November 2023
As we close out the year, investors seem to have concluded that the Federal Reserve has mostly accomplished their mission of containing inflation while simultaneously achieving an economic soft landing. We agree with the consensus. Year-over-year, the consumer price index was 3.1% in November, and we think that getting back to the Fed’s target of 2.0% will prove elusive for a few reasons. Principally, the changing workforce. The workforce is shrinking as the baby-boomers age out, and as it shrinks workers are finding they hold wage bargaining power, as evident by recent union gains and the rising minimum wages. To maintain profit margins, companies are forced to raise prices which creates the dreaded wage-price spiral. The Fed had hoped to avoid the occurrence by slowing the economy, but structural forces have prevented any slowing to date. Instead, the Fed is likely to need to raise their inflation speed limit to 3%. Members of the committee continue to sound hawkish in their public statements, but we suspect that the rate hike cycle has peaked. With that said, we don’t believe the FOMC is going to cut rates as rapidly as the market is speculating. Currently Fed Fund futures are forecasting the first rate cut by next spring and more than 100 basis point by the end of 2024.
There were two recent news stories that harkened back sixteen years to pre-crisis 2007. The first had to do with the Federal Housing Finance Agency (FHFA) and the second was the proliferation of private credit.
The mission of the FHFA is to supervise, regulate, and provide oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. As you’ll recall, the FHFA swept Fannie Mae and Freddie Mac into government conservatorship during the mortgage crisis and continues to sweep all profit from the companies into the government coffers. Fannie and Freddie buy and hold mortgages from banks to facilitate home ownership for low- to middle-income housing. The much-maligned agencies have faced steady criticism from Congressional leaders since they blew up during the financial crisis. With that, we were surprised by the announcement this week that the FHFA would lift the maximum value of the mortgages the agencies can purchase from $726,200 to $766,550. According to the Federal Reserve Bank or St. Louis, the median home sale price in the quarter just ended was $431,000. Granted, home prices have risen steadily as the inventory has remained depressed, but $766,550 is significantly above low and middle-income affordability.
The second pre-crisis throwback has been the proliferation of private credit funds. The private credit market is the shadow banking source of capital for borrowers with a lower credit score than what would be acceptable for a bank loan. Prior to the financial crisis, the private credit loans were called “leveraged loans” because the borrowers were typically over leveraged and had a weak credit-rating. The pitch, at the time, to lure investors into leveraged loan funds was that they’re higher in the credit structure and, as a category, they have never traded below 90 cents on the dollar. That is until the economy tanked and they fell to 50 cents on the dollar. We’ve witnessed on increased frequency the exact same argument, that private credit funds offer a better return than investment grade fixed income investments. Our worry is that thinking could lead to a repeat large credit losses witnessed during the last credit crisis.
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