Category: Uncategorized

by Mark Schniepp
November 2019

Confidence

I’m looking at the sentiment and confidence indices that are constructed from monthly survey responses of American consumers. It is remarkable at how much and how long a time we have been optimistic about the economy.

Consumers like you and me are finding little not to like in the present environment of low unemployment, healthy job growth, low interest rates, low inflation, and a stock market that continues to make record highs this year. Consumer confidence remains high, even though it has ebbed and flowed a little these last 6 months.

Growth in the economy right now is being led by your and my assessments of current economic conditions, which are keeping us happy and keeping us spending. While we believe that the outlook has weakened, it’s only a modest change from 6 months ago, because while there is a trade war, it has had little direct effect on us. Gasoline prices would typically sour our moods if they were to jump suddenly. And they did after the drone attack in Saudi Arabia, but even that proved relatively short-lived.

The way consumers feel and perceive the economy is particularly important for the outlook at present. Often sentiment simply reflects the state of the economy and adds little additional information necessary for forecasting the economy. Nonetheless, sentiment can be an early indicator of a turning point in the business cycle, especially when pocketbook issues are driving the movements.

With manufacturing in a mild recession now and some of the economic indicators weakening, a significant slowing in consumer spending growth now could be fatal for the expansion. Inflation expectations are also important to watch. A sustained drop in inflation expectations would be a concern to the Federal Reserve and may increase the likelihood of additional rate cuts, while a major increase could heighten fears regarding the trade war and the tariffs.

Confidence is high by historical standards since there is much for consumers to be happy about. The strong job market is the primary support. With unemployment at a half-century low and wage growth healthy, there is little in the job market for consumers not to like.

Household debt is at 39 ½ year lows (or the lowest level since records have been kept). And the stock market at record highs is providing another significant boost to our economic sentiments.

If there is a problem then it is this: we know that growth is slowing and the stock market will be unlikely to post sustained gains. The value of your home, for the most part, has also stopped appreciating. Consequently, confidence has nowhere to go but down.

Business Confidence

High consumer optimism stands in contrast to businesses’ attitudes. Global businesses remain depressed, as they have been for much of the past year, since the beginning of the trade war with China and other U.S. trading partners. Business survey results have grown as bleak as they have been since the global economy was coming out of the financial crisis a decade ago. And a weakening in hiring intentions by firms in recent weeks will ultimately be a concern for consumers and their economic outlook.

The Gradually Changing Economy

The economy is slowing. So even if consumers are happy and are in a sound financial position, they are nevertheless starting to spend less and the retail sales numbers including auto sales bear this out.

Manufacturing is contracting now. The stock market is high but there is a lot more volatility indicative of nervous investors. Furthermore, the stock market has gained little ground over the last 6 months, up only 2 percent since April. And this is part of the reason why the confidence or sentiment indices have slipped from their cycle peaks.

Consumer Spending Outlook

The retail spending outlook is positive, but not enough to prevent growth from moderating. The saving rate is high, giving consumers freedom to spend increases in their income, but there seems little motivation for them to spend much more. Job growth will remain the strongest support to sales, and the tight labor market is putting upward pressure on wage rates. However, the pace of job growth has slowed and will slow further as workers are becoming less plentiful and falling profits and uncertainty drag down business sentiment, limiting the support to total income growth.

So as expected, consumer spending growth is slowing after consumers contributed powerfully to economic growth earlier this year.

Growth in spending continues to slow going forward, but it will not collapse, as important supports remain in place. Job gains are still strong, and despite the weakening in business confidence, layoffs are not much of an issue because initial jobless claims for unemployment insurance remain very low. Growth in wage rates is also strong. Hence, income growth will hold up despite slower employment growth than last year.

How long can we remain happy? For the moment, for the next several months without much doubt. And there could very well be surprises to the upside. But in general, the slowdown scenario for 2020 has a noticeable weakening in consumer spending by the summer, and this will manifest in slower sales at Target or the Toyota dealership in your neighborhood. So plan accordingly.

by Mark Schniepp
October 2019

October is the month for stock market corrections, Octoberfest, Halloween parties, the baseball playoffs, clarifying the NFL contenders, and for the last two years, it’s been the month of natural disasters or their immediate aftermath.

I’m referring to the October 2017 fires in Northern California, and Hurricanes Irma and Harvey a month earlier. Then last year at this time, the ashes were just cooling from the Carr fire and the winds were beginning to blow that ultimately precipitated the most destructive fire in California history—the Camp fire in early November.

