Interest rate pretzels and the Zoom shock on real estate

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MR. MICHAEL CEMBALEST: 

Good evening everybody and welcome to the March 2021 Eye on the Market podcast.  There are three topics I want to be discussing today: interest rates and equities, the Zoom shock on commercial and residential real estate and a COVID update.

Also please join us on Thursday, this Thursday, we're going to have a webcast to discuss our SPAC research and the returns for all the different categories of investors.

So on the rate issue, if interest rates stay at or below 2% I think that's a great sign for equity investors and everybody would probably agree.  Where there's disagreement is if interest rates don’t stay below 2% it's amazing to see the pretzels that people contort themselves into to convince themselves that rising rates aren't a problem for equities. 

There's a ton of rationalizations that we walk through each with its own picture of a little pretzel in today's Eye on the Market.  And it's amazing because this whole drumbeat of if rates rise, don't worry about equities from all the research people, I see it's kind of a cause for concern 'cause nobody wants to confront the possibility that there's a disconnect between Fed policy and the long bond and equity valuations.

We thought this year we'd get 10% returns or so on U.S.  Large Cap stocks, assuming a big surge in consumer and business activity, widespread vaccinations, minimal disruption from vaccine resistant variants, another $2 trillion in fiscal stimulus for COVID and an infrastructure oriented bill in the fall, only part of which is offset by increased taxes on wealthy individuals and companies, a collapse in unemployment to around 4.5% by the end of the year, and then combining that with all sorts of investor euphoria  as sky high valuations for everything growth related, things like that and small increases in interest rates and inflation. 

So if rates stay at or below 2%, you know that view or that 10% return view is still in place.  If rates hit 2.5% or higher, I would be much less optimistic in contrast to almost all the other research I see where people are talking about the reasons why they wouldn't worry about the rising--the impact of rising interest rates on equities. 

The primary concern I would have is over the last few years we've had a surge in the price that investors pay for growth stocks.  And you can look at that by just looking at the PE multiples relative to revenue growth.  They are as high or if not higher, that ratio, than we had in 2000.  And this has coincided with a period of not just low interest rates but low expectations for future rate increases.  And you can look at something called the Term Premium from the New York Fed to track that.

The Term Premium is finally increasing as now, all of a sudden, there is more uncertainty about future rates and inflation and so I think this extreme price that people are paying for growth is going to come down a bit and so that's a headwind in a rising rate environment that I think some people are overlooking.  We'll see.

We'll know how it goes over the next few months.  Our estimate is that vaccinations plus non-vaccinated COVID survivors, right, so in other words two different source of antibody protection, is headed to around 70% by late May, right when over $1 trillion of the new $1.9 trillion in stimulus hits the economy: direct checks, small business aid, state and local aid.  That much stimulus could eliminate a big chunk of the spare capacity that's lying around.  And so we've talked about this before and we have some charts here on the output gap and some of the things that Larry Sommers has been saying.

It's interesting because the Fed has been wrong about rising inflation over almost the whole last decade.  They thought it was going to up and they were wrong.  Now they've gotten religion and they're betting the house on red which is that any revival in inflation is temporary and they're not worried about it.  So I'm not sure the long bond is going to agree with them for that long.  And so we'll see.

Now in a rising rate environment, there are some sectors that are doing pretty well: financials, right, obviously, steeper yield curves help banks' net operating income.  We're having a big global post-COVID recovery in industrial production which is helping industrials and basic materials.  And then the energy sector is doing well which is in part a COVID recovery story.

But I think even bigger is the story about industry consolidation and renewed management focus on free cash flow.  We made a bullish call on oil and gas in our energy paper last June around the lows in oil and gas stocks 'cause we thought that the sector's problems which for a decade you could see were related more to the shale supply shock and management decisions to ignore profitability.

If you actually look at the price, 2010 to 2019, there was negative free cash flow in the entire shale industry.  And about 20 or 30 companies, almost none of them, had even a couple of years of positive free cash flow.  That's now changing and that's what's been helping the stocks since last June.  And we're sticking with this call.  Our energy paper comes out, by the way, in mid-May this year where we'll talk about that and a bunch of other topics.

The bottom line is that, again, as long as rates stay at 2% or below everything should be fine but I'm less optimistic that a rising rate environment can coincide with decent returns on large cap stocks.  We'll see.

Now.  I want to take an early look at the Zoom shock on U.S. and residential commercial real estate.  A year ago I wrote that the U.S. would be 70-80% back to normal in a year.  So that year is now.  So if you look at energy consumption, capacity utilization, industrial production, consumer spending, housing starts, capital goods shipments, all of these things have recovered by at least 70-80% if not having now exceeded 2019 levels.

The one thing that I don't think is going to normalize that quickly is the number of people working from home compared to pre-COVID levels.  I'm simplifying here but the average employee in the U.S. would prefer to work from home half the week.  There's a distribution of expectations and desires but the average white collar employee would like to work from home 2.5 days a week whereas employers are kind of anywhere between .5 and 1 day.  So there's a big bid offer between what employees want and what employers want. 

If the compromise ends up someplace in the middle there's going to be something of a Zoom shock for office owners.  There's some really interesting research that's been done on this Zoom shock to commercial real estate.  And it refers to the fact that people aren't switching jobs.  They still spend the same amount of money, almost everything about their lives stay the same, they just work from home instead. 

