Wednesday, December 18, 2013

The Fed Gets it Right

It seems that Chairman Bernanke's decision to taper accompanied by very aggressive forward guidance was following the script I laid out for Janet Yellen in early November. (See Today the Fed announced that it would reduce their $85 billion/month bond buying program by a modest $10 billion and specifically stated that it will maintain its zero interest rate policy "well past the time the unemployment rate drops to 6.5%, especially if inflation continues to run below 2%."

In what looks like zero rates forever, or until well into 2015, the stock market ignited and bonds were range bound. It seems that the Fed played the stock market like a violin and avoided a feared sell-off. Instead of being the Grinch that stole Christmas the forward guidance popped the champagne corks in the equity markets.

Once the fireworks die down I suspect the markets will soon turn their attention away from the labor market and towards the inflation gauges. As I wrote in my latest UCLA Forecast, inflation will be an issue sooner than the market thinks. Even Chairman Bernanke noted in his news conference that health care inflation has been unduly suppressed. That along with rising housing costs will cause the core consumer price index to be running at a 2% rate by the second quarter and the Fed's preferred measure, the core consumption deflator, will be there by early 2015. Thus by the spring, the markets will begin to price in a quicker exit from the zero rate policy than now anticipated.

Wednesday, December 11, 2013

My Amazon Review of Jonathan Haidt's, "The Righteous Mind: Why Good People are Divided by Politics and Religion"

As I write this there are 422 reviews posted on Amazon. Why another? It is because Jonathan Haidt has written a very important book. Using insights from psychology and evolutionary biology offers us some very clear-eyed thinking into the process of making moral judgements. For me Haidt clarified the way I actually think in a very organized manner and he explains, at least to me, why I have so many political differences with my liberal friends.

Haidt builds on the works of David Hume and Emile Durkheim among others along with the works of modern evolutionary biologists to argue that moral judgments are built on intuition and emotion as opposed to reason. In fact the smarter the person the better the person is in making after the fact rationalizations of their hard-wired emotional judgement according Haidt we all have our inner lawyer or press agent.

According to Haidt we have six primary moral matrices: care/harm, liberty/oppression,fairness/cheating, loyalty/betrayal,authority/subversion and sanctity/degradation. Libertarians largely make moral judgement on the basis of liberty/oppression and liberals uses the first three with special emphasis on care/harm. On the other hand classical conservatives and social conservatives utilize all six. To them institutions really matter. Haidt analogizes this type of thinking to taste buds. Do we have only one in our mouth, three or perhaps six.

He also notes that liberals and conservatives are both for "fairness." However liberals view fairness as equality of result while conservatives view fairness as reward for effort or as the the Bible suggests the right to enjoy the fruits of your labor. That is why smart liberals who promote increasing the minimum wage argue that rewards the work efforts of hard working people at the bottom of the wage scale rather than arguing they should be paid more because wage differentials are too wide.

On a personal note Haidt recounts his own evolution from being a card carrying secular liberal to being somewhat of a conservative. Note he will not fess up to being a Republican. His journey is similar to what I encountered in the late 1970s to the mid-1980s.

Finally I thought so much of this book that I bought copies for my three children as holiday presents!

The Amazon URL is:

Saturday, December 7, 2013

"A Growing Economy, In Spite of Ourselves," UCLA Anderson Forecast, December 2013

The economy is growing despite self-inflicted wounds
caused by the 16 day partial shutdown of the federal government
and the botched roll out of the Affordable Care Act’s
(Obamacare) insurance marketplace affecting the giant
healthcare sector which accounts for 18% of the economy.
Parenthetically, it would be far better for our economy if
only our political leadership were dealing with fixing long term
entitlements, reforming the tax code and repairing
and improving our decaying infrastructure.

Although real
growth in the current quarter will likely be a modest 1.8%,
we forecast that by the second quarter of next year real GDP
growth will be on a sustained 3% growth path. (See Figure
1) In this environment employment will be on track to add
about 200,000 jobs a month and the unemployment rate will
decline to about 6% by the end of 2015.

Figure 1 U.S. Real GDP Growth, 2005Q1-2015Q4F
Figure 2 Payroll Employment, 2005Q1-2015Q4F

Figure 3 Unemployment Rate, 2005Q1-2015Q4F

The Yellen Fed

As with most observers, we expect that there will be
a great deal of continuity in Federal Reserve policy as the
chairmanship transitions from Ben Bernanke to Janet Yellen,
the current vice-chairperson. We expect the Fed to start
tapering its $85 billion a month bond buying program early
next year. With the start of tapering, we anticipate there
will be a greater commitment to keeping interest rates at
or near zero longer by, for example, lowering the threshold
unemployment rate from 6.5% to 6% before increasing the
federal funds rate.

Indeed, Chairman Bernanke has consistently
called the unemployment rate a threshold, not a trigger.
Our view is buttressed by the facts that (1) the Fed
was caught completely unprepared for the violent bond
market reaction to Chairman Bernanke’s hint of tapering in
mid-May which triggered a rise in 10-year U.S. Treasury
yields from 1.8% to just under 3 percent by early September
and (2) the release of two Fed papers written by senior
staffers that discussed the efficacy in terms of employment
and output of maintaining a forward guidance policy that
would extend the zero interest rate policy regime past 2016.
Whether or not the Fed papers represent the “correct” policy
is a separate question.

Nevertheless, for the Federal Reserve
Open Market Committee on both market psychology and
policy grounds, it seems likely that any tapering announcement
would be softened by leading market participants to
believe that interest rates will stay lower for a longer period
of time. We could also see movement towards reducing the
interest rate paid on bank reserves, now 25 basis points, to
encourage more active bank lending.

However, what the Fed intends and how policy will
actually play out are two different things. Underpinning the
Fed’s focus on the employment portion of its dual mandate
has been the quiescence of an inflation rate running well
below its 2% target. We think that is about to change. Why?
The rebound in housing prices along with rising tenant rents
will put upward pressure on the housing component of the
price indices. In addition, the chaos associated with the
roll-out of the Affordable Care Act’s insurance exchanges
will likely create the opportunity for price increases in the
healthcare sector along with the increased demand coming
from an improved economy and from people who previously
were locked out of the health insurance market.

As a result we expect that consumer prices will soon be rising at an annual
in excess of 2%. (See Figure 4) To be sure, the Fed uses
the consumption deflator in the GDP accounts, not the more
widely publicized consumer price index, for policy-making
purposes. Nevertheless, a consistent stream of 2% year-overyear
increases in the consumer prices index, including the
all-important core, will most certainly get their attention.
In the face of higher inflation we expect that the
federal funds rate will be increased in the spring of 2015
even though the unemployment rate would still be above

Figure 4 Consumer Price Index v.s. Core CPI, 2005Q1-2015Q4F
Figure 5 Federal Funds vs. 10 Year U.S. Treasury Bonds,
2005Q1 - 2015Q4

the Fed’s threshold. Concomitantly, the yields on 10-year
U.S. Treasury Bonds will be on the road to 4%. (See Figure
5) Our logic is that with a labor market recovery well
underway, the Fed (even a Yellen Fed) will pay heed to an
inflation rate running above 2%. Remember that a rise in
inflation from 1% to 2% is equivalent to a 1% drop in the
real fed funds rate.