For this year to date, cross your fingers because there’s been nothing much yet. Instead we are observing that the major rebuilding efforts from the past calamities are well underway. Thousands of new homes are being built in Sonoma County. Home rebuilds from the Thomas fire are fully underway in Ventura. The first 50 homes from the Camp fire started last Spring with a handful now completed. And also underway are homes in Malibu where 475 were completed destroyed in the Woolsey Fire.

Replacement building is ongoing in Shasta County and in Mendocino and Napa Counties. The economies of all these regions are being lifted by the windfall influx of insurance payouts to replace structures, automobiles, furnishings, furniture and landscaping. How much payout? $12 billion in 2017-2018 and another $12 billion in 2018-2019.

An estimated 23,992 homes were destroyed by the fires of 2017 and 2018, and another 2,181 were damaged. Research at the University of Wisconsin determined that 94 percent of buildings destroyed by California wildfires between 1970 and 1999 were rebuilt. Consequently, we are expecting most of the recent destruction to be replaced.

If you can do construction, you can get a job just about anywhere in California. Even if you know nothing, you will get hired and trained. If you’re in the Bay Area, there’s a building boom occurring in the City, in Santa Clara and in the East Bay. Fire rebuilds are now demonstrably underway in Sonoma and Napa Counties.

If you’re in Ventura, Thomas fire rebuilds are finally moving along. If you’re in Sacramento, housing projects are occurring or planned all over, and workers are in high demand. If you’re in Fresno County, the high speed rail project is still underway, employing more than 3,000 construction workers. Also, there are more housing and industrial projects ongoing throughout the Central Valley region, especially to the north in Madera and San Joaquin Counties.

In Los Angeles, the downtown area is a sea of cranes and tens of thousands of apartment units are under construction. Ditto office buildings. The development of new structures is one the most visual business activities in Los Angeles County from Santa Clarita to San Pedro.

The rebuilding efforts together with the development booms in the major metro areas of the state have resulted in a fully employed construction workforce that has benefitted from an average 4.3 percent annual wage increase since 2015. The average annual earnings for a California construction worker now exceed $70,000.

Are you having difficulty getting a contractor to bid on your bathroom remodel? If not, is it a competitive bid? It would be more competitive if the state was not flooded with construction work, from fires, to high speed rail, to building booms everywhere else.

New and replacement development is a principal engine of growth in California today and construction employment is nearing an all time record high in the state. This is also true nationwide and it’s being called a “shortage.” The National Association of Home Builders reported last year that 82 percent of its members believe that cost and availability of labor are their biggest issues. Back in 2013, only 13 percent of members worried about labor costs.

The impending recession is not likely to appreciably slow down this industry. There is too much momentum right now to build homes, complete Phase 1 of the high speed rail, and construct apartments in Los Angeles and San Francisco that are badly needed by the urban millennial workforce. Besides, much of this construction is foreign or institutional driven.

So if you’re willing to pick up a hammer, we need you now, and your position might even be insulated from the next recession.

by Mark Schniepp
September 2019

The Southern California economy hasn’t changed much so far in 2019. In fact, most California economic indicators appear unchanged for the first 8 months of the year. Unemployment is nearly invisible, your salaries and wage rates are rising. Your spending is not diminishing. The housing market is fighting back and mortgage refinancing is hot again.

But there are signs, and they are becoming clearer now. I can finally quote Bob Dylan from 55 years ago: “These times they are a’changin.”

Four more months remain in 2019. It’s September and it’s still hot and you are thirsty. So sit down, grab an ice cold beer, and contemplate your plan for 2020.

Financial Markets

The stock market is acting like an amusement park ride. The Dow dropped 767 points on August 5, 800 points on August 14, and 623 points on August 23. But it’s still very high because between those precipitous declines, it rebounded sharply. The DJIA is up 15 percent year-to-date and today’s index is less than 3 percent from it’s all time record high set on July 15.

Investors don’t like the trade war with China that has escalated recently. They do like last month’s interest rate cut. However, they don’t like the negative treasury spreads that are persisting. More on this below.

You might want to review and/or rethink your investment portfolio because changes in the economy are more likely to impact financial market valuations. Your stock market portfolio needs addressing now. I’m not suggesting a huge move into cash, but a prudent rebalancing should be strongly considered.