And the people who study this are now looking by geographical area at the Zoom shock and we showed one of the maps for Greater London and you can see the intensity of the employment domicile inflow and outflow that tends to take place.  And again it's not people losing and gaining jobs, it's just where they do the jobs but obviously that has a huge impact on residential, commercial real estate valuations. 

One of the charts in here shows the amazing correlation between an estimate of how many jobs can be done from home, by zip code, and what the residential property prices changes were from over the last year.  This is one of the most linear fits of a regression I've ever seen.

In addition cities where a lot of jobs can be done from home tend to have larger declines in commercial real estate valuations 'cause those denser cities are subject to Zoom shocks as well.  And we have to start thinking about this kind of thing because the implications not just for home prices but for office rents, valuations, sublet volumes, the solvency and ridership of public transit systems, municipalities in terms of bond risks, the tax base, and tax rates and a whole range of businesses tied to office utilization rates in urban centers.

We have an early look so far.  We show 10 large cities and the office utilization rates.  Now there are some places like New York and San Francisco and Chicago where office utilization rates are still only 15-20% and we know that 'cause we have data on key card and fob data of office employees.

But even in Dallas and Houston and Austin where public transit is almost nonexistent, I mean the Census Bureau tracks that kind of thing, and the percentage of workers who commute by public transport in Dallas, Austin, and Houston is less than 5%.  And yet those office utilization rates are only around 35%.

So here we are in an environment where people in those places can commute and reduce their COVID risks and the office utilization rates are still only about a third.  And so it suggest that this battle between employers and employees on work from home is still underway and today's piece just gets into some of the potential implications of that.

So let's finish up with some COVID discussion.  The COVID statistics continue to improve in the U.S.  The pace of vaccination has picked up a lot in the last couple of weeks.  And we have a chart that looks at partial vaccinations, full vaccinations, it's in today's Eye on the Market and you can see this pace has picked up a lot.  And again you know mid-May we could be looking at 50% vaccination plus 20% non-vaccinated survivors. 

It's possible the U.S., and this is what we're on track, it's possible the U.S. will win the race against time here because if you vaccinate quickly enough, you can run ahead of these more contagious and more deadly new variants.  This U.K. B-117 variant is only around 10% in the U.S.  And the South African and Brazil variants are present here but at less than .5% of new infections.

So if the U.S. continues to vaccinate aggressively, we can win this race against time on these new variants.  And you can see Continental Europe is not winning that race.  They're losing that race and they're paying a price for the squabbles they had with Astra-Zeneca and Oxford and with not diversifying their vaccine purchases more broadly and for some of the issues that took place in terms of questioning the efficacy of the Astra-Zeneca vaccine.

The U.K. variant is now spreading more rapidly in France, Italy, and The Netherlands.  More than 50% of new infections and vaccinations are still only around 5-8%.  So Italy had to shut down again in preparation for Easter holidays whereas the U.K., the data continued to decline as vaccinations hit 35% which is many multiples higher.  And even though that U.K. variant is all over the U.K. the vaccination rates are running ahead of it and you're still seeing declines in the U.K. in hospitalizations, mortality, and infection.

So this is really turning out to be a battle between vaccination and variants.  The U.S. is in much better shape that Europe. 

Brazil's COVID situation is worth noting.  It accounts for all of the worsening in Latin America since of most of the other countries in the region are actually improving.  There's this very creepy mortality spike in the Amazon in Manaus.  That was a place where it was believed that the herd mentality, or sorry, herd immunity had already been reached and so it was surprised to see a huge surge in mortality in the Amazon over the last couple of months.  It's now rolling over but has spread to Minas Gerais, Sao Paulo, and Rio and Bahia and some of the other larger states. 

So Brazil is the worst combination where you have extremely low vaccination rates and rapidly spreading, dangerous variants.  This gets to a very interesting discussion that I was reading about the other day where the WHO and other international aid organizations are lobbying the U.S. aggressively which may end the month of June with a surplus of unused vaccines, lobbying them to share those with certain emerging economies 'cause as long as large emerging nations like Brazil are having these kinds of problems it's going to be difficult for the world to get back to normal.  So far the Biden Administration hasn't taken a firm position on what they're going to do here.  And it'll be interesting to watch this play out if we end up with a huge vaccine divide between the developed and the emerging world.

So that's it for today's piece.  Thank you for listening.  Again, please join us on Thursday for our SPAC call.  Bye.

ANNOUNCER:

Michael Cembalest, Eye on the Market, offers a unique perspective on the economy, current events, markets and investment portfolios and is a production of JPMorgan Asset and Wealth Management. 

Michael Cembalest is the Chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.  For more information, please subscribe to the Eye on the Market by contacting your JPMorgan representative. 

If you'd like to hear more, please explore episodes on iTunes or on our website.  This podcast is intended for informational purposes only and is a communication on behalf of JPMorgan Institutional Investments, Incorporated. 

Views may not be suitable for all investors and are not intended as personal investment advice or as solicitation or recommendation.  Outlooks and past performance are never guarantees of future results.  This is not investment research. 

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