Barron's Cover
SATURDAY, FEBRUARY 15, 2014
The Case for 4% Growth
By GENE EPSTEIN
Demand for new homes -- and the outlook for economic growth -- are understated, say these economists. How to play the new boom.
Snow paralyzed the Eastern U.S. last week, but it won't put a chill on what could be the hottest economy since the late 1990s. That's the contrarian outlook of Applied Global Macro Research, an unusually rigorous and prescient group that expects 4% growth in economic output this year and next. The firm's three economists -- Jason Benderly of Vail, Colo., and Carsten Valgreen and Niels-Henrik Bjørn of Copenhagen -- cite the ongoing housing recovery for their bullish outlook, arguing that future demand for housing is understated.
The trio doesn't just advise clients on their research. They also put their money where their mouth is -- a unique sign of their commitment to their ideas. Current investments in their hedge fund include the Standard & Poor's 500 Consumer Discretionary and Homebuilders stock indexes, which they have bought using exchange-traded funds. They also have an interest-rate play based on the belief that the Federal Reserve will respond to the stronger-than-expected growth by hiking the rate on federal funds sooner than the bond market currently anticipates.
But if, as AGMR predicts, the economy grows at 4%, the unemployment rate will likely fall to 6% by the fourth quarter from the current 6.6%. That should be low enough to prompt the FOMC to boost the fed funds rate, now just 0% to 0.25%, later this year.
What do economists Benderly, Valgreen, and Bjørn claim to see that others do not? The key difference, from their standpoint, lies in their long-term analysis of the dynamics of the housing cycle, plus the important positive effects of a rising housing sector on consumer spending. Just as the bursting bubble in housing helped trigger the Great Recession, the prolonged sickness in this sector, which has persisted well past the recession's end, is now poised to give way to an acceleration in the recovery that has been under way for the past few years.
Pent-up demand for housing should therefore boost this sector's contribution to economic growth. The contribution will come directly, via the increase in residential investment, and indirectly, through channels that include the greater purchase of consumer items for the home and a general increase in consumer spending from rising housing wealth.
"We can't overstate the importance of housing," comments Applied Global President Jason Benderly. "The housing cycle is likely to boost economic growth for some time to come."
To these powerful ingredients, add a few others: the feedback effect on consumer spending from rising labor income; the diminished "fiscal drag" from higher taxes and spending cuts; and the likelihood that investment in equipment, another key component of gross domestic product, will heat up in response to strength in these other sectors.
WHAT LENDS PLAUSIBILITY to AGMR's dramatic housing and consumption narrative is that the same variables it uses to predict the rebound also would have predicted the 2006-10 bust.
The key variables include a statistical mouthful that is nonetheless freighted with significance: housing starts as a percentage of the existing housing stock, with both stock and starts measured in units of detached homes and separate apartments. That percentage reflects the rate of additions to the housing stock. But since this addition rate must over the long term be driven by the needs of the population, our analysts adjust the percentage share by subtracting from it the percentage increase in U.S. residents 20 years and older.
Through most of the 1990s and well into the early 2000s, the rate of additions to the housing stock outstripped the needs of the population, a clear sign of overbuilding leading to a likely bust. By 2007, however, the reverse trend kicked in, with the rate of additions running lower than the population increase, an extended period of underbuilding that still persists.
The chances that this underbuilding will soon lead to a rebound are enhanced by two other variables in AGMR's statistical model: the ratio of unsold new homes to the stock of single-family homes, and the homeowner vacancy rate. Leading up to the bust that began in 2006, both variables went through the roof -- forgive the pun -- and remained high through 2010. Both have since plummeted.
THE DECLINE in the homeowner vacancy rate has been slowed by special factors like the unprecedented number of foreclosed homes in this cycle. But at 2% in 2013, down from a high of 2.9% in 2008, the vacancy rate has gotten much closer to the level of the late 1990s, when it ran 1.6% to 1.8%.
The trio doesn't just advise clients on their research. They also put their money where their mouth is -- a unique sign of their commitment to their ideas. Current investments in their hedge fund include the Standard & Poor's 500 Consumer Discretionary and Homebuilders stock indexes, which they have bought using exchange-traded funds. They also have an interest-rate play based on the belief that the Federal Reserve will respond to the stronger-than-expected growth by hiking the rate on federal funds sooner than the bond market currently anticipates.
But if, as AGMR predicts, the economy grows at 4%, the unemployment rate will likely fall to 6% by the fourth quarter from the current 6.6%. That should be low enough to prompt the FOMC to boost the fed funds rate, now just 0% to 0.25%, later this year.