Spending

Consumers are still spending and represent the engine of the 2019 economy. But trade wars don’t help us consumers who buy Chinese imported goods because those goods are going to be more expensive. We can buy other goods for the time being and consumers are doing just that. Furthermore, it’s a good thing China doesn’t export any cars to the U.S, or hardly any. Car sales remain steady, giving us little indication that we’re getting tired or board of our current vehicles. August consumer confidence was strong despite the stock market’s wild ride.

You don’t need to cut back on your spending. Presumably it is the result of your rising earnings and salaries. If not, then focus on reducing your household debt and/or your company’s debt. You will want these to be in sound order if the economy weakens and you need financing to carry you through a slowdown in demand for your company’s services or products.

Interest Rates

The 10 year is now at 1.45 percent—just a hair short of it’s all time record low. This is good news if you need a lower mortgage rate, or a cheaper car loan. However, lower long bond rates are intensifying the inverted yield curve, and this is making economists and financial market analysts more and more pessimistic about the impending recession.

Therefore, refinance your home if today’s rates are lower than your current rate. Refinance your car. Refinance anything else you are in debt on. Now is the time to take advantage of another historically low interest rate environment and lower monthly payments. 2^nd chances in life don’t come that often.

TD Securities said its recession model is based on the spread between 3 month Treasury bill rates and the 10 year bond yield. The model is now predicting a 55 percent chance of recession within 12 months, or by August of 2020.

I don’t yet see that myself, but conditions can change quickly, especially because the economy is more vulnerable today meaning that if something goes wrong, we are closer to a tipping point. The tariff war is impacting the industrial sector. The purchasing manager’s index released this week shows a contracting U.S. manufacturing sector, the first such occurrence in 3 years.

We are certainly on a vigilant recession watch and you should be too.

The Labor Market

More job creation occurred in July throughout the U.S. Wages keep rising. That’s good if you are a wage earner. It’s bad if you are the inflation rate. Unemployment is still remarkably low and we have all become complacent with our seemingly unwavering job security. However, as we reported a couple of months ago, the rate is gradually rising again due to a growing reluctance to hire this late in the business cycle.

What can you do to become more indispensable at work? Because if you are, you’re less likely to be laid off when a weaker economy finally arrives. And layoffs are going to occur. If you are the person that does the laying off, think about what you can do now to reduce potential layoffs and position the company for greater resiliency. Perhaps that includes reducing your hiring of unfilled positions today. While broad thinking along these lines will push the unemployment rate higher, a tougher job market today or tomorrow is better than a horrific one in 1 to 2 years.

Housing

Affordability, particularly for first-time homeowners, is trending downward at the national level. This is not news in California and hasn’t been for the last 5 years. It is becoming increasingly clear that existing-home sales are past their cycle-peak, despite a recent uptick driven by the latest meltdown in mortgage rates.

Are you looking to sell your home? Lower the price and do it. Demand is still strong but affordability is the reason for sluggish home sales in many markets in California. If you’re a buyer, entertain the possibility of delaying your purchase until the recession. There might be lower demand at that time and therefore a higher likelihood that home values will soften. But don’t expect prices to collapse like they did in 2009. That was extraordinary because much of the price appreciation observed from 2004 to 2007 was speculation driven. That’s not the case today.

Existing home prices are moving higher again in many markets, after softening in the Fall of 2018 and continuing through the Spring of 2019. But as the economy shows more signs of slowing, expect additional price contraction.

by Mark Schniepp
August 2019

What’s the Cause of the Housing Crisis?

It’s being called a crisis because many people can’t obtain housing at current prices. But actually when this happens, it’s a crisis for the person seeking housing and a bonanza for the owners of rental and for-sale housing.

The law of supply and demand typically always prevails in markets that are mostly unregulated.

So here we are in the mostly unregulated housing market and due to strong demand and little supply growth, prices move exactly to where they should go, which is up. And why should they go up? To ration the existing housing and allocate it to those who can pay (which is how we allocate most goods in a capitalistic economy).

This sounds callas to many people, because there is an expectation that housing is a basic necessity like air and water and it should be more affordable. Well, it generally is. But not in Coastal California where (1) everyone wants to be, (2) where most of the jobs are, and (3) where building new housing is both limited and difficult (or near impossible) to navigate through the permitting process.

You can find much much much more affordable housing and plenty of it in Kern County, or Fresno County, or Colusa County, or Tucson, Little Rock, or Kansas City. There is no crisis in these housing markets and in the majority of the country.

But is the lack of supply the only reason for high prices in California, or I should say, coastal California? No. But the limits on supply are the principal cause.

