The Bear’s Lair: Losers from higher rates

The August Consumer Price Index’s rise of 5.3% over the preceding year demonstrated that inflation is far from a transitory phenomenon. In these circumstances, it is likely that the Fed will attempt to hold rates close to zero for as long as possible, and then raise them too slowly to prevent inflation from accelerating further. This environment, of rising nominal interest rates and steadily or even increasingly negative real interest rates, is likely to have some anomalous market and economic effects. In this piece, I shall attempt to determine what those effects will be, as a warning to readers.

There are clearly some items in the CPI whose inflation is transitory. Used car prices declined during the month after a 34% increase in the preceding year; the extraordinary inflation in used car prices beyond those of other goods is almost certainly a function of Covid-19’s effect on the auto industry and will not persist long-term. However other price rises, notably the nearly 20% rise in house prices and the nearly 10% rise in rentals over the year, are not reflected in the month’s CPI figures at all, which consequently do not reflect the true rate of inflation actually experienced by consumers.

There are two additional reasons why the August CPI figures may have been “adjusted” to reduce the reported rate of inflation. First, the indexing of Social Security payments for 2022 will be based on the September 2021 figures and if current trends are continued will result in an increase in almost all social security payments of around 6.1% for the whole of 2022. That is an extraordinarily high figure, presumably due to last year’s social security payments increase having been somewhat suppressed. It will throw the actuarial balance of the social security system out of kilter, worsening the system’s cash flow drain and pulling its bankruptcy date forwards towards 2030.

Second, Fed Chairman Jerome Powell wants to be reappointed to a second four-year term from January 2022 and will therefore want to avoid rocking the boat until that reappointment is confirmed. President Biden probably wants to reappoint him, because the alternative would be to appoint some Trotsky figure beloved of the Democrat party’s “woke” left. While Biden would happily appoint Trotsky to the Fed, he can’t take the risk that Trotsky might cause an even bigger disaster to erupt before November 2024 than the one that is coming anyway. So, both sides in the reappointment process are united in wanting low CPI figures for August and September. If Powell has been reappointed by then, look for a really excitingly high October CPI figure, reported in early November, together probably with some “revisions” of previous months’ figures.

The current inflation is mostly caused by the Fed’s policy of artificially low interest rates, and the 27% increase in the M2 money supply in the year after Covid-19 struck. In addition, the Fed’s purchases of Treasury and mortgage bonds have allowed the Treasury to run an extraordinarily large budget deficit, about 15% of GDP, similar to that run by Britain in 1797, the Napoleonic Wars year in which the country suspended gold payments and almost defaulted. Continuation of anything like the current monetary policy will cause a steady rise in inflation – making real interest rates even more sharply negative – while correcting it would cause a sharp rise in interest rates, crashing the stock market (which is why the Fed will do almost anything to avoid that). In addition, budget deficits around the current level seem likely to persist or even worsen so long as Joe Biden is President (not that President Trump was much better in this respect).

Thus, real interest rates are likely to stay sharply negative for the foreseeable future, while rising inflation causes the Fed to make feeble attempts to restrain them and nominal rates creep slowly upwards. For several years, we are thus likely to have an environment of gently rising nominal interest rates, substantial inflation and sharply negative real interest rates.

This will have a number of non-obvious effects. For one thing, it will encourage the formation of SPACs, which will find themselves better able to compete with conventional private equity for new asset-acquisition opportunities. That is because private equity relies on leverage, but in an environment of rising interest rates, leverage becomes steadily more expensive and difficult to obtain – bondholders are after all being asked to incur an ever-widening loss on their holdings, as rates rise. Hence the SPACs, which are pure equity and have no financing costs will have an advantage over leveraged private equity companies.

Real estate should do well in an inflationary environment; it is after all a “real” asset and should increase in value in nominal dollars. However, it suffers from the same problem as private equity: it is often financed by the use of leverage. I remember early in my banking career looking at a portfolio of U.S. warehouses owned by a major developer, which had run into difficulties because the financing costs at then-prevailing interest rates had come to exceed the rental income, when operating costs were deducted. Real estate with a perfectly good yield of say 6% becomes underwater on an operating basis if interest rates on long-term real estate financings rise to say 8% — it does not matter what the inflation rate is; the cash flow can kill you before the inflationary value uplift arrives.

In personal home ownership, the same problem arises. I remember in 1980-81 discovering I was unable to buy a house because the banks looked at my quite substantial income, applied a factor based on then prevailing mortgage interest rates of 14% and told me I could borrow less than my income on a mortgage. They were being idiotic, but this was the retail division of a large bank, so idiocy was to be expected. At the very least however, the fancy “stretch” mortgage availabilities by which asset-poor Millennials have bought overpriced urban real estate will no longer be available; nobody will lend you 6 times your salary if the interest rate you are to pay on your mortgage is even 7%.

Since there will be fewer buyers and some forced sellers, real estate values will decline, to a greater extent than stock values, or values of other assets that are typically purchased without leverage. Urban residential real estate in the expensive “starter home” category in gentrifying areas will be worst hit; there will be far fewer buyers able to afford it. Bye-bye, Williamsburg; you guys better take a look at Poughkeepsie! (Oh no, please don’t — you’re liberal Democrats; if you come here you’ll wreck the local government, as you have in California.)

Other assets will be less badly affected. Stocks, for example, will benefit from higher earnings and faster growth in nominal earnings (so the dozy analysts will push up valuations). The exceptions to this are financial sector stocks; their earnings are not indexed to inflation, and their funding costs will rise as fast as their revenues, if not faster. For non-financial companies, inflation will enable managements to play games with inventories, holding them for long periods, to record a profit when they are sold at higher prices. Corporate managements: ask your grandfathers who were in management accounting in the 1970s; they will tell you how the game is played! Art and other collectibles should do well; they are generally not bought with much leverage, and rising prices will form a self-fulfilling prophecy.

Companies that have indulged in excessive stock buybacks will get in trouble. With interest rates rising, their excess debt will weigh on earnings and cash flows. Conversely, stocks that have kept their shareholder base and paid out the majority of earnings as dividends will do well; the dividend yields will be especially attractive to investors because they will tend to rise with inflation, unlike debt interest.

Eventually, of course, all this will come crashing down. Either the Fed will have to raise interest rates above the rate of inflation, causing many valuations to collapse as real interest rates will become positive again, or inflation will spiral off into the stratosphere, making the United States a replica of Argentina. In Argentina, the consumer price index currently stands at 510, on a basis of 2016=100, and the peso has depreciated by 430 trillion to 1 against the dollar since 1914. In that situation, savings are worthless and the populace becomes steadily impoverished, except for crooks and speculators. Whether the Fed will bother enough to avoid that fate is an interesting question.

The situation of gradually rising inflation and negative real interest rates can only last for a decade or so, before being rectified or degenerating. However, we all have to eat during that decade, so it is worth remembering the rules. Real assets are good, better than they were previously, but leverage, which has been so worthwhile for so long, is now bad.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)