid an asset bubble getting any bigger, and they're trying to avoid a deflation of that asset bubble that could be very messy for the financial system.

So they have been tightening, and they have been tightening this by relatively low inflation or consumer price inflation. We've had a lot of asset price inflation, but consumer price inflation has been – it's measured by the CPI or, better yet, by the Feds preferred measure: PCE. It's been relatively low and below target. And so they're really not targeting inflation; I think they're targeting asset prices. They're trying to, you know, to put a stop to this and out of fear that it might bring the financial system down again if this goes any further.

Because only the assets are leveraged. There's debt behind them, and this leverage is what's risky. So I think the Fed is clearly, this time, on the side of targeting assets bubbles, and people are worried if the stock market drops, if the Dow drops a thousand or two thousand or five thousand points, is the Fed going to step in and put a stop to it? And my gut feeling is, no, they won't. They will let this run unless something, unless credit freezes up. They're trying to bring these asset prices down somewhat. And so I think that's the environment we're in. And we have bubbles everywhere, and now we have Central Banks trying to somehow save the system with minimum damage.

Chris: Well, I know that Central Banks like to think there's such a thing as a free lunch. They can just print up all this money, get some nice healthy tasty asset price inflation; all is going to be good. But, of course, the opposite side, the cost for this lunch was that pension funds were just getting obliterated without having any yield that could get on safe, or so-called safe, assets on the bond side. So they thundered over – sixty percent average U.S. pensions are now – sixty percent of the assets are invested in equities, so an equity correction here would be just absolutely devastating.

So people say, oh, yeah, but, you know, Chris, asset price inflation, a few 0.1 percent, so the stock portfolios go down. What does it really mean? But this would actually hurt the average person who's somehow tied through their local taxing authorities into a public pension, wouldn't it?

Wolf Richter: Yes. And, you know, these pension funds clearly did this with perfect timing, you know, plowing into stocks when after they had already been rising for year. So they're, like you said, they're heavily involved in stocks in that they're facing a correction of those, a big one. They're also still involved in bonds. And they're now having a dual problem; so the stock prices, you know, they're at risk, and they're likely to decline, and that's going to hurt pension funds, but the bond market is also at risk, and the bond prices are declining. And while the yields are going up, the yields that the bonds and the portfolios generate are very low.

So the pension funds that have these bonds and they carry them to maturity, these bonds are generating the yields that were in the market a year or two or five ago, and these are very low yields. These are – they have ten-year treasuries in them that for that, in that portfolio, that yield that portfolio two percent or less than that, 1.8 percent. They may have euro bonds in it that yield a negative rate. And so when yields go up these days those yields don’t change. They're locked in their portfolios.

And unless they sell those bonds at a loss and replace them with high yielding instruments, those low yields are locked in. So now they're having a, you know, they're having the stock and the losses on the stocks, they're having extremely low yields for the next many years on the bond portfolio, and they're gone more risk by going into alternative investments such as private equity and so forth. So they're floated up on risk to deal with this situation.

And that's clearly what the Central Banks wanted, what the Fed wanted. They wanted every investor to go way out on the risk branch, and pension funds have done that. And now, the price, as you said, is right here in front of us, and most of these pension funds are state and municipal funds, so taxpayers may be…This is a legal situation that has yet to be worked out. But taxpayers may be at least partially responsible for picking that up.

And now, corporate pension funds, as we have seen with companies that are going bankrupt, such as Remington, you know, they're guaranteed to some extent by the Federal government and that too, in the end, is probably going to be the taxpayer that will have to step in.

Chris: That's just astonishing. And we've been talking about these bubbles at sort of a macro level. Let's dial in a little bit. I'd like to illustrate this larger bubble in equities maybe using a single company as an example. So let's talk about Tesla. Now, you just wrote a recent piece which was really excellent, by the way: When Will Investors Get Tired of Feeding Their Capital into This Cash Burn Machine? Come on, Wolf. Don't you feel the Musk Tesla love? Come on, he's a genius. First, Wolf, what's going on at Tesla? Help paint the picture. And second, how can such thing actually occur outside of a bubble? Is that possible? So first things first, what's going on?

Wolf Richter: So let me just say right up front I love electric cars, and my next car is probably going to be electric. So this is not about electric cars. This is just about Tesla the company and its finances and its operations. And the problem with Tesla is it's trying to be an automaker, but it cannot manufacture, on a mass production scale, the cars that it promised that it would be able to manufacture. So the model III is just not happening. It's coming up very small volumes. Only the high-end units are being produced right now. It's losing a ton of money on each on of those.

Tesla is bleeding so much cash. This is not a start up company. Tesla's been around for ten years. And it has thousands of employees and it's a global – it has global sales. It's not just some scrappy little startup that's losing money because, you know, it's just at the is beginning of its life. This is a mature company, and it has already ten billion dollars in debt. It borrows from its future customers by soliciting these deposits. It owes its customers over $800 million in those deposits.

Yesterday, Moody's downgraded it, and that was a horrific downgrade all across the board. And it said what I've been saying for a long time, that the debt is actually at risk. The credit markets think that Tesla, because it has a large stock price, instead, is pretty secure. But you can always sell more stocks, more shares to raise more money and to use that money to service its debt, to pay interest and to pay for its negative cashflow and to pay off its debt when it matures. And so the whole premise of this debt is that the high stock price backs it, and so its sort of guaranteed by the stock market.

