Retailing in America: Bricks & Torture

Retailing in America: Brick & Torture, Danielle DiMartino Booth, Money Strong, Fed UpFor those living under Chinese rule of law and inclined to matricide, patricide or simply high treason, their luck in sentencing matters took a decided turn for the better in 1905.

It was then that after 1,000 years as part of China’s penal code, Lingchi, or Death by 1,000 Cuts, was formally outlawed by the merciful order of Shen Jiaben. Consider this method of torture that eventually, emphasize that eventuality, leads to death, to be as far as opposite as can be from a mercifully speedy beheading by razor sharp sword. The good news, for history’s more squeamish voyeurs, is that we mere mortals can only endure so much pain and terror — the 1,000 cuts was probably an egregious exaggeration. Though accounts vary, in most cases, all that was required were a few well-placed, satisfyingly deep cuts and the condemned lost consciousness, missing the worst of their own cuttingly meted misfortunes.

As with many things throughout history, it would seem that necessity is indeed the mother of invention, even in matters of torture. In the case of Lingchi, we can thank dear old Confucius and some of his closely held ideals as they related to filial piety and the form of punishment deserved, if not fully observed. If you respect mom and dad, and your elders in general, you demand of yourself the highest standards. If however, you fail these most sacred of duties, you could not reasonably expect to arrive whole, as in intact, to your spiritual life, hence Lingchi.

As for being intact, after a messy holiday shopping season, some investors have begun to question how the physical retail body will survive Jeff Bezos’ answer to Death by 1,000 Cuts. The poster child for a slow death in retailing, Sears, kicked off 2017 with the announcement that it would close an additional 150 stores, bringing to 200 the total for the current fiscal year. That’s on top of the 78 shuttered last year and the more than 200 in 2015. By April of this year, the once-quintessential retailer will have fewer than 1,500 stores left standing, down from 2011, when it had more than 3,500.

Six years ago, it appeared that Sears might be the only icon to give new meaning to, “Anchors Away!” The reality today is that Sears has been joined by more than a handful of other names we once thought impermeable to the scourge of E-Commerce.

You would agree it’s been a rough go of it for bricks and mortar. Circuit City started things off a decade ago and was followed by Linens & Things, Blockbuster, Borders, and more recently, Radio Shack and Sports Authority. As is the case with the most recent fallen name, The Limited, many of these once-household names were invaded by private equity kingpins and saddled with untenable debt loads.

Outright bankruptcies, nonetheless, are not where the pain is most acute. That preserve is on reserve for a different kind of demise, an appreciably slower descent into irrelevance. At first, the disruptive power of E-Commerce appeared to apply only to things that could be read or viewed on a screen. More recently, though, any product that’s quantifiable at any level is fair game whether it be Jimmy Choo’s, a trip to Katmandu or Vintage Scooby Doo. Hence the frantic game of catch-up so many retailers are playing to raise their online visibility. The problem is catch-up can be costly. Just ask any retailer closing stores, one not-quite-lethal cut at a time, and they’ll set you straight.

On the other hand, as we well know, many nasty storms proffer a silver lining. Surely all of this capacity coming out of the standing retail universe invites opportunity in some form? Sorry to report this to all those investors looking to capitalize on bargain basement retailers, you can consider yourself warned. Not only is private equity sufficiently burned to steer clear of the sector, E-Commerce sales are not nearly as modest as what’s being reported. Wait a minute – “Modest??”

A brilliant, albeit perfectly private, analyst recently deconstructed the retail sales data, carving out auto, food and beverage and gasoline sales from the pool to arrive at what he calls Relevant Internetable Sales, or RIS. Of the roughly $1.2 trillion in annual retail sales, half can be classified as RIS, or the ‘fair game’ referenced above.

Don’t want to lose you here and shouldn’t even be running the risk as this is simple math. E-Commerce sales represent just north of eight percent of the total retail sales pie. Those are the figures you read about month in and month out. Narrow it down to the RIS half of the total retail sales pie, and lo and behold, E-Commerce’s market share rises to 15 percent of the halved pie.

In the event you think yours truly has fallen into an intellectual ditch, promise there IS a point forthcoming. If you examine the growth of RIS sales back to when the economy technically exited recession, in mid-2009, a distinct pattern emerges. The growth in E-Commerce Sales came out of the gate at a run rate of roughly a third of that of RIS sales. Flash forward to today and the growth rate of E-Commerce sales is half that of RIS sales and poised to soon overcome that of RIS’ sales growth. Looked at slightly differently, the growth rate of E-Commerce sales has risen to 15 percent year-over-year while that of RIS has meandered at a third of that rate.

The click, in other words, is in full cannibalization mode and intent on razing a mall near you in the near future.

It would be easy enough to trail off onto a tangent and begin debating how many warehouse jobs will be created even as traditional retail jobs disappear by the tens of thousands. Amazon, after all, just announced it would be creating 100,000 jobs in the next 18 months. (No, Virginia, a lifer retail sales associate cannot miraculously morph into a warehouse workhorse. But let’s not go there.)

Instead, let’s delve into the driving force behind E-Commerce eating into established emporiums’ empires. A gaggle of researchers from Harvard, Stanford and the University of California recently released the findings of a study that delved into the lifetime earnings capacity of different generations of Americans dating back to those born in 1940, one in the same with those who hit 30 in 1970. They then compared subsequent generations born 10 years hence – 1950, 1960, and 1970 – all the way through those born in 1980.

What, pray tell, did the fine professors find? In a nutshell, the impetus behind the exodus.

A neat 92 percent of those born in 1940 made more than their parents did, defining the American Dream, baseball and apple pie. Leap ahead to the baby class of 1980, though, and the legions of leap frogs dwindles to 50 percent. Do you recall that thing about necessity and motherhood and invention? What if, just say, Bezos was such a visionary he foresaw demographics and an atrophying economy necessitating the disruptive forces that manifested themselves in the form of E-Commerce and his brainchild Amazon?

OK – maybe that’s a stretch, even for me.

But Bezos, born in 1964, has been able to connect a dot or two since founding a company that back in the day committed the comparatively cordial sin of putting book stores out of business. That toll was tentative and tame compared to the devastating damage being exacted on countless contemporary chains today.

The fact is, pricing power is dead, having been tortured into extinction. Yes, yes….hallucinogenic harried housewives who’ve convinced themselves they’re busy could well give Alexa a run for their husbands’ money, barking out orders for everything from 52 Weeks of Flowers a Year to 50 Shades of Grey’s sequel’s sequel’s sequel (seriously?).

For the rest of us slaves to Amazon Prime, it could come down to affordability, or the lack thereof. Plan on the punditry assuring you in the months to come that the growth in credit card spending is as clear a vote of confidence in the country’s future as any out there. Consumers aren’t telling you they’re optimistic, they’re showing you, by golly!

While it’s true, that the plastic in peoples’ wallets has caught fire, the incendiary indulging has yet to catch up with still-inadequate income growth. The latest figures from November, lamentably reported with a lag, tell us that inflation-adjusted credit card spending is outpacing that of inflation-adjusted wage growth by 2.8 percentage points, the widest margin of the current expansion, and discernibly greater than October’s gap of 1.7 percentage points.

You tell me – are the rest of us confident or desperate to make ends meet?

Better yet, how much better or worse off will the collective ‘we’ be when tens of thousands of sales associates are shoved out of the workforce? These working folks are some of the last of the non-college-educated souls toiling away in our midst, grinding out honest livings. As things stand, the pay gap between degree holders and those who weren’t fortunate enough to study after high school is at its widest point on record. Wherever exactly do we go from here?