Strength in Housing and Cars

Although we do not expect a boom in consumer
spending, both the housing sector and the automobile sector
will be aiding the growth outlook. (See Figure 6) Specifically
we are forecasting an increase in housing starts from
an estimated 913,000 this year to 1.25 million 1.44 million
units in 2014 and 2015, respectively. (See Figure 7) We do
note that this is a markdown from our last forecast to reflect
a greater sensitivity to rising mortgage rates than we previously
thought. Indeed the 1.44 million unit forecast is still
below the 54 year 1959-2012 average of 1.47 million units.
Similarly, light vehicle sales are rebounding to levels
last seen in the mid-2000s. Automobile sales are expected
Figure 6 Real Consumption Spending,
2005Q1 -2015Q4F
Figure 7 Housing Starts, 2005Q1 - 2015Q4

Figure 8 Light Vehicle Sales, 2005Q 1 – 2015Q4,
Millions of Units, SAAR

to increase from this year’s 15.5 million units to 16 million
and 16.5 million units in 2014 and 2015, respectively. (See
Figure 8) Both home and auto sales are being buttressed by
recovering home prices and new highs in the stock market.

Figure 9 Case-Shiller Home Price Index, 2000- August 2013, Monthly Data, 2000= 100.

Figure 10 Standard & Poor’s 500 Stock Index, January 2, 1995 – November 21, 2013, Daily Data

(See Figures 9 and 10) It is here where Fed policy seems
to be working, but the beneficiaries are largely those who
own stocks and those who either own their own home or
who can qualify for a mortgage. There will also be enough
income left over to modestly increase the personal savings
rate from 4.6% in 2013 to 5.6% in 2015. (See Figure 11)

Business Investment Side of Economy to Get a
Second Wind

One of the reasons 2013 has been so sluggish is that
the growth in business investment and exports slowed
dramatically. Policy uncertainty coming out of Washington
D.C. certainly has not helped, but the underpinnings are
there for strength in domestic manufacturing, commercial
construction, energy development and the investment required
to enable the bandwidth required for the increased
usage mobile technology. To be sure, it won’t be a boom
but it will be far better than the 2% or so growth estimated
for 2013. (See Figures 12 and 13)

In our view, 2013 was more of a pause in investment
spending, not an outright decline, and with the likelihood of
a more level headed (i.e. no government shutdown) policy
discussion in Washington D.C. in 2014 the way will be
open for more spending. The major risk here, as we see it,
is that instead of investing for the future corporations will
use their excess cash flow to increase dividends and fund
share buybacks. This short-sighted behavior is due, in part,
to the Fed’s artificially suppressing long-term interest rates
which creates uncertainty about the long-run cost of capital.

Similarly exports will revive as the growth, albeit very
modest, returns to Europe and Japan. (See Figure 14) Although
not stellar compared to its history China appears to be
on a 7% growth track while the Latin American economies
with the large exception of Brazil appear to be doing well.

Figure 11 Personal Saving Rate, 2005 – 2015F, Annual Data

Figure 12 Real Investment in Equipment and Software,
2005 – 2015, Annual Data

Figure 13 Real Investment in Business Structures,
2005 -2015, Annual Data

The Worst is Over for Government Spending

Federal purchases declined an estimated whopping
4.7% in 2013! That drag will be gone in 2014 as we anticipate
there will be a minimal budget deal in early January
that will encompass a modest relaxation of the sequester and
modest increases in in non-tax revenues. As a result, federal
purchases will be roughly flat over the next two years. (See
Figure 16) Remember for GDP accounting the ever growing
entitlement spending of the federal government counts as a
transfer payment not spending. The GDP effect takes place
when the beneficiaries of the transfers spend.

After a four year decline, state and local spending will
begin to rise in 2014. (See Figure 16) Revenues are up and
spending has been held down. But make no mistake that until
the long-term pension issues are dealt with, state and local
finances will, for the most part, remain far from healthy.

As long as the federal government does no harm,
admittedly a dangerous assumption, the economy will be
spurred by strength in housing and cars combined with an
uptick in business spending and an end to the dramatic drop
in federal purchases. These factors should put the economy
on track to a 3% growth path by midyear 2014 and bring
the unemployment rate down to about 6% by year end 2015.
Policy interest rates will stay low throughout 2014, but with
inflation rising to a bit above 2%, we expect that the zero
interest rate policy of the Fed will come to an end in the
spring of 2015

Figure 14 Real Exports, 2005 – 2015, Annual Data

Figure 16 Real State and Local Spending,
2005 – 2015F, Annual Data

End notes
1. See, English, William B., J. Lopez-Salido and Robert Tetlow, “The Federal Reserve’s Framework for Monetary Policy-Recent
Changes and New Questions,” Board of Governors of the Federal Reserve System, November 2013 and Reifschneider, Dave,
William L. Wascher, and David Wilcox, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct
of Monetary Policy,” Board of Governors of the Federal Reserve System, November 2013.

Monday, December 2, 2013

My Amazon Review of Margaret Macmillan's, "The War that Ended Peace: The Road to 1914"

Having read Margaret Macmillan's "Paris 1919," which focused on the political settlements that accompanied the end of World War I, I was looking forward to her take on how the war started. I was not disappointed. Her take is especially interesting because rather than honing in on how the war started, she is more interested in how the the great European peace ended. She starts her history in 1890 when a general war was far from inevitable. However with each passing year, seemingly independent decisions narrow the options of the key political decision makers that a general war becomes practically inevitable. In her view, it is not only the broad historical forces at play, but the personalities of the political leadership that puts Europe on the road to war.

To me her story is one of great diplomatic success on the part of France, Britain and Russia and monumental diplomatic failure on the part of Germany, in particular the very erratic Kaiser Wilhelm. Look at the scene in 1890, Bismarck has France isolated, has an alliance with Russia and Austria and Germany is friendly with Britain. By 1914 France is allied with Russia and Britain. How did this happen?

First Wilhelm fires Bismarck and doesn't renew the Reinsurance Traty with Russia. France jumps in and allies itself with Russia, militarily and financially. Then France settles up colonial issues with Britain and romances her into the Entente Cordial. France is no longer isolated and Germany fears the dreaded two front war which gives birth to the offense of the Schliefen Plan. Britain's diplomacy is stunning. Ending its policy of "Splendid Isolation" it settles up with U.S. over a border dispute in Venezuela, makes a deal with Japanese in the Pacific, reaches an interim settlement with Russia over Persia and gets close to France. As a result it has a free hand in Europe without having to worry about diverting forces to protect its over-stretched empire.

