Inflation Puts Fed Between Rock and a Hard Place

Hardly a day goes by when investors don’t get a dose of bullish news about the real estate market and the spectacular gains being made in home prices within most regions of the country.

Now with the Fed looking to taper as inflation reaches levels not seen in 39 years, it makes one wonder how the U.S. central bank plans to frame its policy statement at this week’s Federal Open Market Committee (FOMC) meeting without upsetting the market too much. When Fed Chair Jerome Powell offered his assessment of speeding up the taper to a Congressional committee on Nov. 30, it effectively sparked a 5.2% pullback in the S&P.

Powell also stated, “It’s probably a good time to retire using the word transitory to describe inflation.” The hot 6.8% rate for November may have resulted in a negative market reaction had Powell not jumped in front to caution markets, as well as lay out an action plan to dial back quantitative easing (QE).

It is fascinating to see how well the market is trading against what are two counter-intuitive trends, rising inflation that has yet to peak and declining consumer sentiment heading to levels not seen since the last two recessions. On the one hand, home prices and retirement plans are enjoying solid gains, providing for a stiff tailwind to those who are fortunate enough to own one or both asset classes.

On the other hand, a survey conducted by PYMNTS and LendingClub this past June found that about 54% of Americans live paycheck to paycheck. Sixty percent of millennials making less than $100,000 are living paycheck to paycheck, and nearly 40% of high earners — those making more than $100,000 annually — said they live that way.

A typical 35-year-old millennial in a hot job market is struggling to balance a mortgage on an inflated entry-level home, student loans and raising a couple kids, leaving little margin for big purchases like cars or unexpected emergencies. This generation of household creation is facing an affordability crisis, if not already in the midst of it. Wages and salaries are not keeping pace with exponential increases in living costs.

Much of the time, generating a $100,000 household income requires that both partners are working, and having to bear the rising cost of childcare. As a byproduct of these cost-of-living increases, the middle class is rapidly shrinking. The national median family income in the United States for 2021 is $79,900, and after-tax purchasing power is shrinking fast, according to www.huduser.gov.

And while this is a glaring problem facing most Americans, the market continues to trade higher, fueled by liquidity and global capital flows into U.S. stocks. The Fed is still pumping $105 billion into the money supply in November and $90 billion this month, while the European Central Bank (ECB) is averaging $95 billion per month in QE and other global central banks are still binging on a steady monthly diet of QE. 

And it takes three to six months before new stimulus created today makes its way into and through the financial system. Hence, fund flows into stocks will be a huge force for many months after the Fed discontinues QE. The Fed’s balance sheet has mushroomed towards $9 trillion as of November, and the annual cost of interest on its debt and the total national debt is more than the entire defense budget.

Source: www.statistica.com 

So, if I had to venture to guess what the Fed’s game plan is going forward, I’d say it is hoping that a more rapid taper will cool the velocity of money, with the further hope that its taper coincides with the easing of global supply chain disruptions that will dampen inflationary pressures at the wholesale and consumer level.

It also stands to reason that the Fed will allow the long end of the yield curve to rise, so as to prick the bubble in the housing market as mortgage rates increase, since the Fed has to keep short-term rates artificially low to manage the record cost of debt service on its balance sheet and that of the $29 trillion national federal debt.

On the topic of real estate, as an asset class, the Real Estate Select Sector SPDR Fund ETF (XLRE) is up 32.4% year-to-date, versus 25.4% for the S&P 500 as of Dec. 10. Real estate is a more trusted inflation hedge than energy, at least from a historical sense, before Environmental, Social and Governance (ESG) investing became so popular. Plus, liquid real estate in the form of REITs offer an excellent way to diversify portfolios without exposing oneself to the risks of physical possession of the real estate.

Investors who choose REITs can invest in premier properties in small amounts, while for physical real estate, this is not the case. Listed REITs can generate yields in the 3-5% or higher range and additionally save a lot of time. There are no worries about maintenance, management or knowledge of individual markets. After the 2008-2009 Great Recession, it was common to hear investors say, “If I’m going to buy real estate, its going to be on the floor of the NYSE.”

Easy in, easy out is the beauty of owning real estate stocks without sacrificing performance — especially after the sector has enjoyed a multi-year bull market without a correction — fueled by easy money and central bank financial engineering. That is all about to slow and thus argues well that when the time is right to lighten up on real estate exposure, it can be done with the click of a mouse.