Anatomy of a comeback

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

What kind of rebound is this?

Last week, Unhedged asked if anything had changed from the market’s micro-panic earlier this month, given that risk assets have largely recovered. We conclude that volatility is an important market indicator, even if it leaves no obvious traces behind, and that the incident has permanently changed the market’s expectations of what the Fed will do.

In the days since then, the comeback has gained momentum. Risk asset prices are now, if anything, higher than they were before all the commotion. Here are the S&P 500 and corporate Treasury spreads:

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

Sectors dominated by Big Tech (information technology and consumer discretionary) made a strong comeback. But throughout the entire peak-low-new-high journey, defensive sectors (utilities, staples, healthcare) have significantly outperformed. Equity risk appetite has returned, but there is a bit of caution built into it.

Another point, which Kevin Gordon of Charles Schwab brought up to me, is that economically sensitive sectors such as financials and industrials have also outperformed technology. This is an odd fit with the idea that the whole incident was a recession scare. The possibility that what happened was the partial unwinding of an overvalued overcrowded trade probably deserves more emphasis (even though the trade could still be overcrowded and overrated).

Yin Luo of Wolfe Research emailed me to say that “yes, it’s a risk rally, but it’s quite different from typical risk events.” He notes that two types of stocks, those with big price moves and positive revisions to analysts’ earnings expectations, were both up strongly. These “factors” are often an indicator of financial quality, and high-quality names typically underperform in a mad rush to add risk. Again, there’s a whiff—albeit just a faint one—of caution in the air.

And the interests have not recovered. Rates of all flavors are lower, signaling weaker economic expectations. Here are the inflation breakeven and two-year Treasury yields:

We asked Unhedged rates trader Ed Al-Hussainy of Columbia Threadneedle to explain how interest rates can signal a downturn in the economy while spreads and stock prices are just a little less dynamic than they were a month ago . His answer: “greed.”

Kamalanomics Housing

The US housing sector is a major market failure. There is a stock of homes listed but unsold, yet sales are frozen and prices are rising. High prices should encourage home building, but construction has been more or less flat. Affordability is at record lows, according to the Atlanta Fed’s Affordability Index:

Some of that should improve when the Fed cuts rates, but only slightly better. Something still needs to be done. Kamala Harris proposes increasing both demand and supply.

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

Building 3 million homes in four years likely requires changes to local zoning laws. Harris said he would “reduce red tape” at the state and local level, but local zoning is not directly under federal control. And zoning policy is poisonous. As BTIG’s Isaac Boltansky says, “what may work in Atlanta may not work in Bismarck, and those geographic limitations cause parochial problems on Capitol Hill.”

Even federal support for bid financing can be politically contentious. The Biden administration has taken a similar approach to what we believe to be Harris’s. The Inflation Relief Act originally contained $65 billion in housing provisions, including tax credits for developers and incentives for local governments. Nothing passed the Senate.

At the request, Harris said her administration would offer first-time homebuyers $25,000 in tax credits (up from the $10,000 proposed by Biden). Unhedged’s core 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 boost demand and drive up housing prices, making affordability even worse. . . the housing supply chain is not well equipped to quickly turn the ‘on’ button to cope with an increase in demand for new home construction. We learned this during the Covid supply chain crisis and it is highly unlikely that the supply chain can handle this without some inflationary pressures.

There is a recent history of on-demand sweeteners similar to what Harris mentions. From 2009 to 2010, the Obama administration gave first-time homebuyers tax credits of up to $7,500, which temporarily boosted demand, and prices didn’t rise immediately afterward. But the market is very different now. The problems after 2008 were financial rather than mainly about undersupply.

Still, Harris’ focus on supply is encouraging. We have yet to see official housing policy from Team Trump, and hopefully it will focus on supply as well. (Reiter)

A good read

literary (in)efficiency.

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