How did this diplomatic revolution happen. Simply put Kaiser Wilhelm does everthing he can do to antagonize Britain. First by acting as bully in Morocco and then by starting a naval arms race with Germany. Instead of building fast cruisers and submarines, Germany builds dreadnought battleships which goes to the center of gravity of British naval power. Britain was forced to respond.

In a very important chapter of what might have been were it not for Wilhelm, Britain and Germany could have been allies.This is not far fetched.. Both countries were allied in the Seven Years and Napoleonic Wars and it would make sense for the strongest land power to get together with the strongest naval power. They have no colonial conflicts and conducted the largest bilatteral trade relationship in the world. It could have happened and if it did, no World War I.

As with all World War I histories Macmillan covers the two Moroccan crises and the three Balkan crises leading up to the Sarajevo assasination. She asserts, rightly, that the successful ending of those crises made the political leadership too complacent about the severity of the crisis caused by assasination of Archduke Ferdinand. To be sure it was summer and all of Europe's political leadership were either vacationing or away from their respective capitals, but still this was an act of what we would call today, state sponsored terrorism. What is missing in Macmillan's account is the role of the "Balkan incption scenario" highlighted by Christopher Clark's "Sleepwalkers...."

Macmillan does an excellent job in portrayiing the social millieu of Europe of the early 1900s. This was a time of rapid economic growth accompanied by the rise of socialist parties, women's sufferage, militarism and most of all nationalism creating a host of tensions. For some war was viewed as the great unifier. The role of honor becomes very important to all of the statesmen involved as the countdown to war begins in late june 1914. When honor is involved a negotiated settlement becomes difficult. It hard to compromise honor without losing face.

Macmillan has written a magisterial and very readable work of history. My one quibble is that she makes more than a few snarky comments about analogies for today. For example she writes that the German Right's fear of Russian cultural penetration of Germany is analagous to today's Republican Right's fear of Mexico. I beg to differ. Mexico is not a geopolitical rival of the U.S.; the Russia of 1914 was certainly one that Germany rightfully feared.

The URL is:

Saturday, November 23, 2013

Obamacare's Management Failure

On October 23rd I posted a link to my USNews blog on the management failures of the Republican House majority and the roll out of Obamacare.  The link is here: Today the New York Times published a front page story on the complete management breakdown by the Centers for Medicare and Medicaid Services that were responsible for developing the website. This article is an eye-opener for all of my friends who believe that the government is a solution to many of the problems that vex society. As the late sportscaster Howard Cosell would say, "Never have I seen such continuing ineptitude.."  The link to the full article is here: It is a must read.

Now read what I wrote a month ago:

"If this weren't enough, we have had a failure to launch, the entry website for purchasing health insurance under the Affordable Care Act, more commonly known as Obamacare. The administration has had two and a half years to develop a website and all of the necessary back-end systems to enable Americans to purchase health insurance on a government run exchange. After all of that time and hundreds of millions of dollars, the system crashed on its first day, and it continues to fail. Not only is the front-end failing, the back-end is failing as the participating insurance companies are receiving the wrong information with respect to applicants and qualified dependents. This is not a mere glitch, it is a system failure.
Even more striking, Health and Human Services Secretary Kathleen Sebelius noted on CNN yesterday that President Obama wasn't aware of the problem until after the website was launched. Hello! President Obama is not a chief executive. He is now learning that there is a real difference between making policy and implementing policy. The real work is in implementation.
Now, I do not expect the president to be sitting in the Oval Office writing computer code, but I do expect him to be briefed at least monthly on the status of his signature program. He should have been familiar with all of the "deliverables" and "milestones" associated with the law. It is not even clear there was a senior White House staffer in charge of monitoring the program. Only yesterday we found out that former Acting OMB Director Jeffrey Zients will be in charge of the "tech surge" in the Department of Health and Human Services. All I can say is that if we had a real chief executive, Kathleen Sebelius would be fired.
Given what has happened in the past month, it is no wonder a majority of Americans want to replace the entire Congress and it is no wonder that the usually administration-friendly Jon Stewart's "Daily Show" has been offering the most biting criticism of the roll out of the health insurance exchanges. The government is not working and most Americans know it."
All I have to say is that before we embark on another expansive government program we better think long and hard about whether our government has the capability to manage it.

Monday, November 11, 2013

My Amazon Review of Max Hastings', "Catastrophe 1914: Europe Goes to War"

This is a first rate history of the year Europe fell into an abyss that it has still yet to recover from. Hastings, a gifted writer, takes us from the politico-military decision making that sets stage for the Great War. He is definitely in the Fischer school which pins most of the blame for the war on Germany and as a result, he downplays the roles of France and Russia in starting the war. For a more nuanced view I would recommend Chistopher Clark's "Sleepwalkers....." From there he goes on to the battles of the early months of the war. He not only focuses on the western front, but he is very detailed with respect to the eastern front from carnage in Serbia to the German victory at Tannenberg. He is at his best when he discusses the failure of the generals on both sides, whose blunders amplfy the carnage.

Where I disagree with Hastings is his assertion that that Britain's intervention which saved France at the Battle of the Marne in September 1914 was worth all of the carnage that was to come. He views that had Germany won a quick victory 1914 Europe would have been enslaved under the boot of German authoritarianism. This is a tough swallow for me. Although there are no proofs in counter-factual history, I could just as easily visualize a post Wilhelmine Germany evolving into a version of what it is today.

Friday, November 1, 2013

Yellen, Yellen You Got Tapering on Your Mind*

I think the conventional wisdom that a Janet Yellen Fed will be super dovish and that it won't begin to taper until April 2014 at the earliest is wrong. Why? First I think she realizes that if she is going to be an effective Fed Chair, she will have to establish her credibility early in the game. She can do that by aggressively tapering with a commitment to a very low rate forward guidance program. This will give her instant credibility with respect to both inflation and employment. For those who argue that a weak economy early next year will delay tapering, they will have to answer the question if the large scale asset purchase program is so necessary, why isn't it working? And they won't have the benefit of the government shutdown excuse. Beside most of the econometric evidence suggest that forward guidance is far more effective than large scale asset purchases for the real, as opposed to the financial, economy. Sorry Wall Street.

