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.

"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
 

ENDNOTES

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

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.

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.

My Amazon Book Review on Ira Katznelson's, "Fear Itself: The New Deal and the Origins of Our Time"

There have been thousands of books written on Franklin D. Roosevelt and the New Deal. Instead of focusing on the executive branch, Katznelson shifts the focus to the Congress, particularly the southern Democrats who dominated the caucus and chaired the major committees. The author convincingly demonstrates that when the southerners were with him, Presidents Roosevelt and Truman got what they wanted. Conversely when the southerners opposed the Adminstration, the New and Fair Deals floundered. It is here where Katznelson makes an important contribution to our understanding of the New Deal and the early postwar era.

With respect to domestic policy, Katznelson views the approach the southerner took through the prism of race. Specifically where the southerners feared the underpinnings of the Jim Crow south were under attackl they backed away from Roosevelt. Although I largely agree with that thesis, the major failing of the book in my opinion, is that Katznelson ignored the Jacksonian roots of the southern Democrats then sitting in Congress. At its founding the Jacksonian Democrats were both racist domestically and hawkish with respect to foreign policy. Thus while the southerners, opposed Roosevelt dometically after 1938, they stood by him and later Truman in supporting the foreign and defense polcies of the emerging national security state.

I would recommend "Fear Itself..." to both serious students of American history and the casual reader interested in how much the the institutions we now take for granted came into being.

Slowly Ramping Up, UCLA Anderson Forecast, March 2013

 

 

After enduring the slowest postwar recovery on record, the economy is slowly beginning to ramp up. To be sure the acceleration will be more of a 2014 event, but the seeds are being sewn for real GDP growth to rise from the tepid 2% we have been used to to something more on the order of 3%. But this is still below the 4% - 6% growth rates associated with prior recoveries. Specifically, after growing at 2.2% in 2012, we are forecasting real GDP to advance 1.9% in 2013 and 2.8% and 3.1% in 2014 and 2015, respectively. (See Figure 1) Indeed, we anticipate the economy to achieve a sustained 3% growth rate starting in the second quarter of 2014. Along with the higher growth path we are also forecasting inflation in excess of 2% in 2014 and 2015 as the Fed’s extraordinary monetary policies catch up to a slow productivity growth economy.

Nevertheless, before we get to the accelerated growth we are forecasting, the economy has to overcome the headwinds coming from the $85 billion sequester in Federal spending over the next seven months ($1.2 trillion over 10 years), a recession in Europe, the impact of higher payroll taxes and higher taxes on upper income households and the payroll adjustments that business firms will make associated with the implementation of the Affordable Care Act. Because of the way the Affordable Care Act is structured, firms have incentives to convert full-time work to part-time work and for small firms to limit their headcount to 50 full time employees. As a result of these impediments, 2013 will represent the fourth year in a row of less than optimal 2% growth.

We assume the sequester issue will be resolved by another typical Washington compromise. Congress will likely respond to the near-term pain caused by the very quick and very arbitrary cuts in Federal programs that were passed by Congress and signed into law by the President in 2011 by coming up with a combination consisting of mostly long-term spending cuts in entitlements and some tax increases that will take effect in 2014. As a result of the sequester, growth will remain a slow 1.9% in the second quarter which temporarily spikes to 3.4% in the third quarter before dropping back to 2.5% in the fourth quarter. We fully realize this forecast outcome it too cute for our tastes, but that is the way it models out.

The recent revisions in the employment data highlighted the fact that the job situation was better than what we had thought. The economy gained an average 181,000 jobs a month in 2012 and we expect an equivalent gain in 2013 and acceleration to 200,000 jobs a month in 2014 and 220,000 in 2015. (See Figure 2) In this environment the demand we are forecasting the 

unemployment rate will gradually decline from the current 7.9% to 7.6% by yearend to 7.1% at the end of 2014 and to around 6.5% at the end of 2015. (See Figure3)

HOUSING AND CARS LEADING THE PARADE

Growth will be buoyed by a rapidly recovering housing market and continued strength in light vehicle sales. Housing led the downturn; it is now leading the upturn. Housing starts totaled 781,000 units in 2012 up from 612,000 units in 2011. Because housing remains extremely affordable (low prices and low mortgage rates) for those who can obtain credit coupled with substantial pent-up demand, we are forecasting starts to exceed one million units this year and foresee further advances to 1.35 million units and 1.56 million units in 2014 and 2015, respectively. (See Figure 4) Although we are above consensus we do not view our forecast to be overly optimistic. After all, our 1.56 million unit forecast for 2015 is consistent with the historic 20-year average and with long run demographic demand. Where we differ with other forecasters is that we expect housing starts to normalize in 2015, they look for normalization in 2016.

Similarly, the recent strength in automobile sales is expected to continue. The fleet, on average, is 11 years old and onsumer balance sheets have been at least partially

repaired by the modest rebound in home prices and the surging stock market. Practically all of the household wealth destroyed during The Great Recession has been recouped. Light vehicle sales rebounded to 14.4 million units in 2012 up from 12.7 million units in 2011. We expect a further increase to 15.2 million units in 2013 and can easily visualize a 16 million unit year in 2015. (See Figure 5) Remember that will still be below the 16.1 million units sold in 2007.

