Some people in the US are destined to lose a LOT of money in real estate over the next ten years because deflation in bubble assets will happen; markets will ultimately reflect underlying fundamentals. China is the perfect example of this reality after decades of housing being a one-way bet to financial gain. Today, the meltdown in the Chinese housing market shows no sign of abating. Ultimately, I expect a similar move in the US, albeit far more subdued than the insanity that prevails in China.
In the US, housing has been driven by the Baby Boom generation since the 1970’s and sent into overdrive with the 35 years of the Fed’s asset inflation policies. Like the US, China’s housing market was driven by demographics as a major consuming cohort came into the economy. The Chinese housing market hit its crescendo with the lead up to Covid while the US seems to have peaked in the days following Covid.
Demographics
Some calamities – the 1929 stock market crash, Pearl Harbor, 9/11 – have come like summer lighting, as bolts from the blue. The looming crisis of America’s Ponzi entitlement structure is different. Driven by the demographics of an aging population, its causes, timing, and scope are known – George Will
Over the past 30 years, markets have behaved as if the economy follows a linear path upward. The current circumstances reflect an implied belief that the US government will be able to borrow and spend forever while the standard of living in the US will continue to improve as it has since the 1960’s.
Instead, the world runs in cycles – always has and always will. The big fear around the globe, and perhaps the explanation for the illegal immigration movement, is that debt-laden countries are running out of people to service that debt. It’s as if decision makers are so intently focused on fixing one variable that they ignore the problems they are creating with these policies.
Regardless, the people entering Europe and the US lack the skills and the education to take both economies to the next level. They lack the wealth generating capacity to maintain the values of the housing stock in the US at current levels, much like China’s young people lack the opportunities of their parents and are thus, unable to maintain the Chinese housing market. In both cases, the market is running out of people to propel prices higher and in the case of China, the demographic problem is so bad that they lack the people to keep the market from collapsing. This is clear when we review the population pyramids of both nations.
The US was a bit fatter around the waist in 1990, reflecting an opportunity to inflate asset prices for the Baby Boomers and GenX’ers who were about to get comparatively wealthy. In addition, the large cohort of college-educated workers were positioned correctly for advances in finance, science, medicine, and technology, which propelled the US economy towards the higher value-added economic activities. This rising income made the strong housing market possible.
By comparison, China was bottom heavy with the promise of a vast cohort coming into its most productive stage of life, albeit comparatively low-skilled. China’s workforce was an untapped global cost advantage waiting to be levered. Thanks to limited investment opportunities and financial repression, Chinese industrialists had access to cheap, plentiful capital for expansion and a world of global corporations willing to trade know-how for market access.
Once China reached the point of saturation in its industrial base, the next step was to over-build their housing stock, which would then create new demand for the industrial manufactures. They created a virtuous cycle for both China and the global economy that was destined to peak along with the Chinese population.
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By the early 1990’s, Chinese municipalities were experimenting with private ownership of real estate and by 2000, the bubble was in full swing. This was around the time that the US government pushed home ownership for everyone as a means towards maintaining the US economy following the 2000 tech crash. The result in both nations was aggressive bubble-building economic activity.
China’s demographic explosion was a one-time boost thanks to the one-child policy from the 1980’s. The older generation has nobody to sell their property to, even if the economy did not suffer from extreme misallocation of capital.
The US has a somewhat similar problem but not nearly as bad. The Baby Boom generation has invested heavily in the housing stock all along its life cycle. They were fortunate to be able to sell their homes from their more productive years to younger generations but I don’t have the same expectation for their retirement homes as those retirement homes tend to be located away from industry.
With subsequent generations not enjoying the comparative levels of income at earlier ages, combined with the negative impact of education loans, I question whether those retirement homes will be marketable in future years. That’s a tremendous amount of wealth with questionable fundamentals.
Regional Government Impact
I do not think it’s an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments – Friedrich von Hayek
The Chinese bubble was fomented by local governments to generate revenue by selling real estate development rights. Ultimately, this source of funds reached 30% of municipal revenues. The local bureaucracies grew fat and wealthy and were able to set the price of new apartments based on the needs of municipal budgets as opposed to market demand. When I learned this ten years ago, I KNEW the crash would be ugly when it finally arrived, even as it lasted far longer than I thought possible. Such is the nature of government exigency.
US state and local governments depend on the expansion of real estate values as well. In this way, they represent a competitive market to attract businesses and home buyers as they compete against each other for the right to extract rent from asset values. This should be apparent from the chart below.