Few care to admit that most of the malls in America will disappear in the decade to come. For far too many, retail executives included, it’s a simple matter of not being capable of letting go of the past, which is understandable. Nevertheless, and as much as we’d like to believe differently, economic and demographic realities, and let’s face it, cultural shifts in shopping behavior, beg to differ. We do, though, have a choice: we can begrudgingly acquiesce into acceptance, by way of 1,000 blood-curdling cuts, or move on to what will be the next generation of retailing in America, as unrecognizable as she may be.

 

Click on one of the links below to purchase Fed Up:  An Insider’s Take on Why the Federal Reserve is Bad for America.

Amazon.com | Barnes & Noble.com | Indie Bound.com

With Great Pride, I Give You Fed Up

With Great Pride, I Give You Fed Up, Danielle DiMartino Booth, Money Strong

Dear Friends,

Today I am proud to announce that the book I have spent the last two years working on – FED UP: An Insider’s Take on Why The Federal Reserve is Bad for America – will be available wherever books are sold on February 14th.  Consider it a Valentine’s Day Forget Me Not to the country. FED UP is not only important to me, but it’s a critical read for every citizen of this country, especially now. As I stated in my Bloomberg piece last week, President Elect Trump has the opportunity to rebuild the Federal Reserve from the bottom up and reshape our economy in unfettered, uncompromised fashion.

In Fed Up, I pull back the curtain on the Fed and explain what really happened to the economy after that fateful December day in 2008, when interest rates were taken to the zero bound. I elaborate on how a cabal of unelected academics within the Federal Reserve made fatal policy decisions based not on the direct impact it would have on the average American household, but rather on their theoretical models that effectively muffled the voices of this country’s working men and women.

Please know that without the weekly Money Strong newsletter and your loyal support, there would be no book. Accept my humble gratitude for your undying encouragement with this gift of an early look at the book, before it hits the stands. For those of you who choose to order the book in advance, I’ll send you an early sneak peek. Please click HERE for more info.

I cannot tell you how excited I am to embark upon this journey with you and, as has always been the case, welcome your feedback.

All the best,

 

Danielle

The Corporate Bond Market: Binge-Borrowing

The Corporate Bond Market: Binge-Borrowing, Danielle DiMartino Booth, Money Strong, Fed UP: An Insider's Take on the Why the Federal Reserve is Bad for America

Celery and raspberry? Marathon miles of Sudoku and crossword puzzles? Extra reps at the gym? Binge away.

‘Tis the season after the season, that other most wonderful time of the year when it’s a challenge to get a machine at the gym and resolutions are resolute, at least until February or a more intriguing deal comes along. What better way to make amends for that huge holiday hangover that crescendos with so many a New Year’s Eve bash?

Some of us chose to ring in 2017 in a substantially more subdued manner that nevertheless entailed binging of a decidedly different derivation. Enter Netflix. Yours truly must confess that closet claustrophobia was the culprit in keeping this one indoors coveting the control, confining the choices to richly royal romps. It all started innocently enough, with a recommendation to catch The Crown, which has just won a Golden Globe. The devolution that followed began in Italy, with Medici, stopped over in France, with Versailles, and round tripped back to England, with the epic saga that kicked off the modern day, small screen genre, The Tudors. At some point hallucinations began to give the impression that all the series’ stars had British accents. Wait, they actually did.

Thankfully, at some point, bowl games snapped the spell and reality rudely reared its redemptive head before anyone’s else’s head rolled (those royals were a bloodthirsty lot!). Sleep and sanity followed.

Sadly, the same cannot be said of borrowers of almost every stripe these days. For those tapping the fixed income markets, the borrowing bingefest is conspicuous in its constancy. Not only did global bond issuance top $6.6 trillion last year, a fresh record, sales are off to a galloping start thus far in January.

In the lead are corporate bond sales, which accounted for $3.6 trillion of last year’s super sales. To not be outdone, investors ran a full out sprint in the new year’s first trading week, “shattering,” not breaking records, in the words of New Albion Partners’ Brian Reynolds. In the first three trading days of the year alone, investors bought $56 billion of new corporate bonds. Some context in the context of what’s been one record-breaking year after another in issuance:

“An average month in recent years would see investors buy about $130 billion of corporate bonds,” noted Reynolds. “Investors just bought more than 40 percent of that monthly average in just three trading days!”

For those of you who have ever had the pleasure of a good, long visit with Reynolds, he is anything but prone to using exclamation points. (!)

In any event, waves of heavy issuance often coincide with big deals carrying ‘concessions,’ or enticements in the form of higher yields than what the issuer’s existing bonds offer. Despite 2017’s already extraordinary deal flow, a good number of issues stood precedence on its head, coming out of the gate with negative concessions. “It’s as if corporate bond buyers are rabid, as if there are not enough corporate bonds to go around, even though there is a record amount of corporate bonds!” added Reynolds.

The kicker – there always is one when fever sets in – is that issuers are earmarking proceeds as generically as they can, for “general corporate purposes.” In other words, they can use the sales proceeds for whatever they desire, including share buybacks.

But wait! (Can exclamation points be contagious?) Haven’t we just learned that buybacks took a nosedive in the latest Standard & Poor’s data release? That quarter-over-quarter share repurchases had fallen by 12 percent and tanked by a stunning 25.5 percent over 2015’s third quarter? What superb sleuthing you’ve done, Watkins!

And right you are, except this one little thing. The pre-election world is so passé.

What are the odds share repurchases reaccelerate under the new administration? In one word ‘growing,’ fed by two springs. The first is mathematically driven. Calpers, the country’s largest pension, recently announced it would be “gradually” lowering its rate of return target to 7.0 percent from 7.5 percent. In the nothing-is-free department, estimates suggest taxpayers will have to cough up an additional $2 billion per year to make up for what the pension no longer anticipates in the form of pension returns.

(Suspend reality as the pension returned 0.61 percent in its most recent fiscal year ended June 30. We could ride off on a tangent but link to this if you’d like to hear more on pensions’ prospects http://dimartinobooth.com/will-public-pensions-trumps-biggest-challenge-2/)

The funny thing is California governor Jerry Brown just announced he anticipates the state will run a $1.6 billion deficit by next summer as the tax base continues to atrophy driven by – wait for it – rising taxes. And where are a lot of those tax dollars going? You guessed right again – backfilling that yawning pension gap. Will the exodus out of the Golden State continue, leaving only the uber-wealthy and economically immobile behind? You tell me.

Promise there’s a point here. Calpers will lead the way to other pensions also lowering their rate of return targets, which will in short order trigger more in the way of rising taxes and, it follows, more actual monies pensions allocate to fresh investments to thereby generate those fairy tale returns. To stay deeply deluded and convince oneself (still) high returns are achievable, the de rigueur investment is private equity credit funds in their many high voltage varieties. At Reynolds’ last count, pensions have voted a record dollar amount into credit every single month since the stock market panic of 2015.

And the momentum just keeps building. December 2015’s record pension credit fund inflows of $7.3 billion were blown to bits by this past December’s $10.6 billion – and that’s before any leverage is put to work. As we have hopefully learned, the credit machine feeds the buyback machine, and away we go. Tack on the prospects of a Republican Congress facilitating the repatriation of all that offshore cash and you’ve got the makings of a true buyback renaissance. Oh, and by the way, a seriously overvalued bond market.

Jesse Felder, president of Felder Investment Research, recently put pen to paper to quantify the value investors get today. What sets Felder apart from the crowd, in a good way, is that he factors in the backdrop of record bond issuance feeding what had, until very recently, been a record pace of share buybacks.