Second, the more bonds the Fed buys the more difficult it will be to raise interest rates in the future. To be sure it is economically correct for the Fed to use increases in the interest rate it pays on reserves as a substitute for selling securities, but it will be very politically incorrect. Remember when the Fed starts raising interest rates on reserves the proceeds will go to Wells Fargo, JP Morgan Chase and Citicorp. Populists on the left and right will scream as Fed remittances to the treasury drop from an estimated $84 billion in 2015 to $17 billion in 2018.(See a recent Fed paper at

*- With apologies to Gary Puckett and the Union Gap

Thursday, October 24, 2013

My Amazon Review of Mark Spitznagel's, "The Dao of Capital: Austrian Investing in a Distorted World"

Money manager Mark Spitznagel has written a very wordy paean to Austrian Economics. If ever a book needed a tight fisted editor this one is it. However, once you get beyond reading every thing Spitznagel knows about Austrian Economics the reader will get a better understanding of economics and the investment process. The key takeaways from the book are the core notions of Austrian Economics which value roundabout(indirect) production over direct production and the role of monetary policy to distort investment decisions. For example, in the case of the former, the direct route to catching a fish would be to try to grab one in a pond while the roundabout and far more profitable route would be to make a net first and then use it to catch fish. In case of the latter, the low interest policy of the Federal Reserve induces investment that will be proved unprofitable once interest rates normalize leading to a bust. This knowledge leads investors to hedge tail risks when the stock market trades at high price/replacement cost ratios and to buy individual stocks that with high returns on capital that won't be affected by increases in interest rates. Nothing really new here, but puts some real foundation underneath it. That is the value of the book.

Spitznagel uses the biographies of the three great Austrian economists, Carl Menger Eugen von Bohm-Bawerk and Ludvig von Mises to explain Austrian economic theory. All of that is to the good, but he leaves out perhaps the greatest Austrian economists of all time, Joseph Schumpeter and Friedrich von Hayek. I guess Schumpeter's and Hayek's work don't quite fit into his theories. He also ignores the work of three American economists who built on the work of the Austrians: Irving Fisher, Frank Knight and Jack Hirshleifer, a former professor of mine. For example Hirshleifer, in his "Investment, Interest and Capital" outlines a general equilibrium approach to interest rate determination with a society's rate of time preference and an intertemporal production possibilities function, pure Austrian economics.

The full Amazon URL is:

Wednesday, October 23, 2013

Monday, October 21, 2013

After Action Report on the Government Shut Down

The wrecker caucus within the Republican Party failed in their attempt to perform a late-term abortion on Obama Care. After 16 days of folly the wreckers succeeded in damaging the Republican brand name and escalated the civil war inside the Republican Party that will certainly rage until at least the 2016 convention. It won't be pretty.

Strange as it may seem the wreckers were rescued by Senate Minority Leader Mitch McConnell who enshrined the 2011 sequester in the upcoming budget negotiations. The congressional negotiators will be fighting it out on Republican terrain which makes it likely the Republicans will eke out a small victory with respect to spending and taxes. Furthermore government as a whole has taken a big hit, and for better or worse, it will be harder to rally the country for the domestic and international tasks ahead.

Meantime the Obama Care roll out has been disaster. The entry website is not working; it is not a technical glitch, but rather a fundamental software failure. Simply put the back end of the software may not be working which means inaccurate information is being sent to the health insurance companies. This is more than a software failure, it is a fundamental management failure on the part of the Obama Administration. Let's face it President Obama is not a manager and it looks very obvious there was very little hands on control over the past three years on the implementation of his signature program. At the very least HHS Secretary Kathleen Sebelius should be fired.

Over the longer run, despite the explosive rally in the stock market, the U.S. will pay a big price in the global financial markets for threatening to default on our debt. It means the dollar's status as a reserve currency has been devalued. It means higher interest rates, a weaker dollar and a loss of geopolitical credibility. For the wreckers to even threaten default  was criminal negligence.

Taking a step back our country has been through this before. 75 years ago this Veterans Day Kate Smith introduced Irving Berlin's "God Bless America" to a national radio audience. True the country was divided about the coming European War, but she offered hope. We still live in a great country and I think you will enjoy the following clip,

Sunday, September 29, 2013

On Strike, Shut it down

Taking their lead from the student anti-war protesters of the 1960s, the wrecker caucus in the Republican Party led by Senator Ted Cruz is on the verge of shutting down the government. Unlike their 1960s counterparts ( I know they just hate that analogy), today's ideologues can cause real damage. Recall that in the 1960s all the students succeeded in doing was shut down a bunch of universities for a few days. All the university employees got paid, and, for the most part, a good time was had by all. Not to be so cavalier, more than a few people were seriously injured. In the interests of full disclosure I was a participant and sometimes close to being a leader.

To be sure the students highlighted their opposition to the Vietnam War, but along the way they helped set the stage for a conservative revival with the election of Ronald Reagan to California's governorship in 1966 and Richard Nixon to the presidency in 1968. That was hardly the outcome the students were seeking.

Today the situation is far different. The stakes are much higher. Hundreds of thousands of people will be furloughed, others will lose their jobs and essential government services will not be provided. Nevertheless, the House Republicans did one very politically smart move in preparing a continuing resolution that will exempt the Defense Department, but the rest of government will feel the full brunt of the shut down. I remember the 1995-6 shutdown under President Bill Clinton. People got really pissed and Clinton ended up smelling like a rose. And remember the Republican had just come off their great 1994 triumph and controlled the Senate as well as the House. This time they are coming off losing the presidency and seats in both the House and Senate.

Simply put, the Republicans can't win this fight. In the eyes of the American people the Democrats are the party of government and the Republicans are the party of at best limited government, or at worst anti-government. So guess who the American people will blame. This would be true even if President Obama were 100% totally at fault. Thus as a matter or pure politics the government shutdown could very well be setting the stage for the return of Nancy Pelosi as Speaker of the House.

To the the wrecker caucus it is all about defunding or delaying Obamacare. I hate to break it to them, it ain't going to happen. No way the Democrats or President Obama will give up on their signature program. My guess is that the wreckers fear that it will work, and therefore they have to abort the program in the womb. I think that is wrong headed thinking. If Obamacare is going to fail, it will fail of its own weight. My guess is that in 10 years time neither the proponents or the opponents of the health care law will recognize it. In its current form it is way too complicated, but over time it will change, likely for the better.

Thursday, September 19, 2013

The Fed Makes a Mistake

The Fed made a mistake yesterday in not modestly tapering back their quantitative easing program. Simply put the FOMC had a free option from the markets to start the long awaited process of gradually reducing their $85 billion/month bond buying program. Had they reduced the program to, say, $75 billion/month, it would have been a nonevent. After all what difference does a $10 billion change in a monthly bond buying program make for a $16 trillion economy? Instead by continuing the program at its current level, stocks and bonds soared. Also soaring were gold and oil prices and the U.S. dollar tanked. If Fed Chair Bernanke wants to get the inflation rate up to somewhat above the 2% target level, he is going to get that in spades.