Now, Tesla's shares are now down over thirty percent from the peak last August or September. And so there's no guaranty that the stock price will be high enough to guarantee their debt. And when creditors see that – and you know, there's ten billion dollars in debt out there – when creditors see that they're likely to get very shy. And Tesla's bonds, yes, they did plunge. Moody's reported the downgrade in the after hours, and that's why when the bonds plunged today it was a bloodbath. So creditors are getting worried.

The problem with Tesla is it burns through two to three billion a year that it needs to raise. And it needs to raise that money by either selling shares or by selling bonds. And when the markets aren't willing to do that, Tesla is running out of options. Yeah, he has the giga factory. Maybe he can mortgage it. And its got three billion in cash on its balance sheet. So it's not going to immediately collapse like some people think. It does have some resources. And the stock price is still extremely high at $255 bucks right now, something like that. I think it should be in the single digits because of the risk that it poses.

If a mature company burns that much cash year after year and relies solely on investor cash to keep going, you know, something needs to happen. And if Tesla stock, if it trades at $10 a share and all the money you're raising avenues are cut off, then the company will either have to turn its operations around to where its cashflow positive and self-sustaining, or it will have to just throw in the towel.

Chris: Now, as an equity investor you talk about this $250 stock price still it was over $300, well over $300 for a while – I think it hit $380 or something at one point – but as an equity investor, of course, I'm only interested in participating in the positive earnings of that company going forward. Has Tesla ever made a profit?

Wolf Richter: No. Tesla has never made a dime. And so that's…

Chris: Has it been close?

Wolf Richter: On an annual basis, no. I mean, it's getting worse. In terms of GAAP earnings, so that's the accounting measure, and in terms of cashflow, it has lost money every year and in ever larger amounts. And that's the terrible part. You know, as you grow, your initial losses should get smaller. As your revenues get larger your losses should get smaller, and that's not happening. It's the opposite. You know, the more Tesla sells the more it loses. And you know, that's a prescription for disaster.

And the only reason Tesla has been able to do this is because investors have been incredibly willing to support it. Tesla has raised money every year either via stock sales or via bond sales, and so far, there has been no issue trying to do that. Investors have been incredibly eager to support Tesla in its money burning operations. And when that continues, you know, Tesla can continue just fine. But as soon as investors have second thoughts, you know, that show is over.

Chris: Now bubbles, of course, are fueled by ample credit. I can't find any bubbles in history that didn't have easy credit somewhere baked in here. So that is in banker parleys we might say, easy, liquid financial conditions – and a good tale; you need that tale. Tesla's got an extraordinary story. Listen, I loved the Tesla products I've ridden in. I think they're really a really sweet car. But the prices of financial assets and bubbles are not rational. They're rationalized. So that means that you need easy credit and a good tale to make this all work.

So here's a quote from John Thompson of Vilas Capital Management, just came out yesterday. I thought this captured the Tesla story really well. He said, "As a reality check, Tesla is valued by investors twice as much as Ford, yet Ford made 6 million cars last year at a $7.6 million profit, while Tesla made 100,000 cars at a $2 billion loss. Further, Ford has $12 billion in cash held for a rainy-day fund while Tesla will likely run out of money in the next three months. I've never seen anything so absurd in my career." Really, there must be an extraordinary rationalizing process in investors there. Doesn't it sort of capture the bubble ethic here?

Wolf Richter: Yeah, it does. And we see that not just in Tesla but in many other areas. And so Tesla is not the only company or the only financial situation out there where we see this. And that's true. That's a bubble mentality or the financial operation fundamentals are essentially irrelevant. It just doesn’t matter. You know, it doesn't matter what happens at Tesla as long as people believe in the story, it's the story that matters. And the story can be anything. It's just a story, and the reality doesn't matter.

And cheap credit has fallen fawned this attitude. It's fundamental to every bubble. You know, Tesla is more equity financed and credit financed, but it does have quite a bit of debt too, so it is somewhat less of an issue now in terms of cheap credit. But it creates this whole atmosphere where reality just simply doesn't matter.

You know, if the Central Banks are in charge, they're going to inflate this asset bubble to eternity, and the only way to play this game is to be fully in and to believe every story out there. And that's a very good indication, I think, at some point that this bubble cannot go on much longer.

Chris: Well, as I led off in my intro, I think there's plenty of signs to say that the tale, the story, that good yarn, has sort of broken here because if you look across – yes, Tesla's actually gone, you mentioned, down 30 percent. It's down 15 in the last two days. It's had a rough couple days; I think it's 8 percent yesterday, 7 percent today.

But looking out here, I see Netflix stumbling. Facebook, of course. I'd like to talk to you about that. But it feels like the technology sector in general is – the blue might be off of that rose. And, of course, the problem for a company like Netflix, to extend our story out one layer to another company, is that if people start looking at that company and saying wait a minute, I need to see positive cashflows, boy, there's – not only is there not a good story there, there's an actually really bad story there.

Wolf Richter: Yeah. And Netflix is in a very similar ballpark as Tesla in that it uses its high stock price as a guarantee for the lenders for the creditors. And when that high stock price sinks its debt will get in trouble, and it's the debt that causes a company to be pushed into bankruptcy. It's not low sales; it's not a loss; it's when a company can no longer deal with its obligations. And that's what creditors are worried about.