“When you look at corporate valuations more comprehensively, including both debt and equity, we have now matched that prior period,” Felder wrote in a recent report, referring back to peak dotcom bubble valuations. To arrive at this conclusion, he compares the value of nonfinancial corporate debt and equity relative to gross value added, an effective gauge of enterprise value-to-sales.

How does Felder calculate such a clever metric? With the help of some Federal Reserve data, no less, he incorporates the buyback bout to create a holistic valuation methodology to capture comprehensive corporate valuations. Because one frenzy, bond sales, has fed the other, the stock market’s historic run by way of share count reduction, it’s simply disingenuous to not marry the two. You can want to try, but it’s futile to examine bond or stock valuations in a vacuum.

“This has essentially been a massive debt for equity swap that serves to reduce the value of equity outstanding while greatly expanding the amount of debt outstanding,” added Felder. “Equity-only valuation measures fail to account for this phenomenon. This measure incorporates it.”

The point, though, is not that the current rally will necessarily buckle under the weight of bloated valuations. To the contrary, pensions’ sheer buying power, their trillions upon trillions of dollars of monies to be allocated, can indeed make it appear that we are now in 1999, or better yet, 1996. But don’t be fooled – you’re still paying a dear price to play with fire.

So stop yourself the next time you hear some talking head reassuring you that the price-to-earnings ratio on a trailing 12-month basis is dirt cheap. Fight the temptation to validate your sense of security by proclaiming, “Wow, that erudite expert has some set of lobes!” Don’t just move on to the next episode, hitting BUY on that equity ETF. Stop and ask yourself just how profoundly this deep thinker has probed into the true drivers of valuations in recent years. More to the point, ask yourself whether the source is clean or compromised.

If you need inspiration, look to some of the greatest lines ever penned in Politics and the English Language by George Orwell: “The great enemy of clear language is insincerity. When there is a gap between one’s real and one’s declared aims, one turns as it were instinctively to long words and exhausted idioms, like a cuttlefish spurting out ink.” And yes, Orwell was English. You can safely read his words aloud, with a British accent.

The Labor Market: The End of the Innocence?

One of the first of life’s lessons we all learned is that we need not rush life; it will do that for us and in the end against our will.

The inspiration for this wisdom could well have sprung from Ecclesiastes wherein we read these peaceful words: To every thing there is a season, and a time to every purpose under the heaven. Co-writers Don Henley and Bruce Hornsby embraced the spirit of this message as the 1980s were coming to a close. You must agree 1989’s The End of the Innocence, that haunting and mournful ballad, was just the coda needed to move on to the last decade of the last century.

“Let me take a long last look, before we say goodbye,” the song asks of the listener who can’t help themselves but to listen.

Many veteran investors, those who don’t need to be reminded about the Reagan era because they were there, may be feeling a bit more wistful as they peer over the horizon. They have lived through extraordinary economic times and maybe even recall the early 1970s, the last time initial jobless claims were at their current historically low levels. They know, in other words, this can’t go on forever, that we are nearing the end of our own innocence.

Federal Reserve Chair Janet Yellen has been adamant that economic cycles can’t die of old age. At the end of this month, we can proclaim to be living through the third longest expansion in postwar times. The parlor game occupying those on the Street these days entails devising scenarios that can push us into the second, or dare we dream, longest expansion of all.

The Wall Street Journal perfectly captures the infectious optimism, the yearning to keep that dream alive, by asking this in a headline: How Low Can the Unemployment Rate Go? Rather than keep you in suspense, the article’s answer is as follows:

“Assuming the economy adds around 200,000 jobs a month in 2017 and the labor-force participation rate stays relatively constant, the unemployment rate would fall to 3.9 percent by the end of the year, according to a model maintained by the Federal Reserve Bank of Atlanta.”

If we do get there, a big if, we are sure to be staring down the barrel of appreciably higher interest rates and a flat, if not by then, inverted yield curve. The only precedent is, you guessed it, that which occurred in 2000, when the unemployment rate hit 3.6 percent as the longest cycle of all time was finally flaming out. Economics 101 teaches one tenet above all – that the unemployment rate is the most lagging within the data universe.

A recent visit with Dr. Gates, that steel-eyed sleuth, corroborated this maxim. “The unemployment rate is the single, most visible economic indicator for households. It’s easy to understand, black and white. Up is bad, down is good,” Gates observed. “If we keep getting downside surprises, it will feed even more consumer optimism. That happens late in the cycle.”

What goes hand in hand with these late cycles guideposts? Since you asked, that optimism Gates cites tends to correlate with households overreaching their paychecks, which is exactly what we’re seeing.

When adjusted for inflation, credit card borrowing is up 4.5 percent over last year, a full two percentage points above wage income, which is up 2.5 percent over the same period. That’s a new high for the current cycle. At 2.9 percent, inflation-adjusted spending is also running ahead of wage income. These data are validated by separate data that shows state withholding tax collections are way off last year’s figures.

“Vulnerabilities in household demand don’t happen overnight; they take time to rise to the surface,” Gates cautioned. “Households aren’t overstretched yet, but they’re getting there. Just like corporations substitute debt for profits late in the cycle, households also are starting to do just as they ride the wave of Trump optimism. Eventually this will run its course.”

The bottom line is households are really happy about the Trump win and they’re showing it by spending beyond their means. If we haven’t yet seen the low in the unemployment rate – a big if – expect many among the reluctant to be emboldened to jump ship at the prospects of a higher paying gig.

Before rushing out to buy that new SUV, as we know countless millions of Americans have, it might be wise to make note of the recent run in the length of the average workweek. As The Liscio Report notes, at 34.3 hours, the workweek has drifted down from 34.4 hours the first half of 2016 and an average of 34.5 hours from 2014-2015. Their conclusion: “This suggests there’s not a lot of pent-up hiring demand.”

The marked slowdown in temporary hires in December would agree with their assessment as would the trend that’s emerged among retailers. Hiring announcements in the critical September to December period fell to the lowest level in seven years, coming in just a hair above 2009 levels when the economy was on its knees. The paltry 6,000 announced retail hires in December’s nonfarm payrolls report, a third of its long-term average, could be but a precursor to what’s to come in the wake of Macy’s and Sears store closure announcements.

The mirror image is transportation and warehousing, where 15,000 workers were added to payrolls last month, three times the norm. Call that the Amazon effect whose sales figures were in a word, ‘astonishing.’ Bezos & Co. dominated ecommerce holiday sales to such an extent that at nearly 40 percent, Amazon’s share of the pie was ten times that of the next closest e-tailer’s numbers.

The odds are it will come down to a race to the Hill to determine if it’s possible to breathe new life into the last gasp of the current cycle. Will the stronger dollar and tighter financial conditions overwhelm profit margins before tax reform legislation is passed and validates all of that cocky confidence? Good question. If Trump expends all of his political capital on repealing Obamacare and confirming his nominees, the economy could be in for a reality check.

And then there are the conspiracy theorists out there who have begun to spread rumors that Yellen could have a Trump card of her own up her sleeve. The market continues to tell itself we’ll be on the beach by the time the Fed first hikes rates come June. A surprise hike at the March meeting would thus send a loud and clear message that there is more 2017 tightening to come, more than any investor expects and spending bill could withstand if a yield curve inversion is in the making. But wait! Politically motivated maneuvers amount to less than ladylike behavior from the Fair Chair. Surely not!

Dr. Gates for his part expects 2017 to be the year of Red Swans. Come again? “Black Swans don’t happen first. Red Swans precede them,” he explained. “First comes the heat and then they burn out. What we’re left with is Black Swans.” Hey, don’t shoot the messenger on that one. He said it. Plus, the heat, fueled by more credit card spending, subprime car sales and higher wages for coveted skilled workers, feels good when the economy is threatened with catching a chill.