Why? Despite all of the recent good news on the inflation front, underneath the data there are troubling signs that inflation will not be as modest as most market participants now expect. For example buried in August CPI report, medical care services surged 0.7% (up 3.1% year-over-year) and rent paid for a primary residence is also up 3% year-over-year. The Fed's move yesterday added fuel to the embers that will increase commodity and import prices.The upshot of it all is that already hard hit real wages will be hammered even harder. Perhaps that is what they want.

I fully understand that the FOMC was concerned about "tightening financial conditions" caused by Wall Street's "taper tantrum." Those concerns were manifested in a stall in the housing market that in all likelihood is temporary. If the FOMC was so concerned about this they could have toned down Wall Street's consensus expectations that called for a modest taper.  By failing to do this, the Fed has lost credibility and when the Fed finally moves to end the quantitative easing program that nearly all market participants and the Fed itself view as unsustainable, watch out below!

Sunday, September 15, 2013

Political Risk comes to Manhattan Real Estate

To paraphrase Exodus 1:8, now there arose a new mayor over New York who knew not Michael Bloomberg or Rudy Giuliani. With the reactionary Bill de Blasio becoming the presumptive Democratic nominee for mayor and the odds-on favorite to win the general election in November, the 20 years of progress New York City has made threatens to become undone. Simply put de Blasio is throwback to the truly horrible mayors New York had prior to 1993. Think "bungling" Bob Wagner, the limousine liberal John Lindsay, the hapless Abe Beame and de Blasio's idol, David Dinkins. The last, of course, served as Mayor during the nadir of New York City's modern history. What all of these past mayors had in common was that they turned the city's fisc over to the public employee unions and they let crime run riot. By 1990 most informed opinion believed that the purpose of city government was to manage decline, not to create the thriving city that New York is today.

To New Yorkers of today and for that matter the real estate investors of today, that history is only dimly recollected at best. Instead of rewarding success, de Blasio seeks to punish it with high taxes. Instead of building  on the school reforms of the past decade, de Blasio wants to turn the schools back over to the unions. Instead of managing the budget, de Blasio will reward his union backers with pay raises unrelated to productivity. Instead driving down the crime rate to make New York the safest big city in America, de Blasio would end the very successful stop, question and frisk policy of the Bloomberg Administration. Of course the initial victims will be the people of color that now support de Blasio.

What all this means is that real estate investors who now take New York's well run government for granted will have to price in higher taxes and a diminution of services. Given the heady values of Manhattan real estate all the risk appears on the downside. The same goes for the big office REITs with a Manhattan focus, Vornado, SL Green and Boston Properties. The only hope is that Republican Joe Lhota pulls off an upset.

Friday, September 13, 2013

"Returning to Normalcy, Sort of," UCLA Anderson Forecast, September 2013


To paraphrase President Warren Harding’s 1920 campaign slogan, the economy is returning to normalcy. To be sure, the economy will not be normal by historical standards, but it will be noticeably better than in recent years. After growing at a revised 2.5% annual rate in the second quarter, we are forecasting real GDP growth of 2.5% for the second half stepping up to the historical 3% trend growth rate in 2014 and 2015. (See Figure 1) However, we must point out that because of the severe recession of 2007-09 and the sluggish growth thereafter, the economy will still be operating well below what would have been expected prior to the recession. Nothing highlights this better than the fact that, according to Sentier Research, median household income remains lower than in June 2009, the ending month of the recession.

Nevertheless, in keeping with a more normal economy we expect that payroll employment growth will be running at a sustained clip of 200,000 jobs a month over the forecast horizon and that the unemployment rate will steadily decline to 6.5% by year-end 2015. (See Figures 2 and 3) Over the near-term, the quantity and quality of the net increase in employment could very well be held back by the adjustments business firms will make to the implementation of the Affordable Care Act. Simply put, there are incentives for firms to convert full-time employees to part-time and for small business to limit their headcount to 50 full time employees.

The era of very low long-term interest rates appears to be over. In response to hints from the Federal Reserve that the quantitative easing program of buying $85 billion a month of treasury and mortgage bonds might be tapered in September, the yield on 10-year U.S. Treasury bonds spiked from 1.6% in mid-May to 2.9% in late August. As one wag put it, the bond market had a "taper tantrum." In our view the Fed will begin to modestly lower its bond purchases in September to about $75 billion a month and continue on a path that would end the program by mid-2014. Simply put with the improved economic outlook and the efficacy of quantitative easing being questioned, it has become a question of when, rather than if the program will be ended. Of course, in response to geopolitical uncertainties, the Fed could very well delay the tapering process until the next Open Market Committee meeting.

Our position is roughly in-line with the market consensus; where we differ is that we think the Fed will actually raise the Fed Funds rate in December 2014, about six months earlier than consensus. Thus, by the end of 2015 we expect the Fed funds rate to be a more normal 2.5% and the 10-year Treasury rate to be 4.3%. (See Figure 4) That would bring the 10-year rate more in-line with the growth rate in nominal GDP which has roughly tracked over a very long time period. (See Figure 5)

Our aggressive view, compared to the current consensus, on interest rates rests on the belief that inflation will not be as benign as many now think. Specifically, as we have outlined before, we believe the full impact of higher rents has yet to be reflected in the official price indexes.1 Moreover, we believe that the recent quiescence in health care inflation is about to be jolted by the new demands placed on the system resulting from the implementation of the Affordable Care Act. These effects could very well be temporary, but we believe that insuring an additional 35 million people

will have, at least, a modest impact on health care inflation in the short-run.

As a result, we anticipate that both headline and core inflation as measured by the consumer price index will be in excess of 2% in both 2014 and 2015. (See Figure 6) Although the Fed targets the chained consumption deflator used in the GDP accounts, even by that measure inflation will be running at its 2% target in 2015. It is for this reason we believe that the Fed will raise the funds rate prior to achieving their 6.5% unemployment target.



Despite the huge 125 basis backup in the 30-year fixed mortgage rate, we continue to believe that the housing recovery remains underpinned by a five year period of under-building, rising household formations, an improved employment outlook, and still low, by historical standards, mortgage rates. Indeed the sudden backup in mortgage rates could very well have the effect of forcing once hesitant consumers to act quicker once they realize that time is no longer on their side. Simply put, the fear of higher rates in the future makes the current rate environment more attractive. As a result, we are forecasting housing starts to increase to 965,000 units this year compared to 783,000 last year, a reduction from our previous forecast to reflect a slower ramping in production than we had envisioned. For 2014 and 2015 we are forecasting further advances to 1.31 million and 1.55 million units, respectively. (See Figure 7) Consistent with our view for the past year, we believe that multi-family starts will be exceptionally strong throughout the forecast period with starts in excess of 400,000 units in 2014 and 2015.