And Tesla has been borrowing a huge amount of money, and it continues to do so every year in larger amounts. And it's guaranteed to the creditors is look, we have this gigantic stock price; we can always sell shares to pay you off. That's a bubble mentality. You're relying on all these equity investors out there to keep us propped up so that the creditors can sleep in peace.

Chris: Well, and those two dynamics feel off each other, right. So the more credit that's out there that allows these companies to borrow a lot, it also helps the stock prices go up and all that, particularly if the companies are borrowing money and then buying shares back. So those two pieces can feed off of each other. But, of course, they can operate in reverse.

Now, corporate debt is, I think, at the highest it has ever been. And, of course, corporations have been buying shares back, including during that little dip in February; I think they were, by far, the largest purchasers in that dip right there. Where do you think we are in that corporate buyback cycle? When do corporations kind of wake up and go, oh, this is bad idea; maybe we should not be buying our shares back; maybe we should be selling our shares?

Wolf Richter: I think the corporations like to buy high to push share prices even higher. And that's one of the reasons – they're not trying to be the low bidder, you know, they're trying to be the high bidder out there. And so they're really empowered by a bull market. When shares sell off short-term, you know, we have that phenomenon we saw during the last selloff where corporations were just about the only buyer out there. But when it’s a longer-term deal, when the stock market goes down in the longer term and corporations think, oh, if you wait another year we can buy those shares back for a lot less. And we can't really – there's so much volume going on, so much selling going on, the amounts we have available to prop up our own shares are not sufficient right now. We can't stem the tide.

And we've seen that during the selloff in the financial crisis. Corporations pull back. There's no share buybacks really during that period, very few of them. It just kind of fizzled. And they started buying back their own shares later when the bull market had started.

There's another factor in that. A lot of times, many companies such as IBM that borrow money to buy back their own shares, you know, they're going to be handicapped for higher interest rates, for higher cost of money. And that's what the Fed is trying to do right now. It's trying to cause the cost of money to rise for corporations. We've already seen that in high-grade bond market the yields have gone up quite a bit. You know, it's still just the beginning, so the movements have been somewhat timid, but this is going to go on for a few more years.

So money is going to get more expensive, and the rational for borrowing at very low cost to buy back those shares and perhaps save on dividend payments down the road, you know, that rationale doesn't work out anymore. And then, that's another reason to start – it's not an issue for Apple or Microsoft or other companies that are using their own cash, or that could use their own cash, to buy back their own shares. Now, Apple hasn't done that. Apple has borrowed money to buy back their own shares because its cash was supposed to be overseas. It was invested overseas; it was registered overseas. It was invested in Europe's financial products, but those were registered overseas, so it couldn't really use those for share buybacks. Now, there's a new tax law it can.

And so I assume that these companies that have a big pile of cash that they will use that pile of cash to buy back on shares. Other companies like IBM that have big share buyback outfits, you know, they will start when money gets more expensive. That will just grind to a halt, and IBM is already cut their word [PH] back. So I think you'll see the markets sort of split in two on this. There'll be the cash rich companies that might continue for a time longer to buy back their own shares, and there'll be those companies that are borrowing money to buy back their own shares, and they'll stop.

Chris: Well, let's talk about one of the more explosive interest rates rises in my charts here which is the LIBOR, the London Interbank Overnight Rate. LIBOR had really shot up more than a percent in the past year or so. I know, Wolf, that tens of trillions of dollars of loans are linked to LIBOR. And in particular, in the small cap stock space I think they’ve got just huge amounts of loans that are like 30, 35 percent of them are actually tied into LIBOR.

By my math, if there's a trillion outstanding in loans in LIBOR, and those are one percent more expensive in interest costs, that's ten billion of cashflow that's diverted into interest payments. So ten trillion of loans would be what, a hundred billion of diverted cashflow. Do you think – is LIBOR getting to a point now where it's going to – we should consider that a serious headwind, at least in the sectors that are exposed?

Wolf Richter: Yeah. That's the general rule with rising short-term interest rates. And the Fed has only raised its target range to 1.5 and 1.75 percent. So this is really still very low, historically speaking. The LIBOR is a little bit above that. LIBOR right now, the three months dollar LIBOR rate is around 2.25 percent I think, last time I checked. And so that is higher, but it's still very low. And so when we compare it historically, yeah, the interest payments are going to be lower still then they were many years ago. But they're going to be much higher than they were in recent years. And that is a headwind.

And the way I think we need to look at is as sort of a "normalization". These highly indebted companies have gotten a free ride for so long, for so many year, and that free ride is ending, and it's ending gradually. So the, you know, the LIBOR at 2.25 percent, we need to look at what it will look like at 4.0 percent. You know, that's, I think, where we'll head be sometime 2019, and maybe higher even. So this is a slow-moving process, and it's just the beginning of it.

So if there's interest payments that are based on forwarding [PH] rate debt are already troublesome, what are we going to see in 2019? So this is just the beginning. This just started. We forgot. You know, after almost a decade of interest rate policy we don't know anymore what it's like to look at many years of rising interest rates. And that's exactly it. Money will get a lot more expensive for a lot of companies. And those that have to roll over their debt, even if they're not on LIBOR, if they have fixed rate debt they'll have to roll that over eventually. And when they roll that over, they go from, you know, from a 4.0 percent coupon to maybe a 6.0 percent or 7.0 percent or 8.0 percent coupon.