Look. No one wants to see the end of any prosperous era, even one that’s left so many behind. But die off every era eventually does, some quicker than others. To the bulls who refuse to acknowledge that even the best intentions cannot stave off inevitabilities, Henley invites you one and all to, “Offer up your best defense.” But we all know how the song ends right after that – “But this is the end. This is the end of the innocence.”

The Art of Trade Warfare

The Art of Trade Warfare, Danielle DiMartino Booth, Money Strong LLC

For a moral compass, many look to the Bible. For political directives, Machiavelli’s succinct and direct The Prince. But for matters of war, the Chinese have a lock; they’ve literally raised the wisdom guiding generals engaged in battle to an art form. Here is a but a sampling from the Top 500 List of quotes from Sun Tzu’s fifth century masterpiece, The Art of War:

“Appear weak when you are strong, and strong when you are weak.”

“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.”

“The best victory is when the opponent surrenders of its own accord before there are any actual hostilities… It is best to win without fighting.”

“The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and do good service for his sovereign, is the jewel of the kingdom.”

“All warfare is based on deception.”

Speed is the essence of war. Take advantage of the enemy’s unpreparedness; travel by unexpected routes and strike him where he has taken no precautions.”

The essence of the last two quotes is what has many market watchers on tenterhooks as Inauguration Day and the Chinese yuan sporting a seven-handle fast approach. For those of you following the Vegas odds, January 20th is sure to mark both Trump’s taking office and the yuan falling to 7-something, as if they’re somehow in simpatico and synched at the hip.

Does this psychological threshold suggest that China is on a pre-ordained path to freely floating the yuan? That’s certainly where Wall Street’s sell-side sides, especially if Trump swiftly moves to impose trade sanctions. In that event, odds for a free float are 50-50 this year. If Trump’s freshly announced Trade Czar Robert Lighthizer holds off on immediate measures, count on a free float becoming reality in 2018.

If ‘speed is the essence of war,’ a freely floating yuan is a surefire way for the Chinese to counter sanctions. That said, the disruption caused would trigger a global recession and catalyze a concomitant correction in dearly valued risky assets. The attendant insult would arrive in the form of China’s wealthiest citizens’ increased impetus to ferry their fortunes overseas.

“There’s no arithmetic or economic reason Beijing would make that decision which means the only reasons they would float the currency would be out of sheer panic or because they were locked in a trade war and just said, ‘What the hell,’” said Leland Miller, president of China Beige Book (CBB) International, a research firm that produces a private survey on the Chinese economy.

At the most fundamental level, China lacks sufficient funds to take adequate precautions on the heels of 2016’s carnage; last year the yuan suffered its steepest annual decline in more than two decades. Managing that devaluation was anything but free of charge. Estimates suggest China’s foreign reserves will hold at $3.01 trillion when the latest batch of data are released January 7th. Still, that’s down a cool trillion to a five-year low. More to the point, it’s going to continue to be costly to continue to defend the yuan given the trajectory of the currency’s sickly slide. That’s saying something considering some estimates suggest $2 of the $3 trillion are inaccessible — $1 trillion earmarked to construct the Silk Road and another $1 trillion that’s illiquid.

That math is the main reason the “float” argument is reserved for headline writers. So said Neil Azous, founder of Rareview Macro LLC, a Stamford, Connecticut-based research firm. “Professional investors have three concerns,” Azous explained. “The first of these is the pace of foreign exchange reserve outflows, specifically how many months it will take to draw down China’s USD-related holdings. The second is the funding stress in the interbank lending market; the cost of funds and a key measure of counterparty risk has set higher for 53 consecutive days. The third is whether Chinese debt surpassing $18 trillion in 2017 (vs. the current $17.3 trillion) will be a precursor to a more pronounced credit crunch that exports deflation to the rest of the world”

The good news is our new head of Trade is no negotiations newbie and will be highly cognizant of all the moving pieces. In the spirit of not taking any chances, Trump literally reached back into Reagan’s cabinet for his nominee who served back then as a trade representative. Lighthizer surely has a vivid recollection of the recession that greeted Reagan shortly after he took office. Treading lightly will presumably be at the forefront of his mind despite his vociferous aversion to the very imbalances emanating from previous trade agreements that got us to point blank range.

And then there’s the delicate business of those other dithering deals to consider. All you capitalists out there, close your eyes and envision the most formidable foursome the antitrust forces on the DOJ, FTC, Treasury and FCC could combine to conceive. Throw in propaganda perfected and you get to acrimonious acronym MOFCOM, or the Ministry of Commerce for the People’s Republic of China. Of late, this auspicious agency has put the red back in China, as in red tape, dragging out the approval of three major deals that, on a relative basis, swept through its international counterparts’ gauntlets. Call that strategy with tactics intact in the subtle message department even as Chinese firms pursue deals abroad with abandon.

As for the deception aspect of this tentatively tenuous trade war, look no further than the basket the China Foreign Exchange Trade System (CFETS) uses to “manage” the exchange rate of the yuan on a trade-weighted basis.  Manage is in quotes as the basket is but one factor deployed to set the rate. Brute force is the other, as in onshore swings in the spot price of two percent in either direction are simply not permitted. It’s no coincidence that the basket was born in December 2015 as the Fed was raising interest rates for the first time in nine years. The driving force behind the establishment of the basket was the creation of a mechanism by which the yuan can eventually decouple from the dollar.

Where does the deception come in? At birth, the dollar’s weight within the basket was 26.4 percent. Bear in mind, it’s only been three months since the IMF granted China entry into the special drawing rights (SDR) club of big boy currencies; the yuan joined the dollar, the euro, the yen and the British pound. Hence the market’s surprise at the CFETS’ December 29th announcement that the original basket of 13 currencies would be expanded by an additional 11 currencies. Oh, and the new and improved basket’s dollar weighting would be reduced to 22.4 percent.

The stated motive for the move is to better maintain stability against the dollar, which is on a tear and against which the yuan sits at an eight-year low. In telling fashion, a good number of the basket’s new additions are currencies over which China holds great sway. Of course, China can also take more traditional routes to exert control such as relaxing its banks’ Loan-to-Deposit ratio and cutting the Required Reserve Ratio.

“China has many counteracting levers at their disposal to fend off bomb-throwers,” Azous added. “What professional investors have learned over the years is China can remain irrational longer than they can remain solvent trying to fight them. It’s more prudent to hedge tail risk and monitor the risk profile, to be reactive rather than making a big speculative call in advance of a perceived hard landing.” (Any squeezed short worth their salt can validate that statement’s veracity.)

In the near term, investors positioned for a landing of any kind are likely to continue to get burned. By most metrics, China bounced back in fine form in the final three months of last year, albeit off 2015’s historically weak fourth quarter. The Miller’s CBB reported that profits, job growth, capital expenditures and revenues all posted robust gains. The persistent paradox presented is that improvement, especially on the jobs front, dictates the stimulus spigot will be turned off.

That’s not to say the entire Chinese economy merits a clean bill of health. Corporate cash flow showed a marked deterioration, an affront to the prosperous profits picture. The CBB noted multiple culprits including weakness in receivables and payables across a full range of sectors including services, property, transport and especially retail. Weak cash flow goes hand in hand with firm borrowing in the third and fourth quarter hitting the highest level in three years. Miller warned that stronger profits and weaker cash flow can only co-exist for so long: “One will have to give way in 2017.”

With that as a backdrop, you can bet your bottom yuan that China has no desire to float its currency any time soon.

