Awaiting the Washout

10/23/18 08:52AM EDT

“Hold your tongue and say ‘apple’ ”
-Any kid, anywhere, ever. 

Yep, that bad boy is still in full effect among 2nd to 4th graders in CT. 

So, I’ve been imploring my son to read Diary of a Wimpy Kid for the last year or so - it’s a longer-form chapter book, it’s reading level appropriate, my friends kids have recommended it and Bezo’s algo certainly seems enamored with that recommendation, but it’s been recurrently and ardently Heisman’d.          

Before I get to the punchline, hold your tongue and say Diary of a Wimpy Kid …. or just say it fast and without over-pronunciating it.  

As it turns out, for the past year he thought my wife and I were saying “Diarrhea of a Wimpy Kid” which, without any prior knowledge or other context, was sufficient to elicit a hard no.  

I bring this up because it’s hilarious but also because it almost perfectly parallels the apparently distorted perception of our long housing thesis. 

I’ve explicitly laid out the dynamics around prevailing conditions in the domestic housing market and how those conditions would need to evolve to catalyze a (convicted) entry point on the long side.  

But Wall Street remains more merchant of myopia and meretriciousness than purveyor of patience and nuance.  I get it, so let’s do this contextualization dance one more ‘gen.    

Back to the Global Macro Grind …. 

Awaiting the Washout - cnbc

Here, again, is the analytical prologue: 

  1. We expect a Quad 4 environment in both 4Q18 and 1Q19.  #Quad4 represents a macro environment typically characterized by falling rates, a more dovish policy lean and outperformance in defensive yield and select interest rate sensitive equities, including Housing.
  2. Unprecedented late-cycle fiscal stimulus has cultivated an interesting, somewhat anomalous macro condition set as it elevates the prospects for further acceleration in wage inflation and the potential for households to see improved consumption capacity at the same that both headline growth and inflation are slowing and yields are making lower highs -->  a prospective setup that would be broadly favorable for housing, particularly against a backdrop of significant underperformance, trough valuation, and a housing cycle which, itself, is still only mid cycle.
  3. You do not want to be long Housing related equities during rate shock periods, period.  When the magnitude of short-term changes in rates pushes above 2 Standard Deviations the inverse correlation between rates and housing equities pushes towards 1 and housing investing devolves into a single factor model (i.e. the trade is singularly about rates and broader fundamental considerations get sidelined).  Builder Performance during historical Rate Shock periods is illustrated in the Chart of the Day below.    

Now, before getting into timing the entry, it’s worth taking a short didactic digression.

The impact of significant, expedited moves in interest rates flow through the housing fundamental data on a variable lag.  And much of the fundamental housing data, itself, is reported on a significant lag.  

For instance, the latest Case-Shiller Home Price data is for July and it is calculated as a 3-month rolling average covering the May-June-July period ….effectively representing pricing dynamics for June.  Moreover, the HPI data are calculated using closed transactions --> and closings generally occur 6-8 weeks after the signing of a contract.  

In other words, the July HPI data (which is the latest data even though we are in October), effectively reflects supply-demand dynamics in March-April-May when the purchase contracts were actually signed. 

Mechanically, that is the sequencing.  

Intuitively, the sequencing progresses in the following generalized form: 

Rates go up --> Rates ↑ = Affordability ↓ --> A bid-ask spread emerges as the buyer can now afford less house (at the same monthly payment) while the seller remains reluctant to cut price --> That bid-ask mismatch shows up in softening volume -->  sellers change behavior on a lag and in the wake of falling volume and rising time on market -->  price cutting begin --> that cutting shows up in closed contract volumes on lag via official HPI data.   

This temporal sequencing matters because much of the softening in the recent housing data represents a lagged impact of the step function increase in interest rates that occurred in 1Q18.  

The latest ~50bps increase in rates in September will flow through the reported housing data over the next couple/few months and fundamentals will continue to underwhelm or worsen on the margin, nearer-term.  

And this is where the cognitive dissonance kicks in.  

If the market starts to sniff out an easing bias and a protracted leak lower in rates, you’ll see that begin to get discounted in housing equity performance …. even though fundamentals have yet to inflect. 

Here's a selection of dynamics to look for as you wait for the washout:

  • Wait for the quantitative/risk management signal to turn bullish.  KM will flag this and/or you will actually see us get long in the RTA portfolio (we haven’t put any position on yet).
  • Wait for the Quad 4 data to be more tangibly reported.  Remember, we are still getting residual, growth-accelerating 3Q data here in October.  The quad 4 data will begin to be reported more conspicuously as we move through year-end …. and the Fed will react to that data on a further lag.
  • Look the market to continue to price disinflationary trends and mark a slower trajectory and/or lower terminal point for Fed Funds. 
  • Alternatively, monitor the Eurodollar curve for market expectations around the prospective policy path.  I know Eurodollar derivatives markets seem daunting but there are some simple, straightforward read-throughs.  From a macro perspective Eurodollar Futures represent the markets view on the pace/magnitude of policy tightening.  It’s not so much where the curve sits at any given moment but how it shifts.  For example, in August the Eurodollar curve was inverted with 2019 futures higher than 2020 ---> the interpretation is that the market was handicapping fed easing in 2020.  Alongside strong U.S. high frequency macro data in Sept the curve pushed out and was no longer inverted --> the interpretation being that the market had rerated growth expectations higher and no longer expected Fed easing over that same timeline.  Look for the curve to shift back toward inversion …. Either because of deteriorating growth expectations or because of an expectation for over-aggressive Fed tightening (or some combination). 
  • The actual rhetorical shift out of the Fed will be a final confirmation.   

Remember, the early bird may catch the worm (or the falling knife) but the 2nd mouse gets the cheese.  When the rotation/inflection comes, you can be the 2nd mouse and still capture the bulk of the move. 

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 3.00-3.23% (bullish)
SPX 2 (bearish)
RUT 1 (bearish)
NASDAQ 7 (bearish)
Utilities (XLU) 52.60-54.83 (bullish)
REITS (VNQ) 75.04-79.09 (bearish)
Industrials (XLI) 71.32-75.66 (bearish) 
Shanghai Comp 2 (bearish)
Nikkei 216 (bearish)
DAX 110 (bearish)
VIX 16.00-26.12 (bullish)
USD 94.60-96.25 (bullish)
Oil (WTI) 67.18-71.36 (bearish)
Nat Gas 3.11-3.34 (bullish)
Gold 1 (neutral)
Copper 2.69-2.83 (bearish)

To patience, process and profit, 

Christian B. Drake
U.S. Macro analyst

Awaiting the Washout - CoD Rate Shocks vs Builder Performance

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