There is an asymmetry between the growth of supply and the growth of demand. Growth of supply has lagged demand for a major part of the last 40 years in California.

Why? Because there have been increasing constraints on the development of housing imposed by legislation and court rulings since 1970.

CEQA (the California Environmental Quality Act) was enacted in 1970. In 1972 a California Supreme Court decision required an EIR for private development projects including housing projects. An EIR discloses the possible adverse effects on the environment of new development projects.

CEQA enables anyone the ability to litigate against homebuilding (or just about any building) in California. Lawsuits filed under CEQA against housing projects immediately delay them, increase their cost and increase the probability that they won’t get approved or built. Either that or the project is downsized. Therefore, less housing than originally intended is built, and this together with the efforts required to assure protection to the environment, increase the cost of housing.

In 1972 the City of Petaluma established a growth control on housing units, preventing the construction of approximately 50 to 67 percent of the housing units that would otherwise have been built in response to normal market demand. The City was sued. The suit ultimately made its way to the U.S. Supreme Court after lower courts found that builders were in fact injured by the City’s restrictive housing program. The highest court upheld the growth control.

This led to more cities adopting controls particularly in Northern and Southern California. And most coastal California cities have effectively restrictive measures embedded in their housing entitlement processes.

Then there are the development fees on housing that increase construction cost, and these fees are notoriously higher in California than in any other state, and by a magnitude of 2 or 3 or 4 to 1.¹ In the referenced study, it was found that development fees increase the cost of housing in California by 18 percent.

There is therefore significant inertia either against the development of housing, or towards driving up the cost of housing in California.

Development fees are unlikely to go away, and CEQA is unlikely to be changed.

The desirability of coastal California increases demand and clearly, the growth of demand has been disproportional to the growth in the supply of housing. Consequently, predictable outcomes result with the price of housing. The great economic expansion of the 21^st century has exacerbated that demand due to the prolific surge in job opportunities that have been created in California, and especially in the Bay Area and Southern California.

That’s it, a simple explanation of the housing crisis in less than 800 words.

What Can You Do About It?

Two things: (1) Wait for the next recession and hope it actually will soften the demand for housing (which recessions typically do), or (2) Move to Kansas City.

Even if the current level of demand abates, it’s unlikely to significantly impact housing prices and rents in Coastal California, but that all depends on the severity of the recession.

———-

¹ National Impact Fee Survey: 2015, by Clancy Mullen, Duncan Associates, http://www.impactfees.com.

by Mark Schniepp
July 8, 2019

On July 1, the U.S. economy quietly “celebrated” the longest consecutive spell of economic growth on record: 10 years and one month. The expansion officially started in mid-2009, following the horrific Great Recession, and no end is currently in sight.

We have already experienced the longest bull market on record in stocks during the expansion, and we continue to set a new record every month for continued positive job creation.

The current 121-month growth cycle edges out the previous record expansion of the 1990s that ended with the start of the 2001 recession, after 120 expansive months.

Everyone says that while the length of the expansion is remarkable, the strength of the expansion is not, and has in fact represented the slowest rate of growth over the last 70 years averaging 2.3 percent per year since 2009.

But it’s clear from the chart that the nation has shifted to a new growth path of GDP during economic expansions. Is growth really lackluster, or has it merely been replaced with the understanding that today’s $20 trillion economy won’t likely grow as fast as the $7 trillion economy that prevailed in 1975?

The 2 Percent Economy

We’ve been in a 2 percent per year expansion for 10 years. But so what? What’s to criticize? We are at full employment. Wages are rising faster than the rate of inflation. Inflation is historically low. Interest rates are historically low. Your car payment is low. If you financed a home purchase between 2010 and 2015, your house payment is low. If you already owned a home before that, your payments are probably even lower.

Technology has given you extraordinary freedom with smart cell phones and you are connected to everything and everybody practically 24 hours a day. Uber has become pervasive and is one of your best friends, and Amazon delivers you everything you need in 2 days or less. All this has occurred during the 2 percent economic expansion.

The End is Near

There have been numerous predictions of the onset of recession over the last 5 years, but no real consensus. And sure enough, the economy marched on. There is now a growing consensus that economic growth will slow from this moment on, ultimately manifesting in a recession.

A poll by the National Association of Business Economists in May showed that 60 percent of respondents expect a recession next year, even though there is not much evidence that economic conditions are weakening yet.

Corporate profits have weakened, but the stock market continues to set new record highs (the most recent record occurred on July 3, 2019).