Chris: Right. And that brings to mind the Hemingway quote when he was asked how he went broke, he replied, "Slowly, then all at once." So that's going to be, you know, in these headwinds I'm expecting to start to see that we're going to start to see some of these smaller companies, in particular, start to go poof, right, as they go broke all at once and because they simply can't afford things. And this is where I think about the ridiculous low yield in Europe, in particular, looking at their junk rate of debt as of last summer was way below the rate for a ten-year treasury in the U.S. market. They had a just under two percent rate on junk debt. There's no possible way you can normalize rates without somebody taking just an exceptional loss on that junk debt at this point.

Wolf Richter: And that's tragedy waiting to happen for pension funds, not just in Europe but in the U.S. as well because the American investment community is heavily focused on its global assets. And so our pension funds have a lot of Euro debt in it. And so these bonds that they – the only hope is that when you're an American investor that you will make some money on the exchange rate, but that may not be the case either.

And so we're back to the problem where these pension funds are chuck-full with bonds that have either no yield or very small yields or a negative yield. And unless they're selling them, these yields stay the same, you know, for the next three years. And that stuff, that was completely nuts their going to negative interest rates. And even the Fed has seen that, and the Fed has said many times that they don’t want to do that. You know, watching what the ECB has done, that is just – I mean, there will be – we will see the results. That will be obvious, and it will teach Central Banks a lesson to not ever, ever do that again.

Chris: We can hope.

Wolf Richter: Yeah, I mean, when you listen to the Fed governors discuss a negative interest rate, they just dislike that with a passion. And it is just incredibly risky, and it moves so much wealth from the future to the present and creates this current paper wealth and then evaporates. And it redistributes the wealth, and in so many bizarre ways, that it's just going to turn out bad. Negative interest rate; this is just going to be a nightmare down the road.

Chris: Yeah. And, of course, it has to. And everybody's thinking that the Central Banks can sort of pull another rabbit out of the hat and to infinity and beyond and keep inflating stuff. But as you mentioned, the mood right now is that they’ve all publicly committed to not doing that at this point. They're all committed to winding down, and so people are thinking, more vocally, that well, it might take an exogenous shock, some sort of a war.

But let's talk about trade wars as that possible shock. First, what do you make of these trade wars? There were really two very powerful down days last week and the week before this recording with Thursday/Friday Dow was off by I think 700 points one day and maybe 400 the nest. And the explanation given; I'm opening up my newspaper the next morning and it was, "Trade War with China", that was the cause.

Wolf Richter: You know, I think the explanations are media savvy statements. I think the stock market is really ripe for picking and everything's overvalued. There doesn't need to be a trigger. You know, these things, they're so ripe for a big selloff. There doesn't need to be anything that triggers it; it just happens on its own. Now, a trade war can be a really nasty thing. And, on the other hand, the United States has an extremely out of whack trade relationship with China. And when we say China, we actually need to say China/corporate America because those two entities are largely responsible for that.

And so that trade war then also targets corporate America, and at the same time, corporate America is responsible in large part for the enormous trade deficits we've had. And these trade deficits are not sustainable. This is something that needs to be addressed, so I'm glad Trump actually puts it on the table. You know, I've been writing about trade for years, and it's ignored. People just don’t really care about the trade deficit.

So suddenly, Trump comes along and says, yeah, this is a problem, and we do need to do something about it, and we're not just going to have tea with the Chinese and with corporate American, but we're actually going to rattle some chains here, and we're going to put our foot down, and try to get people to think about this seriously. So I think there's some good to that in the long term. And I think the media likes to blame any selloff for something like that.

But we got to remember, in a bull market, you know, the market climbs a wall of worry; that's what everybody says. You know, in a bull market bad news is good news. Stock markets climb on bad news. In a bear market, or when things turn around, that's no longer the case. And so you really don’t want to tie the news necessarily to the market movement because, you know, in a bull market the market goes up no matter what. And we had a transportation recession in 2015/2016. We had all kinds of issues. GDP in 2016 was way low, and the market just surged. And the market surged 30 percent since Trump was elected. I mean, these are incredible melt-ups despite whatever news there might be. So I don't know that I would want to connect headlines to the selloffs.

I do think a trade war, if a real trade war breaks out – which I doubt – I think this will be negotiated on all sides very vigorously. And I don’t think there will be a tit-for-tat trade war that will blow up the global economy. But I think there will be losers and there will be winners, and some of the losers will be among corporate America, and some consumer prices may go up a little bit, even though I doubt that since the actual prices that we have in a lot of these products like the iPhone, the costs are fairly minimal.

Most of the iPhone price is at the profit, you know, so when you look at Apples' growth margins, if the iPhone costs a few bucks more because it's made in the United States or because there's a tariff on something, it's not going to change necessarily the price in the U.S. of the iPhone; it's just going to take a tiny little flittering out of Apple's profit. So I'm not too worried about that trade war. I am seeing the stock markets declining regardless of what the news is.

Chris: Right. Right. You know, I was just a little irked myself where, you know, that 30 percent gain you talked about since Trump was elected was largely credited to the idea that the stock market is forward looking, and it saw the tax breaks for corporations coming, and it was pricing that in. And then, you know, now I'm opening the newspapers about the trade wars and apparently, the stock market didn't see that coming when Trump has been really consistent about everybody that's he's sort of said he was going to do economically, I think he's been pretty true to so far.