What do you think would happen to local governments if we experience deflation in housing prices? The Fed saved the banks in 2008/2009 with quantitative easing but they also saved state and local governments from a fate similar to what China’s regional governments are experiencing.
Regions go into death spirals when they lose their tax base. First, they lose employers, which forces people to leave the region in search of work. Second, they lose their services because service providers need a minimum amount of revenue to break even. With every person that leaves a regional economy, the costs of service – both private and public – needs to be spread over fewer people.
Ultimately, taxes on property rise to offset losses even as the number of services decline. Schools lay off staff, reducing the quality of education, and police protection is reduced, inviting crime into the region. We’ve witnessed this happen across the Rust Belt, the Hudson River Valley, and old industrial cities like Newark, NJ. The more people leave, the sharper the drop in property prices. Perhaps the most extreme example is Detroit Michigan which went from the highest per capita city in the nation in 1960 to virtually uninhabited.
It has happened before and it will happen again. But don’t expect the government to allow markets to clear without a fight. The Fed still has 500 basis points until we get to the 0% lower bound, more if they are willing to take interest rates negative.
Vice President Harris announced her plan to give first-time homebuyers a $25,000 down payment for a house. Yes, the policy would have disastrous consequences but desperate times call for desperate measures.
We can see from the two charts below that housing prices correlate strongly with the US federal deficit. Coincidence? Not likely.
Even investment funds from companies such as Blackrock have the ability to “gate” or block withdrawals so that these illiquid assets can be liquidated in an orderly manner. My point is that people are starting to forecast a collapse in home prices yet there are significant barriers to exit that can prevent an immediate decline in prices. It will happen but the timing may be drawn out like we’re seeing in commercial real estate.
The Chinese housing crisis is roughly two years old at this point and we’re far from near the bottom thanks to extraordinary intervention. Neither population has the income to propel housing upward but the trip to the cellar will likely prove circuitous.
Investors
Until recently, investors chose to jump on the housing bandwagon because most assume that housing is a hedge against inflation. It worked in the 70’s, so it has to work this time. Right?
When prices started to jump during Covid, the prevailing explanation was that people were looking to escape the restrictions of Covid and the municipal policies to fight it. While initially true, this theory doesn’t explain the sharp rise in the value of the housing stock indicated by the two charts above, particularly the move since 2022.
Correlation is not causation but the rise in US federal debt seems to correlate strongly with asset values in general going back to the GFC, or Great Financial Crisis. People see the federal deficit spiraling upwards with government spending seemingly out of control and they naturally assume it’s inflation. Heck, even the Federal Reserve saw it after a while.
People like to blame Wall Street money for this sharp rise in the value of the housing stock but the major driver was investors owning 10 homes or fewer. The major driver was mom and pop investors. Some wanted to front-run inflation, while some bought into Airbnb and other expected social consumption changes.
Regardless of the reason, the decision to purchase housing is starting to hurt investors, particularly the ones late to the game. Airbnb is starting to bust thanks to rising costs, falling demand for travel, excess competition and because local governments are passing laws to restrict short-term hospitality in residential areas. Cash flow is turning negative for many, forcing them to place properties on the market – at the same time.
Yes, Blackrock funds, not Blackrock itself, own a ton of homes. So do a lot of other professional investors. As of March 2024, Blackrock funds own 84,567 homes out of approximately 82 million single-family homes in the US. That’s around 0.1% of total US homes and while change occurs on the margin, that’s not enough beneficial ownership to change the calculus of the national housing market to the degree reflected above. I view Blackrock and other fund buyers as the marginal buyers at the top of the bubble who will be the first to dump. Blackrock and the other professionals merely sold a product the market demanded. That said, they’ll ultimately get vilified for the crash.
Consumers
There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich – Charles Kindelberger
Americans have more housing than they can afford thanks to the innate desire to “keep up with the Jones’s” or better yet, exceed them. This has been going on for generations but really took off starting in the late 1990’s. Housing is more than just the utility of comfort from the weather, it’s a source of competition for status in society.
Chinese society was no different. In fact, they may have been worse for a time but no longer. Chinese homeowners are deep within a downturn that promises to drain them of their wealth. They are two steps ahead of US homeowners on the downward spiral but I won’t concentrate on them here because Chinese economic data is useless.
Comparatively, US homeowners are in pretty good shape but the change on the margin appears to be heading lower at a time when household finances are vulnerable. The two charts below show a consumer that is highly leveraged, particularly when it comes to revolving debt – mostly credit cards.