Housing has weakened in all regions of the U.S., but home prices continue to rise, and the recent sharp decline in mortgage rates has produced another refinancing boom.

The trade war is not helping U.S. manufacturing, but the trade war alone is unlikely to push the nation’s economy into negative growth, unless tariffs and counter-tariffs suddenly escalate. This however is a low probability scenario. Even so, the Fed is poised to cut rates given this possibility (or other signs of weakness), and this would boost the outlook for rate-sensitive sectors including housing and automobiles.

The dreaded flattening of the yield curve has now become more worrisome because the spread between the 3-month and 10-year treasury yield has been negative for more than 6 consecutive weeks. A negative spread lasting a quarter or two is nearly a certain predictor of recession, though eminent doom is often a year or more away.

We have been reporting extensively in recent months on the U.S. labor markets, the housing market, interest rates, and the possibility of recession. We’ve been on a vigilant recession watch for over a year. But the aggregate indicators are either not breaking down or not breaking down enough for us to sound the alarm. And many indicators like the stock market, the labor market, and consumer spending continue to show unprecedented strength.

by Ben Wright
June 2019

After 8 years of persistent improvement, the California unemployment rate began to drift upward in January 2019. A rising unemployment rate typically indicates that business conditions are deteriorating and companies are slashing jobs, and once the unemployment rate begins to rise, the economy often falls into recession within a year.

So is the California labor market indicating that a recession is imminent? Will mass layoffs begin sometime in 2019 or 2020? Not necessarily. The unemployment rate is now increasing because there are abundant opportunities to find a job, wages are rising, and people who had given up on finding a job are now returning to the workforce.

Recruiting Remains Extraordinarily Difficult

Even though the unemployment rate is rising, the job market is still excessively tight, and hiring managers are having problems finding qualified workers. Throughout California there are only 1.3 unemployed residents for every job opening, and in some regions there are more openings than people available to fill them.

The most extreme example is the Bay Area where there are 210,000 job openings but only 104,000 unemployed residents. Even if every applicant in the Bay Area was perfectly qualified for an open position, half of all jobs would still go unfilled.

In such a scenario, companies typically recruit from other cities and increase wages to poach employees from other firms. Both of these strategies are now being deployed, in varying degrees of intensity, across the major regions of California.

Statewide, the median wage increased by 3.5 percent in 2018, and increased much more quickly in some job categories.

In particular, wages are rising at above-average rates for jobs that do not require a college degree. This includes manufacturing, transportation, maintenance, and some healthcare jobs like home health aids and nursing assistants. After the 2007-2009 recession, workers without college training exited the job market in large numbers, but higher wages and fiercely competitive conditions appear to be bringing them back.

Influx of New Job Seekers

The California labor force (the number of people either working or looking for work) is expanding at the fastest rate since 2007. So far in 2019, the state is on pace to get 272,000 new job seekers, and because the job market may not be able to absorb them all, the unemployment rate could continue to move higher.

This is particularly true in the Bay Area, where the number of job seekers is expanding twice as fast as the rest of the state. And as a result, the unemployment rate is rising more quickly as well.

None of this rules out the possibility of a recession. When the unemployment rate gets too low and hiring becomes a challenge, it is difficult for companies to grow and for the economy to expand, meaning that a routine shock, like a stock market decline or government policy error, can more easily knock the economy off course. But in California, the labor market is signaling that times are still good, at least for now.

by Mark Schniepp
May 2018

That was the headline in the LA Times on May 1, 2019.

The growth in California’s population between 2018 and 2019 was the lowest since records have been kept, going back to the year 1900.

The population of California is now estimated at 39,927,315 people as of January 1, 2019. The rate of growth over the last year was under 0.5 percent.

Is this good or bad?

It means there will be a slowdown in the pressure to build more housing which is the biggest economic issue in the state right now. So the ongoing slowdown in population growth is welcomed.

The state still needs more housing units, and the simple and obvious evidence of this is their price—to buy or to rent—principally in coastal communities.

But a slowdown in population is what we’ve been observing and expecting for many years. It’s what we’ve waited for. A population decline actually occurred in Los Angeles County last year. It was slight but it did occur. And it’s likely to occur this year and over the next few years especially if the economy hits a soft patch.

Is Negative Population Growth a Concern?