After stalling in 2013, we anticipate that business investment in equipment and structures will begin to grow at a more robust clip in 2014 and 2015. In part, the slowdown in 2013 was almost inevitable as some of the special tax incentives for investment expired at the end of 2012. Investment in equipment which slowed to 4.2% growth rate in 2012 is expected to grow at 8.8% in 7.6% in 2014 and 2015, respectively. (See Figure 8)

After declining in 2013, investment in business structures is expected to rebound by 5.9% and 8.8% in 2014 and 2015, respectively. (See Figure 9) Continued strength in energy related structures (i.e. drilling rigs and distribution facilities) and acceleration in commercial construction will propel the advance.

Export growth which has been sluggish for two years is about to accelerate. Exports have been hampered by the ongoing recession in Europe which now appears to have just ended. While the emerging markets remained strong through 2012, there has been a very noticeable deceleration in growth this year, especially in India, China, Brazil and Turkey. We assume that the waning of the drag from Europe will more than offset the current softness in Asia. As a result, expect export growth to pick up from the sluggish 2% gain this year to about 5% over the next few years, not great, but an improvement. (See Figure 10)


The long multi-year decline in state and local spending is over. Rising tax receipts coupled with years of austerity have dramatically improved the current fiscal balance of most states and local governments. Thus the way is open for modest increases in spending. (See Figure 11) Nevertheless the longer-term outlook remains cloudy because of increasing liabilities for pension and post-retirement healthcare costs. An extreme example of what can go wrong is the recent bankruptcy filing of the once great city of Detroit.

In contrast, federal purchases are on the decline. Lower defense spending coupled with congressional disagreements have placed a lid on federal purchases. (See Figure 12) Remember in GDP accounting transfer payments do not count as federal purchases. We do note for forecasting federal spending, we assume a compromise will be reached on the fiscal year 2014 budget and the upcoming debt ceiling extension. As a consequence, there will not be a suspension of "non-essential" government functions.


Our forecast calls for a resumption of normal growth on the order of 3% a year in 2014 and 2015, far better than the 2% growth we have been used to since the recession ended in 2009. We also believe that the era of very low interest rates will soon be behind us. The recent dramatic rise in bond yields in all likelihood rang the bell. But make no mistake, as good as a resumption of normal growth is, it still will not be enough to restore the economy back to its pre-recession growth path.

1. See, Shulman, David, "The Housing Recovery: How Strong? How Long?" UCLA Anderson Forecast, June 2013

Saturday, September 7, 2013

My Amazon Review of Mason B. Williams', "City of Ambition: FDR, La Guardia and the Making of Modern New York"

Mason Williams just loves government. He can't get over how New York City became a paragon of an Amercian version of social democracy under the able leadership of Fiorello La Guardia financed by his his good buddy FDR sitting in the White House. With up to a third of the city's budget being funded by Washington, the city had the resources to build the projects we are so familiar with 75 years later. In the interest of full disclosure, growing up in the Queens of the 1950s, I benefited from much of what Williams writes about, especially the parks and the playgrounds.

Williams tells a good story, especially about the La Guardia - Roosevelt relationship and the political millieu of 1930s New York, but he leaves out much. In particular, although he is mentioned, the great "power broker" Robert Moses is hardly discussed. I would have loved to learn more about the La Guardia - Moses relationship. Afterall it was Moses and his public authorities that built the infrastucture for today's New York. Think the airports, the bridges, the tunnels and the roads. Also think the parks and the playgrounds. Second he fails to note that the brilliant administrators the city had in the 1930s were a result of Jews and Itallians who were locked out of the private sector found their way into municipal government. That was an important one off. Lastly Williams is so enamoured with government that he is a booster of rent control. Nowhere is a discussion of the downside of what rent control wrought as the housing stock aged.

I have noticed that several reviewers and implicitly Williams see lessons from the 1930s for today's New York. I hate to break it to you but they aren't there. Why? Both Roosevelt and La Guardia rightly opposed public employee unions. Their presence today makes it far more difficult to administer the city than in La Guardia's day. Also Robert Moses exisited in a world without environmental impact reports and their attendant lawsuits. What took a few years to build in the 1930s would take at least a decade today, assuming the project would even be allowed to start.

Nevertheless readers who have nostalgia for the 1930s and who are more politically liberal than myself would really enjoy this book. It plays into all of their fantasies.

Saturday, August 24, 2013

My Amazon Review of Michael Fullilove's, "Rendezvous with Destiny: How Franklin D. Roosevelt and Five Extraordniary Men Took America into War and into the World"

It is late 1939 and war has broken out in Europe. Roosevelt doesn't trust Joe Kennedy, his ambassador to the Court of Saint James. He desperately needs information on the willingness of Britain to fight and later on the status of Stalin's Russia under the onslaught of the Nazi blitzkrieg. Instead of relying on the usual State Department sources in an era before the OSS/CIA, Roosevelt sends five special emissaries to Europe to find out what is going on and what role, short of war, the United States could play.

He dispatches five extraordinary people to Europe. Sumner Wells of the State Department, Bill Donovan, a Republican lawyer from New York who would soon found the OSS, Wendell Willkie his recently defeated opponent, Averill Harriman a Democrat who happens to be a banker and railroad tycoon who ends up sleeping with Churchill's niece (Pamela, a doyen of Washington society much later), and the indomitable and in the process of dying Mr. Fixit of the New Deal, Harry Hopkins. It is their stories that Fullilove tells and what stories they are. There are meetings in London, Rome, Berlin and Moscow and the reports his emissaries send him, girds Roosevelt's loins for the titanic struggle ahead.

The book captures the foreign policy scene of 1939-41 and if the reader doesn't have time to read the formal biographies of the Five, you certainly will gain quite a bit of insight here.

Thursday, July 11, 2013

My Amazon Review of Susan Dunn's, "1940: FDR, Willkie, Lindbergh, Hitler-the Election Amid the Storm"

Susan Dunn has written a wonderful follow-up to her "Roosevelt's Purge." We move from Roosevelt's intra-party fight of 1937-38 to his his preparations for war in 1940 and 1941. Her title, although flashy, is much more about Roosevelt than Willkie, Lindbergh and Hitler and the story extends beyond the election of 1940. Roosevelt and the internationalist Hamiltonian Republicans are the clear heroes and clear villains are Lindbergh and the isolationist majority in the Republican Party. Roosevelt dominates the action with his masterly setting up the politics for his unprecedented third term and his great speeches pushing the country towards war. However, Dunn gives too much credit to his speeches but fails to note the lack of immediate action thereafter. For example not much happened after his state of emergency speech in May 1941. In many respects Roosevelt feared that he was getting too far ahead of public opinion, when in fact, he very likely was lagging behind the popular will, at least in 1941.

