This quarter’s market commentary is going to take a macro look once again as there are two topics that need to be better understood, that the market pundits have not given proper study. The topics are first, unemployment and the aging of the US population and second, lack of velocity of money and the increase in the money supply.
The Labor Force Participation Rate and the Aging of the Population
I was recently discussing this topic with one of our fund investors. I was suggesting that the baby boomers are going to have to work longer due to the loss of retirement wealth and that this would help GDP until and after the Echo Boomers enter the workforce and increase GDP as well. While this investor agreed (being a baby boomer who has continued to work past 65) he also pointed me toward a JP Morgan article on the effect workers retiring will have on the overall unemployment rate. After doing some additional research on the topic I have come to some distinct observations and conclusions about this demographic force in the economy.
Labor Force Participation Rate
Market pundits have been focusing on the labor force participation rate as an indicator of worker dissatisfaction of job prospects – this is inaccurate for several reasons:
It is not true for Baby Boomers
1) Observation: People ages 55 and up and particularly 60 and up as a group have a stable to increasing labor force participation rate.
2) Observation: Even if the participation rate is increasing within an age group of five year brackets the labor force participation rate does decline from bracket to bracket. An example is people 60 to 64 have a participation rate of 55% and it has been relatively flat in this recession. However people 65 to 69 have a participation rate of 33% which is up in the last few years by a percentage point.
Conclusion: Baby Boomers are indeed working longer which will keep them spending and hold up the economy until the Echo Boom starts earning and spending.
It is not true for Echo Boomers
1) Observation: Younger workers leaving the work force and going back to school are not dissatisfied workers; rather they are making an economic decision about their options.
2) Observation: Echo Boomers are still too young to be at peak participation as that occurs in about five years when they reach 30 years of age. Most of the Echo Boom is below age 25.
Conclusion: Echo Boomers do drop out of the labor force but for other reasons than dissatisfaction with opportunities.
Dissatisfaction with labor opportunities is occurring in prime age groups (25-54), but in a less significant way than the market pundits would lead the public to believe.
1) Observation: Dissatisfaction can mean someone finds more personal utility in collecting unemployment than working. In some cases the potential workers are being incentivized to stay home. Our firm recently tried to hire a qualified worker on unemployment who ultimately decided to stay home and continue to collect unemployment rather than return to the workforce. Needless to say we dodged a bullet as this was not a motivated person.
2) Observation: Ultimately about half the people leaving the labor force or deciding to not participate are retirees and therefore are not necessarily dissatisfied.
Conclusion: Now that means that half the labor force participation rate reduction is due to dissatisfaction of job opportunities or people dropping out of the labor force because they cannot find a job they find acceptable. That could mean a job may be available, but does not pay well, is in another location than preferred, or available positions are increasing, but people are either unqualified or choose not to work because the options are not attractive. This dissatisfaction takes a longer time to naturally fade away, but ultimately people, take classes, move, or are forced to take a lower paying job when unemployment does not get extended. Incidentally half of the reduction in the labor force participation rate is a 1% decline. Currently the labor force participation rate nationally is 65%.
Lack of the Velocity of Money and Inflation
Federal government intervention is the largest problem in getting an economy to function properly. Global or local these governmental interventions have given our government and others an excuse to over leverage (see 4th quarter 2011 market commentary). However they have also disrupted very basic economic principles that drive how the world economy works. While we have talked about these issues before at length the topic that was giving me some pause was how the Fed could increase the money supply and by doing so not cause inflation to a degree that would be commensurate with the increase in the money supply. There are really two reasons why.
Federal Government Spending and the Velocity of Money
1) Observation: The federal government in its effort to spend on our behalf does so less efficiently than we can ourselves. Basically a dollar spent by the Federal Government will turn over fewer times in a year than a dollar spent by the private sector. Over the last thirty years the Federal Government has replaced private spending and represents a larger portion of GDP and therefore money velocity has declined. In the graph below, after you take away the time prior to and adjustment from the Gold Standard, you can see that money velocity has dipped in recessions, but has also on a secular level declined over time as Federal Government spending has crowded out the private sector.