Although the state could use a little of this, we have to be weary of a persistent decline in population that many of the Northern California Counties find themselves experiencing right now. Lassen, Plumas, Sierra, Del Norte, Alpine, and Tuolumne are just some of the counties with persistent declines in population, due largely to the out-migration of the 25 to 44 year old age cohort. As this occurs, there are less workers available to fill jobs needed to provide goods and services to the remaining older populations, aged 65 and above.

That’s not likely to occur in Coastal California or Southern California but a few years of
negative population growth would reduce the growth of demand for housing, and market prices would adjust. But this won’t happen because as prices start to contract populations from outside the state would pour in to buy homes with falling values, and the growth of population would stabilize or increase again. This is akin to a Dutch auction.

Why is Population Growth Slowing Down?

Well, it’s not because there is a lack of jobs here. We have tens of thousands of unfilled positions right now, and it’s only been increasing for the last 5 years.

The usual suspects for slowing population growth are, of course:

• High home prices due to the dearth of housing
• High taxes, and
• Insane traffic, like at the 101 and 405, or on the 101 transition to Interstate 80 in San Francisco, or on the 880 anywhere. And thousands of other spots in the Bay Area and greater Los Angeles metro area.

But There’s Another Reason

The sharp decline in births to millennials. Last year the birth rate in the U.S. dropped to an all time low, meaning millennials just aren’t having children, choosing instead to work and pay off their student loans rather than potential child care costs. ¹

And the lack of birthing today will ultimately create headaches for baby boomers. The delays in starting families by millennial households precludes the need for them to purchase family housing. And family housing is what the boomer generation owns having raised their family and now wanting to downsize or move to Arizona to play golf.

And what boomers own is not what millennials can afford nor is it what they need, yet.

Consequently, price concessions will have to be made by boomers to sell their homes to a more limited home buying demographic that has been reduced by the absence of millennial families today. Now this may change sooner or later, but it’s not changing yet.

So while lack of home building has contributed to high home prices in California and elsewhere, declining population growth and the postponement of family building by millennials may work to lower housing prices.

But, if you’re tired of crowds at the beach, crowds at the bar, traffic on the 101, crowds at Disneyland or Magic Mountain then embrace the lack of new housing and the high costs of housing because that’s the ticket to a slowdown and perhaps even a reversal in population growth.

by Mark Schniepp
April 2019

With the first quarter of 2019 now in the books, we have a clearer picture of how the housing market is likely to move this year. So I’m taking this generous head start in 2019 to forecast 2019, because, frankly, I’m more likely to get it right.

Jobs are the principal driver of the demand for housing and regional home sales. With near unlimited job opportunities right now together with rising incomes, home sales have nevertheless been unimpressive, and in much of California they declined last year.

The demand for rental housing instead has dominated housing choice, as both Millennials and Boomers look to non-ownership housing. That’s why of course so much more apartment product is being built nowadays. Moving boomer households may actually prefer to rent to avoid all those annoying repairs and those big property tax bills in December and April. And Millennials simply don’t have the down payment.

Existing home sales are forecast to remain at muted levels in 2019 and 2020. The fall-out that occurred in 2018 with sales falling 5 percent in California is unlikely to be reversed this year. This late in the expansion, home buyers are reluctant to buy homes at record high prices with the expectation that a recession is coming. There is still the memory of the 2006-2007 housing bubble and the aversion to buying at the top.

While a lack of inventory has been a constraining factor on home sales in recent years, this year inventory is rising, just about everywhere you look. Consequently, with more supply and a reticence to buy, look for softening prices in 2019.

A meaningful correction in prices is not forecast because the economy will remain strong, incomes will continue to rise, and many households will still elect to buy, especially as interest rates surprisingly move lower.

Year to date, the statewide median selling price is about 2 percent higher than year ago values, though there are price corrections occurring in Ventura, Orange, Los Angeles, San Francisco, Monterey, Santa Clara, and Sonoma Counties.

Our base forecast for home price appreciation does moderate however, and the alternative forecast turns negative if sales fall off further. However, a major correction in prices is unlikely to occur in 2019.

by Mark Schniepp
March 2019

I mentioned this in the previous February newsletter but it’s worth exploring it further because “recession” has become a popular concern and this particular indicator has been relatively fail-safe as an antecedent for recession over the last several economic cycles. It should be noted however that most economic indicators are not signaling weakness in the economy yet.

What Does an Inverted Yield Spread Mean?