“It would hurt them much more than anyone else and be greeted with massive retribution from every corner of the world. There would be countervailing devaluations and it would cause global contagion,” Miller said. “It would also be a major blow to (President) Xi’s credibility during a politically sensitive year, since he’s pledged not to float the currency. And it would certainly NOT staunch outflows; all it would do is exacerbate them.”

The technical term for such an outcome, for the global economy, mind you, is ‘Lose-Lose.’ Remember that the next time you wake to a tough-talking tweet. For good measure, keep yet another of Tzu’s sublime maxims in mind: “The supreme art of war is to subdue the enemy without fighting.” As the United States ponders future relations with its largest trading partner, it might want to consider deploying ambassadors skilled in that other fine art, that of the use of velvet rather than barbed tongues.

Year End Outlook: Will Investors Get Hustled by the Pros in 2017?

Year End Outlook: Will Investors Get Hustled by the Pros in 2017?  Danielle DiMartino Booth, Money Strong LLCIt never pays to be an “afterthought.”

That was the word Jackie Gleason used to characterize the proposed reprisal of ‘Minnesota Fats’ in The Color of Money, 1986’s sequel to The Hustler. Chances are Paul Newman himself, who had at least 36 script conferences with the screenwriter, didn’t take offense to Gleason’s rebuff. “We desperately wanted the character to return,” Newman told the New York Times of Gleason’s ‘Fats,’ “but every time we put him in, it seemed like we were trying to glue an arm on a man and make it stick.”

Under the brilliant direction of Martin Scorsese, Newman would go on to win an Oscar for his role in Color. Still, as a whole, the sequel simply couldn’t stand up to the 1961 original. Hence the irony of Newman’s Oscar, which critics suggested was in belated recognition of his original performance as an ace pool player in The Hustler. In his young, glory days, Newman so deeply penetrated his characters’ roles that he literally vanished into them. His brilliance as an actor shined brightest in one scene when Eddie lost to Fats; rather than hostility or animus, his fascinated adoration for his idol was unabashedly on display, reflected in his bright eyes and amused expression. Now that’s Hollywood.

As for Wall Street, it’s recent performance has also laid the drama on thick and in perfect form as stocks pierce record highs. The investor community, the Street’s audience, couldn’t agree more. According to the latest survey from the Conference Board, retail investors’ enthusiasm for the stock market’s prospects is at the highest level since February 2007. A stroll down memory lane reveals that similar readings on the giddiness gauge were contrarian in nature, aka sell signals. That is, unless you’re referring to 1996 as a step-off point. In that case, today’s positive parallels suggest stocks’ 2017 sequel could best the original rally that culminated in the S&P 500 peaking in 2001.

What’s driving the train to stock market stardom? The singular theme since Trump was elected has been happiness bordering on euphoria. The overall December Conference Board survey hit a 15-year high. This echoed the most recent University of Michigan December survey, which hit a 12-year high. But it’s not just your average Joe on the street, as in Main Street. Small business confidence also witnessed its biggest one-month surge since 2009, while regional manufacturing surveys have uniformly topped forecasts. Based on an average of five regional Fed surveys, Morgan Stanley raised to a two-year high its expectations for the upcoming release of the national manufacturing survey.

The question is, can the economic fundamentals Trump the (over?)-heated hope? For that to happen, every bit of optimism has to be substantiated. And that supremely sublime stage has yet to be set.

The entirety of the Conference Board spike was due to expectations; current conditions, which remain high, actually fell on the month. Similarly, small business owners’ expectations for future sales rose smartly, which runs counter to actual sales, hiring and capital expenditures declining last month. And finally, one red flag that’s popped up in multiple places centers on the jobs market. While consumers’ expectations for income growth rose to the highest level in a decade, their perceptions of jobs being ‘plentiful,’ fell while those lamenting jobs were “hard to get” rose, affirming the recent drift upwards in jobless claims.

Some of the regional Fed surveys also showed employment had unexpectedly hit reverse gear, contrary to respondents’ effusive outlook for the future. Most surprising, perhaps, were the losses reported in Texas’ manufacturing sector in November; they defy the recent uptick in rig counts. Renmac’s chief economist Neil Dutta figures the number of operating rigs has surged 120 percent over the third quarter average. That puts the current number of drilling wells at the highest since January; oil maintaining its price gains implies more to come, reflected in Texas manufacturers’ outlook, which hit its highest level in 12 years. Presumably job growth will follow, according to the script, that is, and not just in the Lone Star State. Presumably.

Continuing along the contented motif, homebuilders are downright ecstatic – their optimism is ringing in the new year at the highest level since 2005. As per the National Association of Home Builders (NAHB):

“Builders are hopeful that President-elect Trump will follow through on his pledge to cut burdensome regulations that are harming small businesses and housing affordability. This is particularly important given that a recent NAHB study shows that regulatory costs for home building have increased 29 percent in the past five years.”

Potential homebuyers are also buying in to the potential for falling prices; the NAHB sub-index that measures Prospective Buyers Traffic registered its first print in expansionary territory since August 2005. There’s a good chance the cheery potential homebuyers overlap with the record number of consumers (18 percent) who the University of Michigan reported “spontaneously mentioned the expected favorable impact of Trump’s policies on the economy.” This figure is twice as high as its prior peak, recorded in 1981 as Reagan was taking office.

The teensiest of caveats before continuing – all of this rhapsody is not free; it’s been more than reflected in higher interest rates which have notably manifested themselves in the highest mortgage rates since the bond market threw a taper tantrum in the summer of 2013. Not even Yale economist Robert Shiller can predict which way the winds will blow, good or bad, as he told Bloomberg News:

“I don’t know how people react to rising mortgage rates. One thought is they want to lock in right now. And that’s why we’ve had good home sales recently. And it might continue as mortgage rates rise. This thing could feed a boom. I’m not saying it will.”

Talk about measured!

Paradoxically, households’ inflation expectations looking out five years over the horizon sank to their lowest level on record in data going back to 1979, even as businesses whine about the highest input costs in years.

If you think you’re hearing a wee bit of a mixed message emanating from households and businesses, you’re not losing your marbles. Policymakers and politicians have a heck of a lot to make good on when Congress takes to the Hill and the new administration sets foot in the White House next month.

We can all hope that breaking the gridlock and freeing businesses to conduct business the old-fashioned American way will unleash animal spirits among employers. Job creation, of a meaningful, high-income-generating sort, would thus beget consumption. This in turn would spur the best sort of economic growth we can hope for, and at the same time reflect businesses carrying through on their stated confidence with actions, by expanding their payrolls, inducing a lovely, virtuous cycle that feeds on itself. How economically endearing indeed.

Would you be surprised to discover there are a few skeptics who doubt Goldilocks is primed to whip out those golden locks, validating, well, just about everyone’s cockiness?

Though other perpendiculars have already been posited, it’s fair to interject a friendly reminder that we are not in 1982, the last time stocks were trading at a single-digit price-to-earnings multiple and Baby Boomers were less than half their age. Is it relevant that productivity growth was running at eight times its current pace with the saving rate double where it is today and household debt to income half of where it is? Wait…won’t rising rig counts cap oil prices? And does it matter that Uncle Sam’s debt load has grown to 105 percent of GDP compared to 30 percent back then? Does this country and its inhabitants technically have to have a pot that’s growing in size to piss in?

Not according to the measured volatility on the stock market, which is near the lowest in recorded history. We have nothing to worry about and that’s that. Hence the perplexing pessimism among institutional investors. The State Street Investor Confidence Index (ICI) peaked in March of this year, and after a wimpy stab at a comeback, has retreated anew.

The developers of the ICI observed that 2016 ended on a downbeat note as institutional investors continued to shun the stock market, preferring instead to wait for follow-through from the incoming administration and greater clarity on just how serious the Federal Reserve is about hiking rates in 2017.

