December 14, 2023

I often talk about the bubbles that exist in bonds and stocks and the extreme valuation levels found there. But I want to emphasize that the real estate market is dysfunctional and sits on the edge of a cliff as well. While I do often mention that home price-to-income ratio is at the highest level on record, I have not mentioned the cost of home ownership vs. renting. Buying a home is now over 50% more expensive than just being a renter. The previous peak of this metric was leading up to the real estate crash and GFC of 2008. It was just 33% more expensive to buy rather than rent back then. According to the Federal Reserve Bank of Atlanta, annual homeownership payments, which include taxes and insurance, ate up 46.4% of the median U.S. household income as of the latest data available in October, which is at a record high. The pre-COVID figure was just 29% of median household income.

The COVID Mortgage Forbearance programs for FHA insured mortgages and reverse mortgages ended on November 30th, 2023. These people have not made a mortgage payment since early 2020, and 15% of all mortgages are FHA-insured. This will not only abet the slowing of the economy but also help increase the supply of homes on the market, which should put downward pressure on prices. The latest sales data shows that cracks are already appearing in the foundation. The Median new home sale price fell by 18% y/y in October.

Free money encouraged Wall Street to buy up single-family homes to a greater degree than ever before, which drove up the prices out of reach of the first-time home buyer. Then, Wall Street rented these homes out to people who could no longer afford to own them. According to the National Association of Realtors, only 23% of houses in the U.S. are affordable to the first-time homebuyer. That number was 50% a year ago. With 20-25% of all homes now being of the investment variety, the real estate market is on thin ice. The salient danger here is that the supply of homes for sale could surge when unemployment begins to rise. Once people lose their jobs, they can no longer afford to pay their rent. Wall Street investors will then realize real estate investments are no longer such a great bargain once the cash flow stops and the price of their homes begins to fall. There could then be a rush to cash out and lock in the massive price appreciation enjoyed over the past few years.

The truth is the real estate transaction market has frozen over. The demand for new mortgages is down 20% year over year. By the way, pending home sales in October dropped by 8.5% y/y to the lowest level since the National Association of Realtors began tracking them in 2001. Yes, that includes the time during the Great Recession and the real estate crash of 2008.

The main issue here is that the entire banking system is largely insolvent, and this is before loan defaults spike. Banks’ mortgage assets are paying less than what they must offer to keep depositors from fleeing. According to Whalen Global Advisors, 54% of all U.S. mortgages have a rate between 2.5% and 4%; and that must compete with a T-bill rate that is north of 5%. Just wait until the recession hits! Of course, the problem in the real estate market is not limited to single-family homes. Commercial real estate is a huge issue as well, and in a much worse situation than it was leading up to the Great Recession. Commercial MBS suffer from the same sharp rise in interest rates over the past two years as residential MBS. But in addition, commercial property values have fallen due to the work-from-home phenomenon that has resulted from technological improvements and changes in the desires of the post-covid labor force. The coming recession will only exacerbate the decline in the value of these properties across the board.

The broken real estate market reveals the truly fragile condition of the U.S. economy. The major difference between 2008 and today is that inflation is above the Fed’s target level, and the U.S. government is in a much deeper state of insolvency. Therefore, a massive fiscal and monetary rescue package, anything close to the size that was necessary to bail out the financial system and markets during the GFC has become an untenable solution. The amount of debt needed to be issued by the Treasury and then monetized by the Fed would be catastrophic for bond yields and cause inflation to skyrocket. This would do little in the way of bailing out the real estate crisis 2.0, and even less for the economy.

History has proven that borrowing costs must be about 200 bps above the rate of CPI to win the fight against inflation. With headline CPI still running above 3% and core inflation at 4%y/y, this means interest rates should remain at the current 5% + level until inflation is fully vanquished. The problem is that the U.S. fiscal situation becomes untenable under such a positive real interest rate regime. Therefore, the U.S. can choose to either fight inflation and pay over a trillion dollars per year on interest payments alone, which would exacerbate the Treasury’s insolvency and risk a series of perpetually failing bond auctions. Or, lower rates rather quickly and watch inflation run intractable, as it destroys the standard of living of the average American consumer. The decisions made by government require different trading strategies. PPS has a plan for all paths.

For now, we are allocated in a defensive posture while we wait for the signal to get net-short the market. Financial conditions and credit spreads remain far too quiescent to have any equity shorts. Therefore, we remain patient. Physical gold is a key holding, 1–3-year Treasury Notes for yield and safety, and defensive, non-economically sensitive equities, are the best way to ride out whatever remains of this bear market bounce.

Judging by the panic move at today’s FOMC press meeting and conference, the dot plot for rate hikes going from one more rate hike to zero to now three rate cuts next year, it is clear that Powell, and the rest of his contemptuous cohort of counterfeiters, have suddenly become aware that the economy is already faltering and would completely collapse without a pivot to an easier monetary policy. However, the Fed will very likely be cutting borrowing costs far too little too late. The history is unambiguous on this. Next week, I will try to prove why the recession and phase II of the bear market, which began in late 2021, is still firmly on the agenda for 2024.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check”  and Author of the book “The Coming Bond Market Collapse.”