An inverted yield curve is an interest rate environment in which long-term debt has lower yield than short-term debt of the same credit quality. It occurs when the 10 year U.S. treasury bond yield less the 3 month U.S. treasury bill yield turns negative. This is the conventional spread that is typically evaluated. Alternatively, other analysts use the yield spread between the 10 year and the 2 year T-bill.

An inverted yield curve predicts lower interest rates in the future. The belief that the economy is weakening moves investors to demand longer-term bond yields to lock in those rates. This sends the yields down. Since investors are not buying short term bills, their yields ultimately rise. And since the fed has raised the federal funds rate several times, short term rates have risen.

Clearly then, inverted yield curves occur when investors are bidding for longer-term bonds and thus driving down their yields because they are pessimistic about the short-term prospects for the economy.

There is pretty convincing evidence that inverted yield curves, with short rates higher than long rates, predict recessions. Presently the yield curve is not inverted regardless of which spread we use. There will be a prediction of recession when the spread inverts usually for a period of 2 to 3 months.

Is the Yield Curve Actually Close to Signaling a Recession?

Yes the spread is on a path heading straight for an inversion. We are near to that situation but we’re not there yet. If it remains on its current rate of trajectory, an inversion would occur this summer. However, right now the yield curve is not inverted regardless of which spread is used: 10 year less the 3 month, 10 year less the 2 year, or 5 year less the 3 month. Importantly, there is only a prediction of recession when the T-bill yield on shorter term debt exceeds the yield on longer term debt. So at this moment there is no forecast of an imminent recession in 2019 or 2020.

Furthermore inversion does not spell immediate doom. The evidence is that inverted yield curves, with short rates higher than long rates, predict recessions. Over the last 5 business cycles, the average recession occurred 11 months after the spread turned negative. The range is between 5 and 17 months.

When Will There Be a Recession?

While there will be a recession at some point, the issue is always when.

To repeat, currently the yield curve is not yet predicting recession but moving towards the point where recession would seemingly be imminent sometime over the next 24 months. And though an inverted yield curve has been a consistent predictor of recession since the 1960s, there is always the possibility of a false signal.

I think it’s also important to consider other indicators in the economy, such as the leading indicators index and the Risk of Recession index. Also consider the movement in stock market values.  None of these indicators is predicting recession this year.

by Mark Schniepp
February 2019

Last month I presented the outlook for 2019 and a recession was not part of it. Now just to be clear, a recession is coming, not this year but early in the next decade. It’s unknown what event or issue will serve as the tipping point, but any one or combination of conditions could weaken the economy and make it vulnerable to a downturn in growth.

The candidates I’ve been watching closely are:

• The headwinds in retail
• The trade wars
• Slowing GDP growth in China
• The stock market correction
• Faltering home sales
• Interest rates, and
• Credit spreads

Warning Signs

The Trade war has affected both agriculture and some manufacturers.

General Motors announced in December that it was slashing production at American factories. GM pointed to tariffs on steel and aluminum in its recent decision to close several factories and cut thousands of jobs.

The recent sell-off in the stock market was the sharpest since September 2011. The tech giants (Facebook, Amazon, Alphabet (Google), Apple, and Netflix have lost nearly a trillion dollars in market value since September.

The turbulence is perhaps an early warning sign by investors who are worried about the sustainability of current economic growth in view of

1. Fed interest rate policy, and
2. A noteworthy deceleration of the Chinese economy

Apple is cutting iPhone production to China, due to a weaker economy there. This is a bellwether sign. China is the third largest market for Apple, behind the U.S. and Europe.

Furthermore, tight labor markets are pushing wages and salaries higher, and this is impacting corporate profitability. Profitability reduces earnings, and lower earnings result in lower stock prices. Lower stock prices reduce household wealth and I’ll discuss that further below.

The Retail Sector

Consumer behavior is changing and the way we buy goods is going through a dramatic shift. Retail real estate is desperately trying to adapt with the departure of department stores and malls now renting to big box tenants. There are more restaurants, office users, and recreational activities in traditional retail spaces. Empty space is not necessarily piling up. There are many new retail successes among the growing wave of failures. It does not appear that the so called “retail apocalypse” by itself will crash the system.

Trade Wars

Reportedly, China is willing to resolve trade disputes with the U.S. A ceasefire on further tariffs is currently underway as agreements on trade issues are being negotiated. Though the trade war is a problem for U.S. exporters and it’s a red flag for the economy right now, I’m not too worried that the trade war will remain a growing problem that could lead us into recession.