What do economists Benderly, Valgreen, and Bjørn claim to see that others do not? The key difference, from their standpoint, lies in their long-term analysis of the dynamics of the housing cycle, plus the important positive effects of a rising housing sector on consumer spending. Just as the bursting bubble in housing helped trigger the Great Recession, the prolonged sickness in this sector, which has persisted well past the recession's end, is now poised to give way to an acceleration in the recovery that has been under way for the past few years.
Pent-up demand for housing should therefore boost this sector's contribution to economic growth. The contribution will come directly, via the increase in residential investment, and indirectly, through channels that include the greater purchase of consumer items for the home and a general increase in consumer spending from rising housing wealth.
"We can't overstate the importance of housing," comments Applied Global President Jason Benderly. "The housing cycle is likely to boost economic growth for some time to come."
To these powerful ingredients, add a few others: the feedback effect on consumer spending from rising labor income; the diminished "fiscal drag" from higher taxes and spending cuts; and the likelihood that investment in equipment, another key component of gross domestic product, will heat up in response to strength in these other sectors.
WHAT LENDS PLAUSIBILITY to AGMR's dramatic housing and consumption narrative is that the same variables it uses to predict the rebound also would have predicted the 2006-10 bust.
The key variables include a statistical mouthful that is nonetheless freighted with significance: housing starts as a percentage of the existing housing stock, with both stock and starts measured in units of detached homes and separate apartments. That percentage reflects the rate of additions to the housing stock. But since this addition rate must over the long term be driven by the needs of the population, our analysts adjust the percentage share by subtracting from it the percentage increase in U.S. residents 20 years and older.
Through most of the 1990s and well into the early 2000s, the rate of additions to the housing stock outstripped the needs of the population, a clear sign of overbuilding leading to a likely bust. By 2007, however, the reverse trend kicked in, with the rate of additions running lower than the population increase, an extended period of underbuilding that still persists.
The chances that this underbuilding will soon lead to a rebound are enhanced by two other variables in AGMR's statistical model: the ratio of unsold new homes to the stock of single-family homes, and the homeowner vacancy rate. Leading up to the bust that began in 2006, both variables went through the roof -- forgive the pun -- and remained high through 2010. Both have since plummeted.
THE DECLINE in the homeowner vacancy rate has been slowed by special factors like the unprecedented number of foreclosed homes in this cycle. But at 2% in 2013, down from a high of 2.9% in 2008, the vacancy rate has gotten much closer to the level of the late 1990s, when it ran 1.6% to 1.8%.
In addition to their model, Benderly and his colleagues view the turnaround in home prices since early 2012 as a vital ingredient in a strong general recovery due to its positive effect on consumer spending. While AGMR analyzes all of the main measures of home prices, it prefers the median sales price of existing single-family homes because that series has the longest history of monthly data, starting in 1968.
Tracing this series since 1968, the economists have determined that the underlying trend is for house prices to rise by an annual average of 2%-2.5% above the rate of consumer inflation. By that measure, a price bubble of unprecedented size was clearly forming through 2006, when annual increases in home prices often ran 10% faster than increases in the "personal consumption deflator" -- far above the trend growth rate of 2% to 2.5%. The idea that inflation-adjusted house prices have followed an upward trend in the U.S. not only squares with economic logic but is buttressed by house-price data from the Census Bureau that go back to 1930.
The price collapse that began in 2007 lasted through early 2012. So low did prices go that the inflation-adjusted median price as of December 2013 is still about in line with where it was in late 2001. The result is that house prices can easily rise 5% to 10% faster than the rate of inflation through this year and the next, and still not catch up with the trend growth rate of 2% to 2.5%.
As for inflation, AGMR does expect the rate to rise, but not by much, given the inertia that normally characterizes price inflation.
A FINAL KEY VARIABLE in determining residential investment is the mortgage interest rate. A higher mortgage interest rate does slow the growth of residential investment, but not by as much as one might think. That is partly because residential investment does not just consist of the construction of single-family homes or of broker commissions and other transfer costs relating to home sales. It also includes the construction of apartment buildings and manufactured homes, plus the huge category of home improvements, which frequently include adding new rooms.
At 4.4% in January, the 30-year-mortgage interest rate has risen a little more than 100 basis points (one percentage point) since the low in late 2012. AGMR calculates that, for every 100 basis-point rise, growth in residential investment is slowed by 2% to 3%, but only temporarily. Since it projects that residential investment is likely to rise by 20% this year and next, even another 100 basis-point rise should not slow that advance by very much.