“While markets increasingly look to be ‘priced for perfection’ over the US economic outlook for 2017, it is interesting that institutional investors are more circumspect,” said Lee Ferridge, State Street’s head of North American strategy. “Most noteworthy for me is the decline in the North American index even as US equities and the US dollar continue to rise.”

If the stars don’t align perfectly, if the sequel doesn’t best the original, smaller investors might want to wise up to the fact that they’re being hustled by the equivalent of professional gamblers. Know that they’ve been at this game for long enough to cash out their winnings while they can still be put to good use. What’s the alternative? That would be investors finding themselves in naïve form, as Fast Eddie did, just before he lost to Minnesota Fats, asking, “How can I lose?

The Federal Reserve and the Destruction of the American Dream

“Government is a just execution of the laws, which were instituted by the people for their people’s preservation: but if the people’s implements, to whom they have trusted the execution of those laws, or any power for their preservation, should convert such execution to their destruction, have they not the right to resume the power they once delegated, and to punish their servants who have abused it?”

—John Wilkes, The North Briton, October 19, 1762

 

No truer words have ever been penned to the betterment of a people struggling to break free of tyranny. Indeed, John Wilkes is considered by some historians to be the primary source of inspiration for revolutionary colonial Americans given his staunch defense of religious liberty, prisoners’ rights and freedom of the press, rights we hold dear to this day.

So idolized was Wilkes, our forefathers named countless towns and babies in his name, quite the honor all things considered. You see, Wilkes was also an infamous pornographer and relished his notoriety, raising self-promotion to an art form. Even Benjamin Franklin was disturbed by the raunchy rake, which is saying something considering Franklin’s own proclivity for dalliances.

But what if the colonials, the “We the People” to be, assigned added value to Wilkes’ brand of self-cultivated ill-repute? What if he rose to such fascinating infamy precisely because he launched vicious attacks on the privileged? What better way to become a champion of the powerless? Ring any bells?

On November 8, 2016, a stunned TV audience bore witness to Wilkes’ legacy playing out across this great land. Millions of voters joined forces to punish their elected servants who had so egregiously abused their power. The establishment was disenfranchised overnight.

Since the election, a not entirely unexpected pivot has taken place. President-elect Donald J. Trump is sure to have recruited cabinet members whose rich resumes no doubt raise the hair on the backs of some of his most radical supporters. We can only hope the promised, the demanded, reforms are not sacrificed on the altar of deal-making. It will come as no surprise to regulars of these missives what the deepest betrayal would be for yours truly. Trump must hold firm on his commitment to return the Federal Reserve to its right place as an apolitical institution. The very future of the American dream depends upon our new president being true to his word.

Reams upon reams have been written on the downfall of the American Dream. Social mobility stunted. Generations of stagnant incomes. The decline in new business formation. Income inequality the likes of which hasn’t persisted since the days preceding the Great Depression. Money in the bank is a theory for most Americans, even those fast approaching retirement. If you do have savings, by the way, you are punished with insulting levels of interest rates.

And just so we’re clear here and inside the trust tree, let’s be honest and acknowledge how and especially where the anger this trap incites will manifest itself — that is, shout-out-loud, hostile and open conflict and on our streets. An exaggeration? If only that were the case.

Two weeks ago, Real Vision aired an interview conducted with me right after the elections were held. Many subjects were covered over the hour. But the one that struck the loudest chord with viewers was the issue of underfunded public pensions, which stands to reason given the headlines of late.

But the reaction from viewers was anything but expected. The bile, the contempt, the malicious back and forth in the comments between public and private sector workers stunned me speechless.

It was the teachers, firefighters and policemen vs. you name the line of work among those in the private sector. No side won in the event you’re holding your breath. And both made great points. Promises made should not be broken. Teaching our children, protecting our citizens from harm – noble, often thankless professions without question. By the same token, why should someone who has worked their entire life swallow a spike in their property taxes to foot the bill? It’s not as if the investments in their 401ks are not on the same vulnerable footing as those in pensions.

The outrage prompted a private conversation with a great friend who also happens to be the most insightful municipal bond strategist out there (a subtle way to say the following comments must remain anonymous).

The first order of business was a correction to my concern that Uncle Sam would be forced to bail out weak pensions in the end: “The federal government is most definitely NOT going to write checks to state and local government! If anything, the current lineup on the Hill wants to move more responsibility to the states (and they have no money anyhow).”

There’s no arguing with the no money part. But indulge the rest of the conversation as here’s where we get down to causality, to culpability.

“I would lay more blame on your friend, the Fed. Remember that public pensions were funded in 2000 and prior to that, earning a seven-to-eight percent return on assets was no sweat. For the last 15 years though, we’ve had nothing but volatility and low interest on fixed income, the place where conservative investors are supposed to go to deal with retirement investment. This has clobbered long-term investors of all shapes and the feedback to the economy is not fully being taken into account (in my opinion).  If you are approaching retirement (read: baby boomers) and know you don’t have enough money in your 401k, you are not likely to run out and buy stuff.”

Few would dispute that Keynes’ Paradox of Thrift is alive and well. The ravages of the Fed’s low interest rate policy have forced an increasing number of Americans to save more to offset what they are not earning on their savings. The resulting decline in aggregate demand goes a long way to explaining the current economic recovery’s refusal to accelerate – even factoring in the third quarter’s 3.2-percent pace, current forecasts calling for 2.3-percent growth in the fourth quarter leave 2016 full year growth just shy of the two-percent mark.

But that’s the point of the Paradox. The millions of baby boomers retiring are going to cash, as they should to provide for this little thing called security. Still, the forced frugality sets an anything but virtuous cycle in motion, glaringly reflected in the economic health of the generations behind the boomers, an alarming number of whom still live with their parents. Bunking up remains altogether too common, which of course reflects mobility, or better said, the lack thereof.

The tie that binds the generations comes down to one word: debt. That’s where the Federal Reserve has inflicted the greatest damage. Set aside for a minute U.S. sovereign and corporate debt. While they’re mammoth challenges for tomorrow’s policymakers, it is household debt that has torn at the fabric of our culture and fueled the fury.

The latest figures from NerdWallet, produced by aggregating Fed and Census Bureau data reveal that the average household carries $132,529 in debt, including mortgages. That’s up from $88,063 in 2002. The cost of living, which the Fed lectures us is running too cold, has risen by 30 percent over the past 13 years, surpassing income growth of 28 percent over the same period.

What makes up the deficit? We read nonstop about student loans helping to bridge the gap. But it’s credit cards that have taken up the slack of late. The average indebted household is sitting on $16,061 in credit card debt, a hair shy of 2008’s high. As for those low interest rates, the average credit-card interest rate is 18.76 percent which translates into $1,292 in annual interest payments.

Add it all up and total household debt is $12.35 trillion. Estimates call for the prior housing boom peak to be surpassed by the end of this year.

Putting a face on these nameless numbers, these ‘indebted households,’ provides much-needed perspective. Imagine you’ve grinded out a living as a building engineer in Western Pennsylvania for over 35 years. Your pension was long ago converted into a fee-laden 401k that’s taken plenty of hits over the years. Meanwhile, the guy who works on the top floor of your building makes multiples of your income, a reality you don’t even resent. Your pride runs too deep to throw a pity party. But that’s not to say you don’t have your limits.

How exactly do you take the latest headlines in the Post-Gazette that at over $60 billion, the shortfall in Pennsylvania’s pension fund makes it the ninth-worst in the country? That state Democrats are battling to raise your already high taxes to cover the funding gap? Do you fall in line with the lemmings, taking your lumps? Do you apply for yet another credit card to cover your own newfound budgetary shortfall? Do you slip further behind, accepting your station and the demise of the American Dream?