Wolf Richter: Yeah. He stuck to his guns. You know, the trade war was part of his campaign just as much as the tax cuts. And, you know, NAFTA renegotiations have been going on for a month. People who are worried about a trade war today should have looked at that. He's serious. And NAFTA was sacrosanct; you didn't touch it; nobody did. And suddenly, here he is, threatening to call it off and starting to renegotiate it. And that started last year sometime. And they’ve been doing that for months.

So there's no surprise in it. I mean, the trade war rhetoric has been out there from the Trump campaign since 2016. So, yeah, you said it perfectly, I mean, there is no surprise; the stock market should have priced it in just like it priced in the tax cuts, and so I think it was just a media savvy way of explaining a selloff. Everybody jumped on that trade war excuse. Nobody really wants to say in the media that the stock market is way overpriced, and it needs to sell off, that we have an asset bubble and it needs to come down. I mean, that's a hard thing to say.

Chris: Right. Right. Well, my headline would have been, you know, bubbles are always in search of the pin. So if the pin was the trade war suddenly emerging unexpectedly, fine. It really doesn’t matter. As you said, look, when things are this overpriced, often it doesn’t matter that the reason they start going down is valid or not. It just starts happening, and then we try to make headlines that sort of explain something. That's what journalists try to do.

So hey, while I have you, because bubbles do tend to burst in series, stocks bursts, then real estate, for example, especially like in key areas like California, that are most exposed to equity gains as drivers of housing prices. Recently, there have been some notable rollovers in sales volumes; couple key bubble markets – Toronto and New York, just to name a couple. First, where are we in terms of the prior housing market bubble peak nationally in the United States? Then, riffing off of a recent article title of yours, let's pick out a few splendid markets to focus on.

Wolf Richter: Yeah, so in terms of – housing markets are hard to measure. So let me just give this caveat a print. So there are different ways of measuring it, and no measurement is perfect. So this is now based on the Case-Shiller index and the data they provide. This data is based on price changes between sales pairs; so the same house sold in 2011, and then it sold again in 2018. And so they used that price change, and they have an algorithm to make that work, and they have a three-month rolling average. So that number that you're getting is delayed. And so we're looking at today are the price changes late last year, and they're rolling three-month average changes, so they're smoothing out that way. So that's a long caveat, but every measure shows very different numbers, so that's why I need to put that out.

And the Case-Shiller is one of the best measures, perhaps, long-term to look at this even though it is a little bit behind, and it doesn't show the month to month quirks of the market very well. But it does show the long-term situation very well. And so on a nationwide basis, the index is now over six percent above the prior housing bubble peak. And that means that in some cities the prices are still below the prior housing market peak, and in some cities, those prices are way, way, way above. And we've got to remember that the prior housing bubble peak wasn't some sort of state of calm, some sort of place to return to. This was the moment when things collapsed. So this is not exactly the best place to just buyer to be.

Now, we've had price inflation and wage inflation and other things in the market, so it is not 100 percent comparable, but we'll look at it this way. So in Boston, for example, the Boston market, according to the Case-Shiller, is up almost 13 percent from the prior peak, and the prior peak in 2006. Boston has seen some declines in recent months, so actually the gains have stopped, and for the last half year or so it's sort of been float in terms of the price gains. It is one of the more expensive markets in the country, and its sort of run into a ceiling at this point.

Seattle is probably one of the hotter markets out there. It is now 22 percent above the bubble peak, and it had a huge bubble peak. I mean, when you look at the chart, you know, the way the Housing Bubble I, as I call it, they way it surged was just incredible. And it has now even outdone that; prices now 22 percent higher than that. Consumer price inflation measured by the CPI over the period is less than 22 percent, so it's like around 18 percent, so even on an inflation adjusted basis, Seattle home prices are now quite a bit above the prior bubble peaks.

And Seattle has a huge building boom, maybe the biggest building boom in the country right now, and it's all high-end. It's all multifamily, apartments and condos. There's no shortage of supply. There's a lot of shortage of affordable supply, but not general supply. These new units that are coming of the market, they don’t show up in any of these figures because they haven't been sold yet. They don’t even show up in the median price figures because the – that the multiple listing services issues – because they're not sold through the multiple services listing services, they're sold directly by the developers. So these new units are not showing up in the data. And there is tens of thousands of them waiting to be sold or rented out, and new ones all the time, and we're not able to capture them very realistically.

So the numbers you're looking at on a town with a big building boom like Seattle are actually not reflecting reality. The reality is we have developed or are sitting of thousands of units that they need to sell and that they need to rent out. And, you know, they might, in terms of the sales, you know, they might try to hold off and wait for better price. In terms of the rents, Seattle rents are starting to come under pressure because developers need to fill these buildings.

So the building boom cities are not fully reflected in the numbers that we're seeing. Now, Denver's got one of the most gigantic home searches I've ever seen. So since the peak of the housing bubble I, prices have now surged 46 percent.

Chris: Above the prior peak.

Wolf Richter: Above the prior peak. So this is not from low to high, this is from high to high. And I know some people that live in Denver, and they say it's just completely nuts what's going on there.

