Bears and Butterflies
No that title is not an oblique reference to chaos theory and the idea of a butterfly in Tokyo fluttering it wings and creating an avalanche in Switzerland. That is another blog. This title is in reference to Madame Butterfly, Puccini's brilliant opera about a Japanese maiden naively trusting the big, bad ugly American naval officer. This is also not a socio-political rant, that is also another blog (or at least a later part of this one). What I am referring to is the vision of looming destruction which Puccini lays out very early in Act I and which never fails to command the viewer's attention, no matter how many times this work has been seen. For those unfortunate enough to have missed the pleasure of this great work, Lt. Pinkerton takes a 15 year old geisha nicknamed "Butterfly" as his Japanese "wife", not for a minute taking the commitment seriously. His bride, on the other hand, takes it with deadly seriousness (of course, would it be opera if no one died?). It is not just the musical achievement which keeps the spectator enthralled, but the impending doom, which everyone but the two principals can see.
It seems as though we have reached a similar point in the global (read US-centric) economy. Most, if not all, players seem to realize that something is wrong. Some people are even beginning to openly wonder if something is seriously wrong. But like the supporting cast in Madame Butterfly, virtually no one is capable of comprehending the scope of the imminent disaster. The real estate bulls confidently state that the market has now returned to normal and that we should expect historically typical returns in the single digits, positive single digits, of course. Not many, except for Barron's, are capable of contemplating the possible that housing prices may actually decline. Especially, when the supply/demand balance is rapidly shifting in the opposite direction of what it has been for the last five years. And as the article in Barron's suggests, it will likely only get worse if the %40 drop in asking prices in some markets causes more owners of vacation and second homes to head for the exits. And yet, the building continues and why shouldn't it? The housebuilders are in the business of building houses! What do they care if last year's customers paid 10% more than they are asking for the same pile of lumber? That is probably still about a 44% margin compared to last year's 50%. In other words, as long as it is clearly profitable to build houses, the housebuilders are going to build houses. Or in more other words, until housing prices fall 50% or more in the hottest markets in the US, they will continue to build and build and create an even larger glut which will take even longer to absorb (if we ever do absorb it all). Up until recently, I have been of the opinion, that the most overvalued markets, like California, Phoenix, Las Vegas, Boston and Miami would need prices to fall by two thirds. I am now starting to believe that I have been too optimistic. I don't think I can even fathom how low prices could eventually go, but after visiting Phoenix for the first time recently, it seems that at some point it will simply make sense to bulldoze some of the buildings which may have been erected only months earlier. Yes, I know it sounds insane, but what has been occurring in the country (as well as others) for the last five years makes insanity look respectable. When your income is basically flat and the price of your house has doubled or even tripled, something has to give. It is a simple formula, and I am only able to understand simple formulas. "But housing affordability is at normal, even historically high levels!", the bulls cry. "That is only because interest rates have been pushed to artificially low levels.", I respond. But that condition is being remedied. Yet, that remedy may have further to go. At the very least, the Fed may not be in a position to lower rates to ridiculously low levels as it has every time the economy started to get a little winded. Although I do not know how it will play out, it seems likely to me that short-term rates will likely stay relatively high, regardless of whether they have reached a peak or not. (My gut instinct is that there are one or two more rate hikes coming from the Fed). The point is not really how high rates go, but that it is too late, regardless, because they have been kept too low for too long and too much excess liquidity has been created that one way or another, this mess is going to have to be cleaned up! The two camps are that the Fed will err by hiking rates too high after lowering them too much and cause some sort of deflationary recession or that they will not have the courage to be agressive enough and we will experience an inflationary crisis. I prefer the middle way: we will alternately have both of the above scenarios. I would imagine that the bubbles will start to deflate under their own pressure and at some point (probably next year) that will cause the Fed to be concerned about deflation again (possibly reasonably so) and they will attempt to "reflate". But a couple of hundred million Asians, as well as a hundred million Middle Easterners, a hundred million or so Russians and even a few million Venezuelans and Nigerians may balk at accepting these "cheap" dollars for their oil, autos or manufactured goods that we must import even if our economy is in freefall because we have a "service" economy. (Frankly, I am tired of getting "serviced", if you know what I mean!)