Or do you switch sides and vote for the party that’s vowed to tackle pension reform come hell or high water? The outcome of Pennsylvania’s state legislative elections speaks for itself. Democrats lost seats in Harrisburg, Johnston and Erie. Outside Pittsburgh, there are no Democrats west of the Susquehanna leaving Republicans with a 34-16 majority, enough to override the governor’s veto. An override in the House is not in the cards — Republicans hold only 122 of the 203 seats. Still, it’s the largest GOP majority since the 1950s.

Now, back out to the rest of the country. Take a moment to study “The Two Maps of America.” A gracious reader suspecting I might miss the dueling visual wonders was kind enough to forward me the article published in the New York Times on November 16th, days after the election. In the spirit of paying forward good deeds at this time of giving, a link to the article can be found below.

What do these maps convey? Rather than a geographically divided nation, the first map reveals Donald Trump won most of the land mass. A stunning 80 percent of the counties voted Republican, many in traditionally blue states like Michigan, Minnesota and Wisconsin, and yes, Pennsylvania.

Meanwhile, so illustrative is the NYT’s Tim Wallace’s description of the second map, it would be criminal to paraphrase: “Hillary Clinton overwhelmingly won the cities, like Los Angeles, Chicago and New York City, but Mr. Trump won many of the suburbs, isolating the cities in a sea of Republican voters. Mrs. Clinton’s island nation has large atolls and small island chains with liberal cores, like college towns, Native American reservations and areas with black and Hispanic majorities.”

A separate publication recently highlighted the irony of Clinton’s staunch support in the ‘liberal core college towns.” According to the Economist, a college education in America equates to more in lifetime earnings than is the case in every other developed country save Ireland. As for the why: “the use of maths in the workplace is 10 percent greater than the OECD average. The supply is limited, since Americans are not particularly numerate.”

In the event you bristled at the pretense, at the elitist tone, you’re not alone. Our being “innumerate” means we’re incapable of conceptualizing and working with numbers. It means we don’t educate our children, that we’ve given up on the American Dream as evidenced by our de facto indentured servitude. To think, some still wonder how the media and the establishment drove our electorate to revolt.

President-elect Trump, consider this to be an open letter. The time has come to quit placating the masses with subprime this and that to still their spirits. Please fulfill your promises to represent them and their children with integrity, knowing the road ahead will be anything but easy, and that the temptation to allow business as usual to continue at the Fed will be enormous.

Millions upon millions of your supporters voted to do just as John Wilkes urged the oppressed colonials to do on October 19, 1762. They punished the servants who so abused their power by voting them out of office. Serve your country by refusing to squander their hard-fought liberty.

Link HERE:  New York Times, The Two Americas of 2016

Will Public Pensions be Trump’s Biggest Challenge?

Dear friends,

Over the past week, as the Trump rally has marched on, I’ve been on the receiving end of an entirely different sort of unexpected acclaim. It started with an hour-long interview I did with Real Vision’s Grant Williams that is going ‘viral’ (I’m still new to these terms given I was inside the Federal Reserve for so long where social media was banned, and with good reason.)

The subjects covered in the extensive interview, filmed just after the election, include prospects for the Fed under the new administration, what had the Italians so piping mad and most of all, public pensions. It was this last subject that most captured the media’s attention, catching me off guard.

Some subjects such as global debt and public pension shortfalls are so massive that most choose to pretend they don’t exist. An entire cottage industry has sprung up to debunk any concerns about that little $200 trillion global debt issue, even as Libor skips upwards. It’s as if Reinhart & Rogoff’s work on record debt inducing stagnation never existed.

As for public pensions, earlier this week, I observed that Meredith Whitney’s bearish call, as aired on 60 Minutes, marked the beginning of the end of the public’s concerns. So coordinated was the campaign to disprove Whitney’s timeline that her entire body of work ended up vanishing into thin air.

And so we have learned to live with elephants in our rooms. The alternative doomsday scenarios are simply too big to get our heads around. That’s all good and well unless our mothers were right, you remember, that thing about ignoring problems not making them go away.

In the event you don’t follow me on Twitter and LinkedIn, a) congratulations as you live a much less frenzied, information-overloaded, cluttered life, and b) please enjoy the links to a five-minute slice of the Real Vision interview as well as the three articles in which I was featured this week.

Wishing you a joyous and warm holiday weekend.

All best,

Danielle

What’s racier than Vegas? Pensions, says former Fed insider .

A Pensions Time Bomb Spells Disaster for the US Economy — Business Insider

Former Fed Adviser: ‘Some Miracle’ Needed to Defuse $1.3 Billion Pensions Time Bomb — Newsmax

Danielle DiMartino Booth on the Trump Federal Reserve — Investopedia


Click HERE to purchase Fed Up:  An Insider’s Take on Why the Federal Reserve is Bad for America

Commercial Real Estate: From Towers of Gold to Pillars of Salt

Danielle DiMartino Booth, Money Strong LLC, Commercial Real Estate: from towers of gold to pillars of saltMix together mortar and lime with pressed hay and you too can construct a Tower of Gold, or at least the illusion of one.

If you have any doubts, pop on over to Seville, yes, the one in Spain, and have a look at the original Torre de Oro. Particularly entrancing is the vision of this 13th century dodecagonal watchtower at night. The gilded color reflected on the waters of the Guadalquivir River is as rich as you’ll ever be fortunate enough to behold.

The Spanish tower was originally one of two anchor points for a massive chain that blocked the river forming a defense against the Castilian fleet under Ramon de Bonifaz in the 1248 Reconquista. Unfortunately for the city’s residents, the chain did not hold and the besieged Muslim mecca eventually succumbed to the Christian forces. Despite its having been repeatedly under assault down through the ages, the Torre has withstood a series of attacks of the sort Mother Nature and revolutionary looters have thrown at it. So adored was the golden edifice, its destruction was never allowed. The Sevillians have demanded it be restored and re-restored over and over again. The time value of the building has clearly held strong to our aesthetic and architectural benefit.

As for the current generation of erected structures, today’s investors in commercial real estate (CRE) can be forgiven if they’ve got the urge of late to go soft on the sector. Fine, so the current CRE cycle is long in the tooth. The same could be said for the length of the rally in just about every other asset class and for that matter the current economic expansion.

What differentiates CRE from other asset classes is that it’s been hyper-driven by monetary policy gone wild. Flows into both U.S. commercial and high end residential real estate reflect the currency tug of war that started over three years ago. You remember that hissy fit the bond market threw at the mere mention the Fed might throttle back on its quantitative easing (QE) machine. Would inflation waltz hand in hand back onto stage? If so, might an inflation hedge into a hard asset naturally, dare say, logically follow? Well, then – let’s all join hands and pile hand over fist into real estate! For safety (never works out that way in numbers) that is.

In what can only be described as a full 360-degree turn from the initial days that followed the summer of 2013’s ‘taper tantrum,’ the Wall Street Journal recently ran an article titled, “Chinese Rethink U.S. Plans.” To say those trolling the Twittersphere took umbrage is an understatement. Vitriolic accusations of pots calling kettles black and casting stones in (overpriced) glass houses flew for days (good thing Tweets are capped at 140 characters as less is blessedly less when tempers flare).

Though few real estate consultancies are foolish enough to bite the hand that feeds them, there is a nascent acknowledgement that supply is becoming conspicuous in its abundance. “Supply rising but generally not over supply,” and “Real estate is late cycle,” are but two tentative subtitles to one to remain unnamed firm’s 2017 outlook. The real kicker, though, was, “Foreign buyers – from tailwind to headwind.” That gem speaks to the nitty gritty in the WSJ article, namely that foreign buyers, for all of their enthusiasm to jettison their capital, have hit their valuation threshold.