Dunn's portrait of Willkie shows him clear eyed in the face of the Nazi menace and way ahead of his time with respect to civil rights. Unlike Roosevelt, who was too dependent on the racist southern Democrats, Willkie was a full thoated supporter of Negro rights in the early 1940s. It is here where I have my main quibble with Dunn's book. In order to keep her plot-line going she all but ignores the critical support given to Roosevelt's foreign policy by the very Jacksonian and very racist southern Democrats. Without internationalists like Georgia Senater Walter George, a target of the failed 1938 purge, Roosevelt's whole enterprise of aiding Britain in its time of desperation would have floundered on the rocks. For a full discussion of the South's role in the foreign policy of the period I would recommend Ira Katznelson's, "Fear Itself...."

I also have two other quibbles. She ignored the role of future Secretary of State Dean Acheson's legal opinion in support of the destroyer for bases deal of 1940 and while she mentions the role of German intelligence in aiding the isolationist forces, she completely ignored the the role Britain's agent, William Stephenson in pushing America into the war.

All told Susan Dunn has written a fine book which vividly captures an era where politics really mattered and the American people really cared.

Saturday, June 15, 2013

Leading from Behind

President Obama is afraid to lead. While speaking to a gay pride event in the White House, deputy national security advisor Benjamin Rhodes told reporters that Syria's Assad regime crossed the "red-line" with the use of chemical weapons in that country's civil war. My guess is that the red line was crossed sometime ago and the President was unwilling to acknowledge it. It took the deteriorating military situation to get the President off the dime. The next day Rhodes defended the administration's position to provide lethal aid to Syria's rebels,  all the while President Obama was hosting a Father's Day luncheon. All of this was on the front page of today's New York Times. This is not how a President goes to war!

From Egypt to Iran the whole Middle East is in turmoil and our President acted as if nothing were going on. Former Hillary Clinton aide, Anna-Marie Slaughter noted in the same article, "I really worry this is going to be remembered as the United States standing by and watching a Middle East war ignite." Knock Knock we are in a proxy war with Iran in Syria. That fact was emphasized with the critical support Hezbollah, Iran's ally in the region, gave to the Assad forces in the battle of Qusayr. Those forces are now on the march to the rebel stronghold of Aleppo, Syria largest city with a population of three million. With over 90,000 dead the slaughter is only beginning.

The stakes in Syria are enormous. Seventy-five years ago there was another proxy war, in Spain. There a civil war between the loyalists and Franco-led rebels brought in Russia along with its security apparatus on the side of the loyalists and Germany and Italy on the side of their fascist ally. It was a dress rehearsal for World War II. Britain and France stood idly by, sending the very clear message to Hitler that they were unwilling to fight. Unfortunately Obama is sending the same message to Iran and it nuclear ambitions. I hope we are not too late.

Friday, June 7, 2013

"The Housing Recovery: How Strong? How Long?" UCLA Anderson Forecast, June 2013


At long last a sustained housing recovery is now underway. Home prices are rising and housing starts have approximately doubled off of their depression lows of a few years ago. This scenario is very much in line with our forecast of one year ago. Nevertheless, the questions remain how strong will the recovery be? and how long will it last? In short, our answers are that housing starts will reach a run-rate in excess of 1.6 million units by mid-2015 and home prices will continue to rise, albeit not at the heady 9% rate of the past year. As a result the housing recovery will last until at least late 2015.

Specifically, we are forecasting that housing starts will increase from the 782,000 units recorded in 2012 to 1.03 million units and 1.35 million units in 2013 and 2014, respectively. For 2015 we are projecting housing starts to reach 1.56 million units. Along the way, multi-family housing starts will boom with an excess of 400,000 units a year being started in both 2014 and 2015.

Although this forecast may appear to be overly optimistic, against the long sweep of history it looks decidedly modest. (See Figure 1) For example, the modern era all-time low for housing starts of 554,000 units in 2009 was approximately half the recession lows reported over the period 1959-2012. Housing was truly in a depression, not a recession, from mid-2008 through the end of 2011.
Furthermore over the entire 1959-2012 time period housing starts averaged 1.47 million units a year, a level that we predict will not be exceeded until 2015. Remember that in 1959 the United States had a population of 180 million people, while today it approximates 315 million, a 75% increase. Thus it can be reasonably argued that, if anything, we are being too pessimistic.
Figure 1 Housing Starts, 1959Q1 – 2015Q4E   Sources: U.S. Department of Commerce and UCLA Anderson ForecastOur forecast is underpinned by the facts that house prices are now rising from a very low base and mortgage rates remain at historical lows. These two factors imply that ownership housing remains very affordable on a national basis and the rise in prices is gradually removing the deflationary fears that gripped the market only a few short years ago. (See Figures 2 and 3) We learned in 2010 that affordability alone is not sufficient to drive a rebound in housing starts.

To be sure the risk remains that the rise in mortgage rates we are forecasting to just under 6% in 2015 could choke off the rebound. Our sense is that with prices once again rising, a gradual rise in mortgage rates will act more as a motivator rather than as an inhibitor to potential homebuyers. Simply put, a sense of urgency will return to the market. Our view is buttressed by the fact that homebuyers are now being motivated to bid aggressively in the face of a lack of
Figure 2 Case-Shiller Home Price index, 2000 – March 2013, Monthly Data, 2000=100.
Source: Standard & Poor’s via Federal Reserve Bank of St. Louis.
Figure 3 30-Year Conventional Mortgage Rate, 2000Q1 – 2015Q4F

Figure 4 Existing Home Sales, 2000 -2015F
Sources: Freddie Mac and UCLA Anderson Forecast

Sources: National Association of Realtors and UCLA Anderson Forecast

inventory of existing homes. As prices rise, the amount of existing homes listed for sale will increase and home sales are forecasted to increase from 4.8 million in 2012 to 5.7 million units in 2015. (See Figure 4.) Of course, as the recovery matures, higher interest rates will weigh on the market.

On the macroeconomic side, housing demand will be supported by a gradually improving labor market and the continued rebound in household formations. (See Figures 5 and 6) We project that employment will reach a new all-time high in 2014, seven long years since the prior peak, which would make it the most sluggish recovery in the postwar era. Similarly, household formations which collapsed to a mere 40,000 in 2009, won’t really get back to levels achieved nearly a decade ago until this year, but 2014-15 run-rates of 1.5 million-a-year are certainly supportive of our housing start forecast for those years which are approximately at that level.