The boost to GDP growth from the rise in residential investment reflects the direct effect of housing. According to Benderly, however, indirect effects are at least as great, once you include all of the ways housing tends to boost consumer spending. There is the increased purchase of rugs, furniture, and appliances when people form new households or move to a larger apartment or detached house, or add rooms to their home. And there is the increase in consumer spending generally through the positive wealth effect from rising home prices.
Also, since residential construction is a labor-intensive activity, there is the boost to consumption from the increased number of construction jobs and the associated income that is created. There are now 2.2 million residential construction jobs nationwide, down from a peak of 3.4 million in April 2006. While that 3.4 million might not be attained, an additional half-million looks plausible. And finally, as the labor market tightens, there is the added boost from a pickup in hourly-wage growth, which by some measures is already under way.
Then add the diminished head winds from "fiscal drag"; the federal deficit as a share of GDP will continue to decline, but at a slower rate than the past three years. Also add the likely response to the increase in consumption of enhanced investment in equipment, software, and inventories to the increase, all of which could make substantial contributions to growth of GDP.
As for the impact of the polar vortexes that have repeatedly slammed the country this winter, Benderly concedes they've caused some loss in output, but says most of the loss will be made up in the spring thaw.
APPLIED GLOBAL MACRO RESEARCH, managed since 2008 by the Vail-based Mary Allyn, a former head of Merrill Lynch's private banking group, has been making specific trading recommendations that are subsequently implemented by its separately run hedge fund, with assets of $45 million. Barron's published an article on these activities when the firm was called Benderly Economics and had made 18 recommendations ("Stock Picks From -- Hold the Jokes -- Economists," Nov. 29, 2010). AGMR has since issued 18 more.
Including a predecessor fund launched in October 2009, the firm's SYFOGLOMAD fund -- the name is an acronym for Systematic Forecasting of Global Macro Developments -- returned 40% through December 2013, net of fees. By comparison, the average macro fund in the HFRI database is up less than 5% over the same period.
Current recommendations that reflect Applied Global's expectation for higher consumer spending, a rebound in housing, and higher output generally, include the SPDR S&P Select Sector Homebuilders ETF (ticker: XHB), SPDR S&P Select Sector Bank (KBE), and SPDR S&P 500 Select Sector Consumer Discretionary (XLY). They also recommend going long lumber futures, although the fund does not currently hold that position.
The reason: Given its other positions in the markets, it is now near the maximum of the risk-constraints limited by its protocols. But if that situation changes, the fund may well take a long position in lumber.
And based on their forecast that the FOMC will hike the short-term interest rate by the end of this year, Benderly, Valgreen, and Bjørn expect the two-year interest rate to rise in relation to the 10-year. They have therefore taken a "yield curve flattening" position by shorting futures on two-year Treasuries and simultaneously going long 10-year Treasury futures.
Pessimists should not be especially challenged by AGMR's optimistic outlook, since it would barely alter the "new normal" of recent economic growth. Two consecutive years of 4% growth pale beside the record of the 40 years from 1960 through 2000, when sustained periods of 5% and 6% growth were fairly common (see chart). Even the subpar expansion of 2001-07 saw growth of 4.3% in 2003.
More importantly, economic expansions are supposed to make up for much of the output lost to the recessions that preceded them. But in this case, if real GDP does grow at an annual rate of 4% through fourth-quarter 2015, the period that includes the Great Recession of 2007-09 and runs through 2015 will still look dismal.
Annual growth since fourth-quarter 2007 -- the last peak, just before the Great Recession -- will have run just 1.8% in the eight years from 2007 to 2015. By contrast, through the eight years following the onset of the last deep recession, of 1981-82, growth ran 3.6% a year, or twice as fast. Real catch-up with the Great Recession requires a few years of 5% to 6% growth, and not even the optimists at Applied Global Macro Research are anticipating that.
Tracing this series since 1968, the economists have determined that the underlying trend is for house prices to rise by an annual average of 2%-2.5% above the rate of consumer inflation. By that measure, a price bubble of unprecedented size was clearly forming through 2006, when annual increases in home prices often ran 10% faster than increases in the "personal consumption deflator" -- far above the trend growth rate of 2% to 2.5%. The idea that inflation-adjusted house prices have followed an upward trend in the U.S. not only squares with economic logic but is buttressed by house-price data from the Census Bureau that go back to 1930.
The price collapse that began in 2007 lasted through early 2012. So low did prices go that the inflation-adjusted median price as of December 2013 is still about in line with where it was in late 2001. The result is that house prices can easily rise 5% to 10% faster than the rate of inflation through this year and the next, and still not catch up with the trend growth rate of 2% to 2.5%.
As for inflation, AGMR does expect the rate to rise, but not by much, given the inertia that normally characterizes price inflation.