When you consider that credit card debt is approaching 30% interest rates, the chart shows a consumer who is desperate. Yes, much of that debt will be eliminated in bankruptcy and that’s where we’ll find out who the bagholders are. Regardless, the two above charts are not reflective of consumers with the capacity for furthering the housing bubble. But it gets worse.
Below are two charts that reflect the impact of inflation on households. Like the credit card data, the chart on the right of real personal consumption expenditures relative to real gross domestic product tells us that either the government is undercounting inflation or overstating real GDP. This is because a decline in real median household income should result in a decline in real personal consumption expenditures.
The near doubling of transfer payments over the past ten years tell part of the story but those transfer payments are picked up in household income which are now roughly 18% of personal income. Yet despite the sharp rise in transfer payments, real median household income has been declining since 2019. Perhaps more than anything, this dynamic portends the approach of a consumer-led economic downturn. Given the high cost of mortgage service expenses, we may witness a sharp rise in housing inventory hitting the market before long.
We can triangulate the above thesis with auto sales which have declined since 2019. Auto sales are down roughly 9% since 2019. We also know that vehicle repos have been exploding of late suggesting household cashflow may be worse than reflected in the broad data. And then there are mortgage applications…
The chart to the right shows mortgage applications for purchase and they are dropping rapidly! Interest rates are part of the story, as is the ridiculous level of housing prices and that suggests two things.
First, the Fed is going to cut interest rates. Yes, they have already indicated a September rate cut but it won’t end there. More on this topic below.
Second, the fact that people aren’t applying for mortgages tells us that they are tapped out; they can’t afford a new home, in general. This suggests that prices are going to fall before much longer. The sharp rise in home prices driven by investors will be reversed before much longer. The pace of home prices falling will depend on how quickly investors move to liquidate.
Interest Rates
KISS – Keep It Simple Stupid – Kelly Johnson
I’ve been saying for a few years that the Fed would come to deeply regret having raised interest rates in response to inflation. Unfortunately, Congress forced their hands by approving the wrongly named Inflation Reduction Act of 2023 and the Consolidated Appropriations Act of 2021. The CARES Act of 2020 was at least defensible given the Covid lockdowns but the subsequent two spending bills fueled the inflation were are presently experiencing.
Both acts were pure fiscal pork and together, they forced the Fed to act against the best interests of the country. Now, we are going to experience the negative impact of those rate hikes that were previously hidden by fiscal largesse.
The simple truth is that the US economy is addicted to lower interest rates thanks to the start of quantitative easing in 2009. The growing pressures on real estate and consumers are coming together rapidly. I expect things to fall apart over the next six months as really bad economic headwinds hit the US and the global economy at the same time. It’s why I expect interest rates to head to 0% around the world.
Normally, a sharp move lower in domestic interest rates would be bad for the dollar but I expect the opposite. I believe the dollar is going to spike and that it’s sitting at the lower end of its range, coiling for a sharp move higher. If you have read any of my past work, I believe that investment decisions in the Eurodollar markets, particularly in China, have created dollar deflation around the world. My thesis is that we have a domestic surplus of US dollars and a global shortage of Eurodollars, most notably in China.
This will be the final nail in the coffin for China because they won’t be able to export their way out of current economic and financial problems. The Japanese markets are telling us that we’re getting closer.
Conclusion
Successful investing is anticipating the anticipations of others – John Maynard Keynes
We’ve been living on “borrowed time”, economically speaking, for 15 years as we never purged the financial mistakes from the markets that prompted the Great Financial Crisis. Instead, we made them much worse while training a generation of Americans to go further out on a limb financially than what is prudent.
But with the dire prediction in place, declines in asset values rarely follow a predictable path and with the Fed having 500 basis points of room to cut interest rates, there are still significant barriers to a crash in housing prices. We’ve been trained to “buy the dip” for the past 25 years, so why not this time?
The Chinese housing situation is many times worse than the problems in the US and there are still people willing to buy homes in China at these still elevated price levels. The total collapse hasn’t yet occurred in China and I believe we’ll have to wait until 2025 before we see conclusive evidence of real weakness in the US housing market.
When I see tons of analyses of a decline in the housing market, like I see today, I’m forced to conclude that it’s going to take a little longer than most expect. Unlike 2008, this won’t be catching anybody by surprise which means that institutions have it on their radar as does the Fed and US Treasury.
