Anatomy of a rebound #NewsMarket

Good morning. The Federal Reserve kicks off its annual Jackson Hole symposium this week. Unhedged will be listening in, hoping to find out not only how big the September interest rate cut will be, but also which Fed governor wore the biggest cowboy hat. Email us with your predictions: [email protected] and [email protected].

What kind of rebound is this?

Last week Unhedged asked if anything had changed because of the market micro-panic at the start of this month, given that risk assets had mostly bounced back. We concluded that volatility is an important market indicator even if it leaves no obvious marks behind, and that the incident did durably change the market’s expectations for what the Fed will do.

In the days since then, the rebound has gained strength. Risk asset prices are now, if anything, higher than they were before all the hurly-burly. Here are the S&P 500 and corporate bonds’ spreads over Treasuries:

But there are some important differences between the before and the after. Start with sector performance:

The sectors dominated by Big Tech (information technology and consumer discretionary) have had a roaring comeback. But over the full peak-trough-new peak journey, it is the defensive sectors (utilities, staples, healthcare) that have outperformed significantly. Appetite for equity risk is back, but there is a small pinch of caution embedded in it.

Another point, made to me by Kevin Gordon of Charles Schwab, is that the economically sensitive sectors, such as financial and industrials, have also outperformed tech. This is an odd fit with the notion that the whole incident was a recession scare. The possibility that what happened was the partial unwinding of an overcrowded overvalued trade probably deserves more emphasis (even though the trade might still be overcrowded and overvalued).

Yin Luo of Wolfe research emailed me to say that “yes, it’s a risk rally, but it’s quite different from typical risk-on events”. He notes that two types of stocks, those with a lot of price momentum and with positive revisions to analysts’ earnings expectations, were both up strongly. These “factors” are often a proxy for financial quality, and high-quality names usually underperform in a mad rush to add risk. Again, there is a whiff — though just a small one — of caution in the air.

And interest rates have not recovered. Rates of all flavours are lower, signalling weaker economic expectations. Here are inflation break-evens and two-year Treasury yields:

I asked Unhedged’s go-to rates trader, Ed Al-Hussainy of Columbia Threadneedle, to explain how it is that interest rates can be signalling a softening economy, while spreads and equity prices are only slightly less gung-ho than they were a month ago. His reply: “greed”.

Housing Kamalanomics

The US housing sector is one big market failure. There is a backlog of listed but unsold homes, yet sales are frozen and prices are increasing. High prices should encourage homebuilding, but construction has been more or less flat. Affordability is at record lows, according to the Atlanta Fed’s affordability index:

Some of this should get better when the Fed cuts rates, but only a little better. Something else needs to be done. Kamala Harris proposes increasing both supply and demand.

On the supply side, she wants to “end America’s housing shortage by building 3mn new homes and rentals that are affordable for the middle class”. Good. The question is what tools the federal government has to achieve this. Harris has said she will “work in partnership with industry” to build more houses, and has promised to crack down on what she calls “corporate landlords”. This is maddeningly vague, but typically the main way for the government to boost housing supply is through financial incentives. Indeed, there are already some policies on the books, such as the Low-Income Housing Tax Credit, which incentivises homebuilders to allocate a portion of new builds to affordable housing.

Building 3mn homes in four years probably requires changes to local zoning laws. Harris has said she will “cut red tape” at the state and local level, but local zoning is not directly in federal control. And the politics of zoning is poisonous. As Isaac Boltansky at BTIG puts it, “what may work in Atlanta may not work in Bismarck, and those geographical limitations cause parochial issues on Capitol Hill”.

Even federal supply financing support can be politically contentious. The Biden administration pursued an approach similar to what we believe is Harris’s. The Inflation Reduction Act originally contained $65bn of housing supply provisions, including tax credits for developers and incentives for local governments. None of it made it through the Senate.

On demand, Harris said her administration would provide first-time homebuyers with $25,000 in tax credits (up from the $10,000 proposed by Biden). Unhedged’s basic view is that solving a supply shortage with demand support is putting out a fire with gasoline. Here is Rick Palacios of John Burns Research & Consulting:

My concern . . . is that it would immediately stimulate demand and [bump] home prices higher, making affordability even worse . . . the supply chain for housing isn’t well equipped to quickly flip the ‘on switch’ to accommodate a surge in new home construction demand. We learned this during the Covid supply chain crisis, and it’s very unlikely the supply chain would be able to handle something like this without some inflationary pressures.

There is some recent history of demand sweeteners similar to what Harris is mentioning. From 2009-2010, the Obama administration gave first-time homebuyers up to $7,500 in tax credits, which momentarily boosted demand, and prices did not shoot up immediately afterward. But the market is very different now. The issues post-2008 were financial, rather than mainly about undersupply.

Harris’s focus on supply is encouraging, though. We have yet to see official housing policy from the Trump team, and hope that it focuses on supply, too. (Reiter)

One good read

Literary (in)efficiency.

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