A FINAL KEY VARIABLE in determining residential investment is the mortgage interest rate. A higher mortgage interest rate does slow the growth of residential investment, but not by as much as one might think. That is partly because residential investment does not just consist of the construction of single-family homes or of broker commissions and other transfer costs relating to home sales. It also includes the construction of apartment buildings and manufactured homes, plus the huge category of home improvements, which frequently include adding new rooms.
At 4.4% in January, the 30-year-mortgage interest rate has risen a little more than 100 basis points (one percentage point) since the low in late 2012. AGMR calculates that, for every 100 basis-point rise, growth in residential investment is slowed by 2% to 3%, but only temporarily. Since it projects that residential investment is likely to rise by 20% this year and next, even another 100 basis-point rise should not slow that advance by very much.
The boost to GDP growth from the rise in residential investment reflects the direct effect of housing. According to Benderly, however, indirect effects are at least as great, once you include all of the ways housing tends to boost consumer spending. There is the increased purchase of rugs, furniture, and appliances when people form new households or move to a larger apartment or detached house, or add rooms to their home. And there is the increase in consumer spending generally through the positive wealth effect from rising home prices.
Also, since residential construction is a labor-intensive activity, there is the boost to consumption from the increased number of construction jobs and the associated income that is created. There are now 2.2 million residential construction jobs nationwide, down from a peak of 3.4 million in April 2006. While that 3.4 million might not be attained, an additional half-million looks plausible. And finally, as the labor market tightens, there is the added boost from a pickup in hourly-wage growth, which by some measures is already under way.
Then add the diminished head winds from "fiscal drag"; the federal deficit as a share of GDP will continue to decline, but at a slower rate than the past three years. Also add the likely response to the increase in consumption of enhanced investment in equipment, software, and inventories to the increase, all of which could make substantial contributions to growth of GDP.
As for the impact of the polar vortexes that have repeatedly slammed the country this winter, Benderly concedes they've caused some loss in output, but says most of the loss will be made up in the spring thaw.
APPLIED GLOBAL MACRO RESEARCH, managed since 2008 by the Vail-based Mary Allyn, a former head of Merrill Lynch's private banking group, has been making specific trading recommendations that are subsequently implemented by its separately run hedge fund, with assets of $45 million. Barron's published an article on these activities when the firm was called Benderly Economics and had made 18 recommendations ("Stock Picks From -- Hold the Jokes -- Economists," Nov. 29, 2010). AGMR has since issued 18 more.
Including a predecessor fund launched in October 2009, the firm's SYFOGLOMAD fund -- the name is an acronym for Systematic Forecasting of Global Macro Developments -- returned 40% through December 2013, net of fees. By comparison, the average macro fund in the HFRI database is up less than 5% over the same period.
Current recommendations that reflect Applied Global's expectation for higher consumer spending, a rebound in housing, and higher output generally, include the SPDR S&P Select Sector Homebuilders ETF (ticker: XHB), SPDR S&P Select Sector Bank (KBE), and SPDR S&P 500 Select Sector Consumer Discretionary (XLY). They also recommend going long lumber futures, although the fund does not currently hold that position.
The reason: Given its other positions in the markets, it is now near the maximum of the risk-constraints limited by its protocols. But if that situation changes, the fund may well take a long position in lumber.
And based on their forecast that the FOMC will hike the short-term interest rate by the end of this year, Benderly, Valgreen, and Bjørn expect the two-year interest rate to rise in relation to the 10-year. They have therefore taken a "yield curve flattening" position by shorting futures on two-year Treasuries and simultaneously going long 10-year Treasury futures.
Pessimists should not be especially challenged by AGMR's optimistic outlook, since it would barely alter the "new normal" of recent economic growth. Two consecutive years of 4% growth pale beside the record of the 40 years from 1960 through 2000, when sustained periods of 5% and 6% growth were fairly common (see chart). Even the subpar expansion of 2001-07 saw growth of 4.3% in 2003.
More importantly, economic expansions are supposed to make up for much of the output lost to the recessions that preceded them. But in this case, if real GDP does grow at an annual rate of 4% through fourth-quarter 2015, the period that includes the Great Recession of 2007-09 and runs through 2015 will still look dismal.
Annual growth since fourth-quarter 2007 -- the last peak, just before the Great Recession -- will have run just 1.8% in the eight years from 2007 to 2015. By contrast, through the eight years following the onset of the last deep recession, of 1981-82, growth ran 3.6% a year, or twice as fast. Real catch-up with the Great Recession requires a few years of 5% to 6% growth, and not even the optimists at Applied Global Macro Research are anticipating that.
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