Housing

Home sales are weak nationwide. In California, new housing is not keeping pace with commercial and industrial development. Consequently, California has predictably ended up with less new housing and sharply higher housing values. Higher home values are currently indicative of most robust regional economies in the nation.

And though higher housing values are making homeowners happy, they are slowing down the new and existing home sales markets, along with marginally rising mortgage rates.

The housing slowdown in and of itself won’t likely derail the economy, but it represents another sector that would weigh negatively on GDP growth and jobs in finance and real estate.

The Wealth Effect

The decline in stock market valuation has evaporated billions of dollars in household wealth. And through the wealth effect, consumer spending is interrupted by declines in asset values that represent household wealth. This includes home prices and stock prices. Declining values could overwhelm the positives that are now powering consumer spending and much of the economy, so the stock market is a key indicator for economists to watch closely.

If stock prices fall further in 2019, consumer spending could be meaningfully impacted and the risk of recession will certainly rise.

Foreign Trade

The fiscal stimulus in 2018 enabled U.S. companies to shake off signs of slower growth in China, Japan, Germany and elsewhere.

That stimulus won’t have the same impact in 2019. So investors worry about future growth, 2019 corporate earnings and 2019 profitability.

China is the third largest importer of U.S. goods and services representing over eight percent of all U.S. exports. Slowing Chinese growth is a drag on world GDP growth meaning a drag on U.S. GDP growth as well, due to less production of goods and services going to China. Lower growth rates for other countries exporting to China further slows our exports to those countries. This represents another potential crack.

Oil prices are sliding despite cuts in production by Saudi Arabia, one of the largest producers in the world. Why? Because everyone else is maximizing their production. Softer oil prices are good for consumers and the airlines, but bad for oil companies who employ thousands of workers worldwide. Falling oil prices won’t derail the economy but would likely produce energy sector layoffs and volatility in energy stock values.

Interest Rates

The Fed was poised to increase short term interest rates three more times in 2019, and perhaps a fourth time as well, pushing the federal funds rate to as high as 3.5 percent by the end of the year.

Higher rates reduce the demand for goods in interest rate sensitive sectors, such as housing and automobiles. They increase debt service levels and business credit costs in general, i.e., the cost of financing business operations and/or expansion plans.

But on January 30, the Fed issued a statement that surprisingly altered its course from one of normalizing interest rates to one of “patience” with interest rates as it evaluates the economy in 2019.

Economist Mark Zandi of economy.com predicted: “ . . . If the stock market fails to rally from here, it is possible there would be no [further] rate hikes in 2019. And, if stock prices fall measurably further, the slowing in growth could even force the Fed to ease monetary policy by the end of the year.”^[1]

Even Fed chair Jerome Powell said himself, “The case for raising rates has decreased somewhat.”

A more dovish monetary policy stance along with inflation being a non-issue has led investors to buy both stocks and long term bonds, rallying the stock market over the last month and depressing longer term interest rate yields again.

Consequently, as of now, it does not appear that interest rates will lead to the possibility of a weaker economy in 2019.

Finally: Credit Spreads

Bond investors are now demanding high yields for the higher risk they perceive on government treasury bills or are selling short term paper to buy longer term notes.

The yield curve, as measured by the spread between short-dated yields and longer term bond yields, has steadily flattened towards “an inversion.”

An inverted yield curve has a pretty reliable reputation as a precursor to recession, Right now, the spread between the two is 27 basis points, the narrowest spread since August 2007.

This is a signal we can’t ignore because it’s been correct in predicting the last seven recessions.^[2]

Even when it turns negative, the yield spread doesn’t signal immediate doom. Over the past 60 years, inversions have occurred anywhere from five to 17 months before the downturn in GDP growth. The average time period is 11 months.

Now, no one can predict a recession based on the inversion of the spread. Just predicting when the spread goes negative is a presumptive endeavor. But I’ve never been accused of avoiding presumptive behavior so here’s my guess:

At the current pace of a narrowing spread, it would turn negative as early as this summer and as late as March 2020. That would imply a recession as early as the second quarter of 2020 and as late as the first quarter of 2021. What would cause a recession sometime between mid 2020 and early 2021? We don’t know yet.

———-
^[1] Mark Zandi, “2019 U.S. Outlook: From Virtuous to Vicious Cycle,”, Moody’s Economy.com commentary, January 2, 2019

^[2] https://www.washingtonpost.com/news/wonk/wp/2018/06/28/people-are-worried-about-these-economic-warning-signs-they-can-relax-for-now/?utm_term=.9c2c8e718a46

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