Although it is possible to make a case for a stronger housing recovery in the sense that we are coming out of a sustained period of under-building, housing activity is still being held back by a less than ebullient recovery in the broader economy, still tight, albeit easing somewhat in recent months, credit conditions in terms of down payment and credit score requirements for potential homebuyers and the rapid buildup to nearly one trillion dollars in student loan debt. (See Figure 7) Never before have so many young people been saddled with so much non-mortgage debt and that burden will keep them out of the home buying market for years to come.
The flip-side of more stringent credit requirements for home purchase and mounting student loan debt is an increase in the demand for rental apartments. After peaking at 69% as far back as 2004, the homeownership rate has steadily declined to 65.4% at the end of 2012, with a further decline likely this year. (See Figure 8) Moreover, multi-family housing demand is being buttressed by a change in consumer preferences for a more urban, as opposed to suburban, lifestyle. In order to accommodate the demand, developers, out
Figure 5 Payroll Employment, 2000Q1 – 2015Q4F
Figure 7 Student Loan Debt, 2003Q1 – 2012Q4

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 6 Household Formations, 2000 – 2015F

Sources: Federal Reserve Bank of New York and The Wall Street Journal

Sources: Bureau of the Census and UCLA Anderson Forecast

of necessity, are building more dense projects and they are being encouraged by governmental planning authorities to do just that. One of the major sea changes in the past five years has been the radical shift on the part of government from opposing higher densities to encouraging it. Where density was once considered the bane of the environment it is now considered "green." Thus where multi-family construction in many urban areas was deemed to be supply constrained, that is no longer the case.

The increased demand for apartments coupled with the recession induced collapse in construction has caused the apartment vacancy rate to plunge and rents to increase rapidly. (See Figures 9 and 10). After peaking at 8% in 2010 the 79 city REIS Apartment Vacancy Rate series declined to 4.3% in the first quarter. Concomitantly, rents, according to the consumer price index, are rising at a nearly 3% annual rate, about double the overall rate of inflation.

We believe that the official consumer price index is understating the true rate of inflation for rents because most of the publicly held apartment real estate investment trusts and private surveys have been reporting rent increases of 4% or more for the past two to three years. Why the difference? For starters, the official series over-weights rent controlled cities such as, New York, Los Angeles and Washington, D.C. Furthermore, the process of vacancy decontrol slows down the mark to market process for in-place tenants and rents in smaller apartment buildings tend to lag those of larger developments. Thus, we believe the official series will soon begin to catch up to the market reality on the ground.

With the strong fundamentals outlined above, coupled with the world-wide scramble for yield caused by global central bank policy, investors are buying apartment houses with abandon. Prices have more than surpassed their previous peak of 2007. Put bluntly, with going-in yields approximating 4-5% and with rents rising, apartment house investments look very attractive when compared to the sub-2% yields available on 10-year U.S. Treasury notes. Indeed the frenzy has spilled over to single-family home rentals where both private equity firms and newly capitalized publicly traded real estate investment trusts are buying up single family homes in bulk for the rental market.
Figure 8 Homeownership Rate, 1990 -2013F, Yearend Data, Percent
Sources: Bureau of the Census and UCLA Anderson Forecast

Figure 9 Apartment Vacancy Rate, 1980-2013Q1, Percent
Sources: REIS and Calculated Risk

Figure 10 Consumer Price Index, Rent for Primary Residence, Jan 2000 –Mar 2013
Sources: U.S Bureau of Labor Statistics via Federal Reserve Bank of Saint Louis  

All of the factors outlined above have led to a surge in multi-family construction. (See Figure 11) After bottoming at 112,000 units in 2009, multi-family housing starts more than doubled to 247,000 units in 2012 and are forecast to reach 365,000 units this year.
We fully anticipate that starts will exceed 400,000 units in both 2014 and 2015. Of course this surge in supply will begin to elevate the vacancy rate and cool the rent increases that most investors now expect. In the meantime, higher apartment rents as we noted last year, will cause tenants to once again return to the ownership market



1. See Shulman, David, "Rebuilding the Housing Economy," UCLA Anderson Forecast, June 2012.

Saturday, June 1, 2013

Bond Servants: REITs Under the Lash of the Bond Market

NAREIT starts its annual investor conference this coming week. Until a few weeks ago it was going to be a celebration of the near 20% gain posted by the RMZ Index as of May 21. Since then the world became a very hostile place for REITs with the RMZ declining from 1070 to 969 as of Friday's close, a drop of 9.4%. To be sure REITs are still up 8% for the year, which would normally be a cause for celebration, but not this week.

Although most REIT investors paid lip service to the fact that very low bond yields acted as a tailwind behind the REIT bull market, most of them were caught by complete surprise as to how powerful the negative effect of the 50 basis point backup in 10-year U.S. Treasury yields to 2.16% that occurred in the month of May would be.

My sense is that the back-up in yields is just beginning. Although I do not believe that it will be dramatic as the last few weeks, it would not surprise me to see the 10-year treasury yielding 2.5% at yearend and in excess of 3.5% by the end of 2014. As a result the bond market will become a major headwind in front of REIT share prices.

If REITs were inexpensive, the benefits of a growing economy would work to offset some or all of the negative effects coming from higher interest rates. Unfortunately that is not the case. With REITs trading at around 20X EBITDA they are far from being attractively priced. The true test will come from the private market where it is way too soon to see if cap rates have been affected by the the back-up in rates. If the past is any guide it will take awhile because there is way too much investor intertia in this market, especially where public pension plans are concerned. Thus the effects of rising rates on the private market probably will not be visisble until the Fall.

In the meantime the joys of being a bond substitute will give way to sorrows. As a result selling the rallies might very well be a better strategy than buying the dips.

Sunday, April 28, 2013

My Amazon Book Review of Christopher Clark's, "The Sleepwalkers: How Europe Went to War in 1914"

Sleepwalkers is about how, not why, Europe fell into the abyss of war in 1914. It is a terrific work of history, but for the lay reader, it is way too long and gets too bogged down in minutia. Hence four stars instead of five. What makes this book different from the volumes I have read on the origins of World War One is that is puts the emphasis on where it started, the Balkans. After reading the early chapters of the book, Clark proves, intentionally or not, the Bismark aphorism, that the Balkans were not worth the bones of a single Pomeranian grenadier.

For someone like myself schooled in the works of Tuchman (chaotic and inept decision making theory) and Fischer (Germany wanted a war from the get go) Clark's book is an eye opener. First it makes all of the players seem rational and second it puts far more emphasis on the role of France and Russia in starting the war. Both France and Russian planning was based on a "Balkan inception" scenario; something that was given to them on silver platter by the assasination of Archduke Ferdinand in Sarajevo on June 28. Within five weeks Europe was at war. As an aside the fear of growing Russian power not only motivates Germany, but also France in that France feared that in only a few years Russia would no longer need an alliance with them.

Although Clark convincingly covers the intrigues of Belgrade, Venice, St. Petersberg, Paris and London; he does not spend sufficient time on Berlin. I know that might be more of a "why" question than a "how" question, it is necessary for the story. It speaks the need to understand whether Austria-Hungary was an independent actor or a pawn of Berlin.

These quibbles aside there is so much to learn here and there are lessons for today. Afterall the Sarajevo trigger was an act of state-sponsored terrorism.