It is at this point when the finale will be played out, but when this fat lady sings the roles may be reversed, with the American paying the ultimate price and the Asian sailing off into the sunset.
It seems as though we have reached a similar point in the global (read US-centric) economy. Most, if not all, players seem to realize that something is wrong. Some people are even beginning to openly wonder if something is seriously wrong. But like the supporting cast in Madame Butterfly, virtually no one is capable of comprehending the scope of the imminent disaster. The real estate bulls confidently state that the market has now returned to normal and that we should expect historically typical returns in the single digits, positive single digits, of course. Not many, except for Barron's, are capable of contemplating the possible that housing prices may actually decline. Especially, when the supply/demand balance is rapidly shifting in the opposite direction of what it has been for the last five years. And as the article in Barron's suggests, it will likely only get worse if the %40 drop in asking prices in some markets causes more owners of vacation and second homes to head for the exits. And yet, the building continues and why shouldn't it? The housebuilders are in the business of building houses! What do they care if last year's customers paid 10% more than they are asking for the same pile of lumber? That is probably still about a 44% margin compared to last year's 50%. In other words, as long as it is clearly profitable to build houses, the housebuilders are going to build houses. Or in more other words, until housing prices fall 50% or more in the hottest markets in the US, they will continue to build and build and create an even larger glut which will take even longer to absorb (if we ever do absorb it all). Up until recently, I have been of the opinion, that the most overvalued markets, like California, Phoenix, Las Vegas, Boston and Miami would need prices to fall by two thirds. I am now starting to believe that I have been too optimistic. I don't think I can even fathom how low prices could eventually go, but after visiting Phoenix for the first time recently, it seems that at some point it will simply make sense to bulldoze some of the buildings which may have been erected only months earlier. Yes, I know it sounds insane, but what has been occurring in the country (as well as others) for the last five years makes insanity look respectable. When your income is basically flat and the price of your house has doubled or even tripled, something has to give. It is a simple formula, and I am only able to understand simple formulas. "But housing affordability is at normal, even historically high levels!", the bulls cry. "That is only because interest rates have been pushed to artificially low levels.", I respond. But that condition is being remedied. Yet, that remedy may have further to go. At the very least, the Fed may not be in a position to lower rates to ridiculously low levels as it has every time the economy started to get a little winded. Although I do not know how it will play out, it seems likely to me that short-term rates will likely stay relatively high, regardless of whether they have reached a peak or not. (My gut instinct is that there are one or two more rate hikes coming from the Fed). The point is not really how high rates go, but that it is too late, regardless, because they have been kept too low for too long and too much excess liquidity has been created that one way or another, this mess is going to have to be cleaned up! The two camps are that the Fed will err by hiking rates too high after lowering them too much and cause some sort of deflationary recession or that they will not have the courage to be agressive enough and we will experience an inflationary crisis. I prefer the middle way: we will alternately have both of the above scenarios. I would imagine that the bubbles will start to deflate under their own pressure and at some point (probably next year) that will cause the Fed to be concerned about deflation again (possibly reasonably so) and they will attempt to "reflate". But a couple of hundred million Asians, as well as a hundred million Middle Easterners, a hundred million or so Russians and even a few million Venezuelans and Nigerians may balk at accepting these "cheap" dollars for their oil, autos or manufactured goods that we must import even if our economy is in freefall because we have a "service" economy. (Frankly, I am tired of getting "serviced", if you know what I mean!)
It is at this point when the finale will be played out, but when this fat lady sings the roles may be reversed, with the American paying the ultimate price and the Asian sailing off into the sunset.
posted by Matt Butler at 8:54 PM
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