Chris: As you and I talked about, Denver, the response in Colorado has been for a call to help subsidize people's rents there rather than asking for the rents to normalize to what the market can bear. Because a bubble exists when prices rise beyond what incomes can sustain. So this whole idea that we're rationalizers, not rational and all of that – as I troll through the various real estate blogs, including in yours, I see in the comments, people run through the usual litany. They're not making any more land anymore; there's a big shortage of these things; the prices will always go up because that's what they have to do. But they are no longer affordable, even remotely, particularly by the generation that's coming along that the millennials that presumably would be buying them. In what you're seeing, Wolf, what's the connection between prices and incomes at this point in time? Because that's ultimately the only thing that really drive real estate is jobs.

Wolf Richter: Yeah. So in a city like San Francisco where home prices have just gone completely nuts, you only have like 500 sales a month. So it only takes 500 people, or 500 households, to keep the market going for a while. So if you can bring in 500 households, you know, with enough money to keep the market going you can't. And so that's why markets like that keep going because it doesn't take all that many people to do. It's not like stocks where you have a lot of volume. And so this is amazing. They'll try to stir up bidding frenzies, and now you have the same 500 people bid of the houses that are available for sale.

And in San Francisco everything that's been built in the last decade is multifamily. So nobody's built a single-family home in San Francisco in long, long time. So the prices that have really surged are single-family homes, and that is limited, and there are no more single-family homes built. Condos have already run into trouble, and apartment rents are already down. So the market is starting to exert pressure here in San Francisco. And it's just started. The high-end in San Francisco that you're talking about – just a few units – and so it can do really bizarre things.

But we have seen some real problems in the high-end because so many high-end condos are coming on the market, and there really isn't that demand. And that's a scary – I've seen some scary charts on that, you know, these condos that sell for two, three, four, five million dollars, and there are a lot of them, and they're coming on the market. And they're not showing up in the actual real estate figures because they're sold directly by the developers, so you don’t really know how many there are, but people are going around counting, So it's a worrisome development.

But so far, the overall prices haven't not come down instead they’ve gone up in San Francisco largely because of the explosion of prices in single family houses. But the majority of the market in San Francisco is condos, and they're under pressure. So, yeah, the market will eventually work this out.

And you mentioned stock market. You know, California in particular, Silicon Valley and San Francisco are incredibly dependent of the stock market for income and the state is for revenues. So a major decline in the stock market will have a major impact, everything else being equal, you know, will have a major impact on the housing market in San Francisco and in Silicon Valley all around because suddenly that perceived wealth disappears. People thought, you know, their stock was worth a million dollars, and now it's worth two hundred fifty thousand to nothing. You know, during the dot.com bubble, or after the dot.com bubble, the NASDAQ went down seventy eight percent. Seventy eight percent. A lot of companies just disappeared.

Chris: And worse, a lot of people got caught because, you know, a lot of their wealth was in stock options, so they would vest their options. You know, you vest your option at – your internet company is at $200 bucks, you vest in, and then it drops to $50. Well, you still owe the taxes on what you vested at and the gains you had on that, not what it was worth when you sold it. That's just a – it really caught a lot of people in a very punishing situation.

Wolf Richter: Yeah, it did. This is a scenario that is much denied now, but it is likely to happen again. And there are more, a lot more people now, in stock options today than there were back then, and the prices are further inflated. And this is something that the whole Bay area is – we're not oblivious to it. This happens every time. It's not something that surprises people that have been here for a while. This is just how it happens. And then San Francisco will empty out. People can't afford to live here anymore, and they'll leave; they go back home. And this happened before, and this happens in Silicon Valley too.

And suddenly these high-end condos, there won't be any buyer for them. So this is something that is largely triggered by the stock market, even if everything else stays the same, a major decline in the stock market, even if the economy holds up, you know, will have a really strong impact on the situation here in California.

Chris: So, Wolf, probably one of the most common questions I get asked is around this decision to buy real estate or not, particularly people who have been watching the bubble dynamic or millennials who are just sort of biting their nails wondering if they should just hold their nose and take the plunge. So looking at where we are in this overall story, if you were giving advice, would you advise somebody to wait or to buy, or how would you go about making that decision yourself in terms of real estate?

Wolf Richter: So, if that person is a first-time home buyer, I would definitely need to know where they're located because some markets are okay. You know, some markets it's perfectly alright to buy, and in other markets, like in San Francisco, you would be nuts to buy. I mean, California is a no recourse state, so, you know, you can walk away from your mortgage without penalties from your purchase mortgage. So if you want to take that risk don't put a lot of money down, and if the property plunges in price, you know, you can walk away from it, and let the bank take the loss. California is one of like twelve states that have that nonrecourse. The remaining states, the banks can go after you, so it's not recommended. And it's not recommended in general, but there is an exit clause here in California.

But the prices are ludicrously high here. You're looking at a basic condo over a million dollars. I mean, it's a basic condo, nothing, a one-bedroom condo. So I would say, if you have to live in San Francisco you're paying rent, you're paying a lot of rent, too. But now you can make deals, and rents are coming down, so they might be cheaper next year. So I would definitely – I wouldn't be a buyer in San Francisco at these prices, that's for sure. In other cities you may be okay, and it would really depend on the local real estate market.