THE NEAR-TERM ANCHORS: EXPORTS AND BUSINESS STRUCTURES

Simply put, it is hard to export when your trading partners are in recession. Eurozone output shrank at a 2.4% annual rate in the fourth quarter of 2012. Japan contracted as well, albeit at a smaller 0.4% annual rate. With most forecasters looking for a very sluggish Europe in 2013, it is hard to visualize a rebound in U.S. export growth until 2014. Export growth rebounded a stunning 11.1% in 2010, but since then the growth rate has been on a decidedly downward track, dropping to a mere 2.5% in 2012. Although still positive, we forecast export growth to be a very low 1.5% in 2013 before rebounding to 5.3% and 5.8% in 2014 and 2015, respectively. (See Figure 6)

Adding additional risk to the forecast is the abrupt shift in Japanese monetary policy designed to end that country’s 20 year deflation. Concomitant with the change in policy, whether by design or not, has been a substantial decline in the exchange rate of the Yen. Since last fall

the Yen has been effectively devalued by 17%, thereby making Japanese goods far more competitive in global markets. Clearly this abrupt change in the exchange value of the Yen introduces a negative factor for the prospects for U.S. exports.

Another source of sluggishness in 2013 is the stalling in the investment in nonresidential structures. Specifically, the drop in natural gas prices lowered the investment in new wells and the completion of several major utility projects will cause growth in this sector to drop to essentially zero in 2013. However, a rebound in energy activity along with a marked increase in commercial construction will cause this sector to increase at 9.8% and 11.4% in 2014 and 2015 respectively. (See Figure 8)

THE FISCAL TRAIN WRECK

To be sure, Federal purchases, thanks to significant declines in defense spending and more modest declines for civilian spending coming off the stimulus highs of 2010, are heading lower. (See Figure 9) Those reductions along with higher tax revenues coming in from the recent tax increases will cause the federal deficit to decline from $1.1 trillion in fiscal 2012 to about $860 billion in fiscal 2013 with further declines extending throughout the near-term forecast horizon. (See Figure 10)

However over the long-run, the scale of the Federal deficit is not a result of the federal purchases which fund defense, the FBI, the national parks, and the FDA, for example. And it is not the result of insufficient tax revenues because we forecast a return to a somewhat above average 19% share of GDP allocated to federal taxation.

Indeed, in the very long-run, according to the Congressional budget Office, by 2037 Medicare, Medicaid (including the Children’s Health Insurance Program) and Social Security will account for 16.6% of GDP swallowing over 80% of revenues. Of course, given our aging popula

tion a 20% share going forward maybe more appropriate. The real reason why the projected deficit starts expanding from $640 billion in 2019 and rises to $800 billion dollars in 2022 is entitlement spending and until that is controlled, no nominal deficit reduction package will work. Of course this and most all deficit projections naively assume no recession over the next decade.

INFLATION AND THE FED

Although inflation has remained quiescent we believe the economy is about to deliver more inflation than what policy makers now expect. To be sure, headline inflation will remain low for most of 2013, but core inflation will soon be running at a 2% annual rate and be well on the path to 3% in 2015. (See Figure 11) Why? We believe that the extraordinary monetary policy of the Federal Reserve is about to translate into higher prices as spot shortages of skilled labor put upward pressure on wages in an economy suffering from less than 1% a year productivity growth. (See Figure 12) Furthermore, inflation will be in part driven by the welcome rebound in housing prices as the owners’ equivalent rent calculation drives the consumer price index higher. We note that apartment rents reported by the publicly traded apartment Real Estate Investment Trusts are now increasing at a 4% pace and that rate of gain will soon find its way into the official price indices.

Fed policy has been nothing but extraordinary since the financial crisis began in August 2007. The Fed’s balance sheet has nearly quadrupled to over $3 trillion and it is on the road to $4 trillion if, and according to the minutes of the January Fed policy meeting that has become a bigger if, the $85 billion a month in asset purchases announced last fall continue throughout 2013. (See Figure 13) Although this policy has yet to show up as price inflation, the monetary kindling is certainly there to be ignited. We note that the potential for inflation is a new concern for us because until very recently we have been forecasting inflation to stay well within the bounds of the Fed’s target.

Along with massive asset purchases the Fed has targeted a zero interest rate policy since late 2008. We like others expect that policy to continue well into 2014. (See Figure 14) Unlike others and the official statements of the Fed we believe that policy will end in late 2014, and not continue on well into 2015. Simply put, the inflation we are envisioning will first show up in the long-term bond market and that will put pressure on the Fed to act sooner than what is now contemplated. Instead of waiting for the unemployment rate to drop to 6.5% before acting, we believe that as the unemployment rate approaches 7% with inflation rising, the Fed will begin to move away from its extraordinary monetary policy.

CONCLUSION

After overcoming a host of near-term hurdles coming from the sequester, recession in Europe, higher taxes and transition issues associated with the implementation of the Affordable Care Act, we believe that the economy is setting the stage to break out of the 2% growth path of the past four years and ramp up to a 3% growth pace in 2014. By the end of 2015, the unemployment rate will approximate 6.5%. The growth will come from the gradual removal and/or adjustment to the negative factors and continued strength in housing and automobile sales along with renewed growth in business construction and exports. Along the way inflation will pick up and that will challenge the Federal Reserve to rethink its zero interest rate policy in late 2014.

 

My Letter to Barron's on MLPs, March 11

To the Editor:
I was disappointed in the cover story on "The New MLP Landscape" (Feb. 25) because it failed to discuss the most fundamental risk facing the sector. Practically, the sole reason that master limited partnerships exist is to game the tax code. Thus, any serious policy discussion involving business tax reform would have to include the role of MLPs, real-estate investment trusts, and large-scale limited liability corporations and partnerships. If corporate tax rates are to be lowered as they should be, the lost revenue will have to made up from somewhere.

Prudent MLP investors should keep a close eye on the congressional tax-writing committees.