The specific deal punctuating the article draws the reader to a Street in Brooklyn, or more precisely, “a 22-acre, 15-building mixed use project in various stages of construction (that) is facing stiff headwinds.” As a nominal nod to said headwinds, the U.S.-based partner of the Chinese investor has taken a $307.6 million impairment charge and declared it will, “delay future vertical development.” The Chinese unequivocally deny any construction interruptions, insisting that they are, “meeting the goals and targets that were established when we invested in 2014.” Hmmm. Raise your hands if you want to read between those lines, in Mandarin, no less.

Rather than be plagued by such deep thoughts, perhaps at this point it would be best to step back and examine some basic metrics gauging the health of the commercial real estate market. If we start in the most amply supplied sectors and move our way down the spectrum, you may note that a pattern begins to emerge.

Let’s start with home away from home, as in hotels. To say we’ve built a few more lodging units in recent years than justified by the fundamentals insults veteran developers. In polite parlance, hotel room supply will outstrip corporate demand in 2017. In less genteel jargon, the main metric measuring the health of hotel profitability, as in RevPar, the product of a hotel’s daily room and occupancy rates, has tanked. The latest month’s read has RevPar nationwide growing at 1.6 percent over last year. In the event you like to keep score, that’s half the 3.2-percent rate thus far this year, and half the rate again of the 6.3-percent pace clocked in 2015. So yes, there’s a light on at the inn.

As for that stopover station in life, otherwise known as your apartment years, it’s a good thing cultural norms have shifted. It’s now cool to rent well into your prime earning years. Coming soon: it will also be economical as record supply finally chokes off rent growth. Over the past 12 months, 190,000 units were delivered across the 54 largest U.S. metros, a tad bit more than the 140,000 15-year average. But wait, there’s more! Another 244,000 units are slated for delivery in 2017, taking the bull run that started in 2013 in multifamily construction to a neat million unit. In the supply crosshairs, and in order of expected deliveries, are Houston, Dallas, New York, Washington D.C. and Austin. The deluge has finally cooled nationwide rental growth to 2.99 percent from a five percent pace a year ago.

It will come as no surprise that rents are outright falling in Houston (what’s the opposite term for ‘liftoff’?). But sliding rents are also a reality in New York. Would you believe Kings County, aka Brooklyn, is largely to blame? Just two years ago, as the Chinese were breaking ground on that mixed-use monster, 18 percent of the Big Apple’s supply entering the market was in Brooklyn; as of the third quarter that share had doubled.

It’s easy enough to attribute emerging stresses in CRE loans to oil patch woes. Take a drive through anywhere in suburbia and you’ll conclude quickly enough that retail is the next major source of loans behaving badly. Retail is a subject in and of itself. Rather than take a deep dive, take it on faith that there’s no way all of the excess supply can be absorbed and repurposed. E-commerce momentum cannot be contained and will push more household names into the netherworld. The true visionaries among real estate developers have long since slipped away from brick and mortar’s never ending funeral. They’ve got their sights set squarely on the lucrative potential for the fire sales of the land sitting under all those shuttered stores.

Less visible to the naked eye is the trouble brewing in office space.  Be that as it may, the numbers don’t lie. Commercial mortgage-backed securities (CMBS) comprise a mere tenth of CRE debt. Still, they provide an ideal prism into the health of the overall market given they are publicly traded; performance metrics are readily available. With that said, the most recent batch of data reveal that office delinquencies have been ticking up since midyear. Moreover, at $5.1 billion, the balance of delinquent office CMBS is second in size only to retail, which is saddled with a $5.9 billion pool of debt gone bad.

Did a lightbulb just gone off over your head as you pondered the preponderance of pressured properties peppered across this great nation? Is it time to head for the hills? Even short real estate, which we already know to be underperforming the broad market? The short answer to your urge to swiftly short the sector is, “It depends.”

It’s no secret that rising interest rates are an enemy of real estate in all its forms. Tack on the slow grind of the current economic recovery and you quickly conclude that the insufficient income thrown off by plenty of properties will easily be engulfed by higher financing costs. It’s critical to note that this dynamic was rendered moot in a zero interest rate environment. Refinancing you name it – from junk bonds to malls in the morgue – wasn’t near the challenge it would have been otherwise.

The reality of, “It’s the level of interest rates, stupid!” has Morgan Stanley’s CRE team a bit worried headed into the new year. First, a term of endearment, for developers, that is. ‘Net operating income’ (NOI) is the revenue a property generates after deducting the expenses required to operate the property. Word is, the higher the better. Enter Richard Hill & Jerry Chen at Morgan Stanley and the aforementioned rising interest rates. To keep things simple in formulating their forecast, they assumed a one percentage point increase in rates, which happens to be one in the same with the rise in the yield of the benchmark U.S. Treasury, give or take a basis point.

“We estimate that NOI growth would need to average nearly five percent over 10 years to produce the same levered return as today,” Hill and Chen wrote. “If NOI growth remained stable at three percent, near the historical average, then property prices would fall over eight percent to produce the same levered return as today.”

At the risk of mixing apples and oranges, the flashy new Standard & Poor’s real estate sector in the S&P 500 is off by precisely that much since it premiered September 19th.

As for what’s to come…did someone mention an election upset in the United States?

Animal spirits are the one thing that can rescue CRE in the year to come as a magnificent wall of maturing debt comes due. Some $120 billion in CMBS is up for refinancing in 2017. Tack on all other forms of CRE debt and the figure rises to $400 billion. A special feature of this debt vintage is that only 40 percent produces sufficient income to ensure refinancing is a sure thing (For any CRE types out there reading this, pardon the paraphrasing of industry terminology. This ain’t easy stuff to communicate to us laypeople.)

Add up all the factors and throw in tightening lending conditions for good measure. Hill and Chen estimate that 60 percent of the debt maturing in 2017 will be successfully refinanced while 20 percent is modified and 20 percent liquidated. Call that the base case scenario.

How to improve upon that projection? In two words, premature allocation on the part of investors either hungry for management fees or starved for yield.

Private equity is sitting on a $230 billion mountain of dry powder, as in funds earmarked to buy up real estate. That’s up from $210 billion at the end of 2015 and a mere $156 billion four years ago due in large part to pensions chasing returns. Meanwhile, it looks like CMBS issuance will rise to $65 billion next year pushing up the sector’s market share to 15 percent. And don’t count out insurance companies. Some analysts predict their market share could double or more from 2016’s 13-percent base, a prediction that’s been validated by insurers’ rising share of lending volumes in recent months. No doubt some of these insurers are international, which is understandable given negative, albeit rising, yields in so many countries. For identical reasons, many other types of foreign investors, especially of the sovereign wealth fund ilk, continue to flood the U.S. market with funds.

Global property investment will easily top $1.5 trillion this year. And New York will be crowned as the top-ranked target city, unseating London. The US will also boast the largest share of growth, with 15 of the top 25 cities on the top-ranked investment list.

If I’ve just talked you back into your own personal real estate investments, you may want to beg to differ…with yourself. Recall that the outlook remains iffy at best. At this late stage in the cycle, it can be prudent to be early and live to be liquid another day.

Not every tower, you see, maintains its golden allure forever. Real estate developers are the first to say they must be optimists to succeed in their chosen line of work. That said, many developers have gone down in flames, denying that the party has ended. Like Lot’s wife, they refuse to relinquish the past. They too look back, destroying what riches they had built, turning them into pillars of salt.