Chris: Yeah, but if you look through the charts that you have in that article based on the Case-Shiller, you can see a lot of places have just gone really, really hot, and for those to remain that way mortgage rates can't climb. I think we're still at the slow-motion stage of this where that one percent, roughly, rise in the thirty-year mortgage is – I think it's going to take a little while to see that sort of bleed through to the actual statistics. But that's got to be hitting people because if you could afford a million dollars at three percent there's no way you could afford it a four percent possible, or five percent, depending on where mortgage rates are the time. So that's obviously sand in the transmission of this story, isn't it?

Wolf Richter: Yes, that is true. And we have seen, even today, pending home sales came out – and it's always so funny when the media reports on it – they say, pending home sales rose. Yeah, they rose from January, but they always rise from January. You know, pending home sales were down four percent from a year from February a year ago. And in January, they were down seven percent from a year ago. So pending home sales are a measure of activity in the market, and it's not very accurate, but it's kind of an indication.

Volume sales – in general, volume has been dropping, and people blame the availability of inventory, but that's the same phenomenon we had before the last housing bubble. There was nothing available; there were bidding wars going on. The same 500 people were bidding on the same 200 houses, and you had these bidding wars. And then when house prices started to decline, suddenly, the inventories started showing up on the market because people stopped gambling with it, and they tried to get rid of those vacant homes. And suddenly, just when buyers started disappearing, this flood of inventory came on the market.

So I'm not buying this excuse that there's nothing available, that there's a housing shortage. There is a huge supply of high-end housing. We know that. There's a shortage of affordable houses simply because prices have risen so much. You know, we've had this housing bubble going now on for a few years, so that has taken reasonably priced homes way up the scale to where they're no longer affordable for a lot of people. And that inventory, that shadow inventory that's out there, that will hit the market as soon as we have some major price declines. This just fits the pattern. You know, what I see today fits the pattern.

Chris: The pattern we saw in 2006 and 2007, right?

Wolf Richter: Yeah. Exactly.

Chris: Yeah. And, of course, that would fit with the larger pattern which is that, you know, in 2007, if you repeat the larger, larger pattern, you know, everything seemed to be going along swimmingly. You know, the economic growth was okay, and we saw reasonable gains here and there, and unemployment was low. There was all kinds of things that were sort of right, but that always when things go wrong is when they're at their most right and vice versa. When things are at their most wrong they begin to go right again. So things – this is a really long, strange bull market in asset prices inspired by Central Banks, and it's just absolutely astonishing to have witnessed. I'm of the mind that it feels like we could be rolling over here. What do you think?

Wolf Richter: Yeah. The one thing that I think is going to be very different is last time it happened fairly quickly, and things sort of plunged, and also, the Fed was raising rates very quickly going into it. This time, everything, as you said, it's slow motion. So we have four tiny weeny little rate hikes maybe this year, maybe another four next year. We had three last year. I mean, the Fed used to do that in a few months. They used to do 100 basis points in one sitting. So now they're stretching this out. And there's so much liquidity out in the market that it will take a long time to dry up.

And you mentioned LIBOR. You know, it's come up, but it's come up very slowly. It's taking it two years to come up this far. It's not like it spiked in a three-week period like that. Everything shocks us; we're not used to rates going up. So something goes up a little bit we're kind of shocked; where does that come from? But it's slow motion. Everything is slow-motion.

So I think what we'll see is not a dramatic selloff of double digit percentages that we had last time. I think we'll see a long, drawn-out, much more difficult process, and at first, it won't even look like a sellout. I think on housing on a national basis, housing will continue to look strong even though the selloff will start in particular cities. And so you will have some cities that are turning around, but overall, nationwide the numbers are still stable. And so the Fed won't even be worried about it because they're looking at the nationwide numbers, and they're saying, oh, it's still okay, it's just declining a little bit or it's plateauing whereas house pricing may be coming down pretty sharply in some of the most bubbly cities.

Chris: Well, very well said. And Wolf, that's all the time we have for today. I could talk with you for hours about all of this. But thank you so much for you time today.

Wolf Richter: Well, thank you, Chris.

Chris: And people can follow you at wolfstreet.com. Also, at Twitter which is @wolfofwolfst, spelled S-T. wolf of wolf S-T. I have that correct?

Wolf Richter: Yes, you do. And it's easier just to go to wolfstreet.com. that's where everything is.

Chris: That's where everything is. Of course. Well, again, hey, thanks a lot.

Wolf Richter: Thank you.

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8 Comments

Uncletommy's picture
Uncletommy
Status: Platinum Member (Online)
Joined: May 4 2014
Posts: 553
Surprise, surprise? Leveraged buyouts by another name?

The LBO strategy has been around for the last several decades and done wonders for firms like KKR, (et.al). always on the backs of investors when the "funders" dump their shares. Do we really think the major equity firms didn't foresee the huge potential in ultra-low interest rates? Pension funds will be taking it in the shorts by buying (safe?) municipal bonds for infrastructure projects that will be funded, eventually, by the taxpayers. Does Warren Buffet look stupid for buying utilities, railroads, water projects? Automation companies have an opportunity in productivity generating firms as opposed to social tech firms. How many robots buy cell phones? Absolutely, one of the best featured voices interview guests PP has had on. Well done, Chris and Adam and Wolf. Yogi Berra was right on! 

pat the rat's picture
pat the rat
Status: Silver Member (Offline)
Joined: Nov 1 2011
Posts: 113
hr5404 bill congress

I took a fast look at this bill , I think they have it backwards. Gold should become the standard for the dollar, not the other way around.This bill needs  fixing!

richcabot's picture
richcabot
Status: Silver Member (Offline)
Joined: Apr 5 2011
Posts: 172
Correlation vs Causation

These are clearly correlated, probably with the S&P itself,  but does one lead in time by enough to establish causation?