Conclusion: The Fed will have to increase the money supply in order to maintain growth which will ultimately cause inflation. This will be countered by the increase in Government debt that will force interest rates to rise. This could ultimately lead to “Stagflation Lite.” That would be low to moderate inflation with even lower growth, but not recession. Right now growth and inflation are fairly low and almost equal. However, we have to ask if that is the case because of Operation Twist by the Fed which lowers long term rates through a Fed open market operation that buys long term treasury bonds. Particularly if QE3 comes to fruition as it is expected to be an expanded Operation Twist.
Chinese Foreign Reserves and the Velocity of Money
1) Observation: The Federal Government is not the only interventionist. The Chinese Government is doing its best to disrupt basic economic forces. US Federal Government debt is being issued and bought to a very large degree by the Chinese Government who have kept the US Government debt as foreign currency reserves. That has taken a large amount of newly created US dollars out of circulation. The Fed is not increasing the monetary base nearly as quickly or by the amount as people fear because a tremendous amount of the dollars are going into a proverbial vault. So too is the interest on the bonds as in either case these dollars are trapped and are not being spent in the economy. To put this in perspective our money supply (M2) is about $10,000 billion up from $5,500 billion around 2002; China’s US foreign currency reserves have grown in that same time about $1,500 billion. So about a third of our money supply growth has gone into a vault that then does not allow for a liquid freely trading currency that could devalue the dollar. One could also conclude that the Chinese are artificially holding up the value of our currency.
Conclusion: The Fed will have to increase the money supply more than ever to maintain any real and sustained growth. We will start to see a greater disparity in the growth in the money supply and velocity of money.
What this Means for Us
Labor Force Participation Rate and the Aging of the Population
The Baby Boom working longer and the Echo Boom coming along in the next few years is a demographic bridge for the economy. The Baby Boom working longer will help to balance the outside economic forces fighting growth and allow us to continue to muddle through the next few years. The tepid recovery means that we will find good real estate to buy if we are patient and we can afford to be patient. Also, it means that when we buy real estate, at the right price, we will have some leasing demand to drive our leasing and returns. Banks and Special Servicers are still bloated with property that needs to work its way through the system and will increase the supply of properties to buy. The perfect storm of fundamentals of improving leasing and the vast majority of problem assets starting to become available is still in its infancy. That is the perfect storm: Coupling oversupply of investment sale product with improving leasing demand! This means selective product types could be priced cheaper and will be able to be bought with less risk because there is more demand for vacant space.
Lack of the Velocity of Money and Inflation
Our relationship with China will also have its ups and downs over the near term which is where the opportunity to buy and sell real estate will be realized by investors. Where fear in this relationship exists it will be a good time to acquire real estate at attractive prices. Keep an eye out for the Chinese Government beginning to loosen the rules for foreign currency as that will be an inflationary force on the world economy and particularly the US. Inflation will then begin and make the debt used to purchase the real estate cheaper and be repaid with inflated dollars as China decides to realize value for some of its US foreign currency reserves. The continued pressure from economic détente with China will make a cheaper dollar and deleveraging (see Q4 Market Commentary) an unstoppable trend that is only starting. Buying real estate though this deleveraging cycle will make for a great portfolio with the advent of Echo Boomer entering the US economy.
Stay patient, diligent in underwriting, and buy when fear is pervasive. Pick the niches that will benefit more than typical real estate. For us that is student housing and multifamily (Echo Boom), medical office (Baby Boom), and convenience retail (both Booms are consumers). We will also be investing, as we have discussed, in preferred equity and mezzanine debt as the gap financing market in transaction sizes below the institutional market. These investments are very attractive with strong cash flow characteristics and these structures allow us to participate in more of the real estate we like with excellent downside protected returns.
If you have any questions about this market commentary or the Redwood-Kairos Real Estate Value Fund III, LLC please contact us.