Dante's picture
Dante
Status: Bronze Member (Offline)
Joined: Jan 22 2009
Posts: 31
Trade Deficit

Very good interview.

I have one point I am still confused about.  Again, this man reiterates that our huge trade deficit with China is a big problem.  He is not alone in this but for every one I read that holds this view I can find another that states is not an issue.  Both sides “seem” to have credible arguments - thus my confusion.

To be simplistic - I personally have a huge trade deficit with my local grocer.  I buy all my food there but he buys nothing from me.  On the other side I have a huge trade surplus with the purchaser that buys all my produced product.  Isn’t that just the way it is?  We all have different products to peddle - we can not always be even on an individual basis can we?  Is there not other countries that we have huge surpluses with?

i would love to see an interview that digs in to this issue and helps clear things up .... or it may be I am the only one confused.

MKI's picture
MKI
Status: Bronze Member (Offline)
Joined: Jan 12 2009
Posts: 77
Surprise, surprise?

Key graph? The S&P 500 dividends has doubled since 2008. This was mostly blue-chip, big companies who pass on their profits to stock owners, not smaller companies trying to grow.

Seems an obvious consequence of the government regulations post-2008; if you aren't a politically connected big player, you really can't compete very well. This was easily predictable and why I've been in the (blue-chip) stock market for this last decade. These companies are making big bucks and paying fat dividends, and have been for 10 years.

I think people are crazy not to be in the blue-chip stock market these days making huge ROIC (I'm not taking about FANG stocks here, or small companies). As the FED pours cash into the economy to prop up jobs, where does it go? Politically connected blue-chips. If fearful of a stock market apocalypse, just keep funneling 10% of one's dividends into gold. 

richcabot's picture
richcabot
Status: Silver Member (Offline)
Joined: Apr 5 2011
Posts: 172
Lots of trade deficits, few surpluses

Yes, trade surpluses balance trade deficits.

The United States has the world's largest trade deficit. It's been that way since 1975. The deficit in goods and services was $566 billion in 2017. Imports were $2.895 trillion and exports were only $2.329 trillion.

The U.S. trade deficit in goods, without services, was $810 billion.

It imported $2.361 trillion. The largest categories were automobiles, petroleum, and cell phones.

see https://www.thebalance.com/trade-deficit-by-county-3306264

MKI's picture
MKI
Status: Bronze Member (Offline)
Joined: Jan 12 2009
Posts: 77
Huge Trade Deficit
Dante wrote:

I have one point I am still confused about.  Again, this man reiterates that our huge trade deficit with China is a big problem.  He is not alone in this but for every one I read that holds this view I can find another that states is not an issue.  Both sides “seem” to have credible arguments - thus my confusion.

To be simplistic - I personally have a huge trade deficit with my local grocer.  I buy all my food there but he buys nothing from me.  On the other side I have a huge trade surplus with the purchaser that buys all my produced product.  Isn’t that just the way it is?  We all have different products to peddle - we can not always be even on an individual basis can we?  Is there not other countries that we have huge surpluses with?

i would love to see an interview that digs in to this issue and helps clear things up .... or it may be I am the only one confused.

The problem many see with trade deficits is that everyone is not using the same currency. Regarding why your analogy isn't the same thing: you and your local grocer use the dollar (USD) and are required by law to do so. If one of you uses something else, sometime, somewhere, there must be a balance. When this happens, it's gonna be a wild ride, unless it's slow a multigenerational. Especially since the US has the largest military, lots of oil, food, natural resources, and a huge population, and nobody dares to piss us off. And this rebalancing of the deficits could have happened anytime since 1980 to now.

In 2008, we used QE to create lots of USD which should have helped weaken the dollar and deal with the gap via inflation. But everyone else laughed and did the same thing (hello, China!). But it will happen somehow or another.

mntnhousepermi's picture
mntnhousepermi
Status: Silver Member (Offline)
Joined: Feb 19 2016
Posts: 159
not equivalent comparison
Dante wrote:

Very good interview.

I have one point I am still confused about.  Again, this man reiterates that our huge trade deficit with China is a big problem.  He is not alone in this but for every one I read that holds this view I can find another that states is not an issue.  Both sides “seem” to have credible arguments - thus my confusion.

To be simplistic - I personally have a huge trade deficit with my local grocer.  I buy all my food there but he buys nothing from me.  On the other side I have a huge trade surplus with the purchaser that buys all my produced product.  Isn’t that just the way it is?  We all have different products to peddle - we can not always be even on an individual basis can we?  Is there not other countries that we have huge surpluses with?

i would love to see an interview that digs in to this issue and helps clear things up .... or it may be I am the only one confused.

 

Your example as a person is not equivalent. USA trade does not overall balance out, taken alltogether, we have a deficit. It is not balancing out. It would be more similar, on a personal level, to you having a part time job, but still buying the same stuff, and making up the difference using your charge card.

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