AIPIS 183 - The Opportunistic Investor Sentiment with Frances Donald

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It's my pleasure to welcome Frances Donald to the show. She is a senior economist at Manulife Asset Management and she is here bringing us good news about the economy. I think we'll let her tell you directly. Frances, welcome. How are you?

I'm doing well. How are you?

Good, good. It's good to have you on the show. So obviously a lot is changing. There seems to be a lot of optimism out there. The Trump administration promises to loosen regulations to control the border to bring jobs back to America. What are your thoughts?

Well, it does seem like the US Economy is pushing off the dock. There are signs that growth is re accelerating and the seeds of this acceleration probably began in about July of 2016. The consumer is looking strong, business investment intentions are rising, exports are looking stronger, and the pain felt in the US Economy from too strong of a US Dollar and falling oil prices now seems to be subsiding. So over the next six months or so, I would say I have a positive outlook for the US Economy.

Okay, good stuff. Now you do regular investor sentiment surveys. What are those telling us? Right.

So the John Hancoc with which we're affiliated does run an investor sentiment survey. It's a poll of affluent investors. And what we found is that investors are certainly more optimistic this year relative to a year ago. So the investor sentiment survey rose about 10 points over last year. That's the highest level in two years. And when we ask investors what is it that's making you so optimistic about the future, they come back by saying it's the stability and strong performance of the stock market. I have to say, however, that when scanning the results of the survey, it is clear that there is a lot more optimism about the US Economy in general.

Yeah. So the stock market and the economy, do they go in lockstep or can you differentiate them a little bit?

Oh, they certainly don't always go in lockstep. One of the differentiators is that the stock market tends to price in what's going to happen to the economy pretty far in advance so one of the things we've seen now is the expectation that policies out of Washington will translate into better economic growth. Now that economic growth is not here just yet, but the stock market has chosen and to price it in. So the downside risk is that we don't necessarily get that upside growth. And then the stock market needs to correct.

Of course, the stock market is always a, you know, a window into the future, if you will, because that's exactly what it reflects as expectation of the future. How far out does the stock market price things in? You know, is it, is it generally thought to be six months, two years? What, what's sort of the time horizon there?

Well, our rule of thumb is generally about six months ahead. The stock market has a good sense of where the economy will be six months from now. Although what we do tend to see is that if there's a piece of economic news that hits, the stock market can price it in almost instantly. I mean, we saw that when Donald Trump was elected. Within 24 hours the stock market had priced in many of his policies.

Very interesting. So talking about Trump policies and so forth, what, what do you think we can expect? I mean, is this all, is this all kind of like a Trump bull run or does Trump not deserve credit for what's going on?

Well, I'm certainly no political expert. I just look at hard data. But what's clear is when we're adjusting our forecasts looking forward into 2017, 2018, number one, we haven't made any changes to our forecast because there haven't been any actual policy announcements. As of right now, everything is a hypothetical and you' find that central banks follow that same convention as well. Don't price anything in, don't incorporate it until we know for sure. But essentially there are three areas where we're paying a little bit more attention that could alter forecasts. And these are probably where the stock market is most focused as well, as well as the bond market. The first one is deregulation and the potential deregulation has to lift certain sectors and to put more money back in the economy. The second is tax cuts, which always tend to be good for growth. And the third might be the most important and that's the expectation of infrastructure spending moving forward. So the potential for these three elements to move forward or not is probably the top of most financial markets, stocks, bonds and others at this point.

What are your thoughts on real estate, especially the housing sector?

I generally like real estate and one of the reasons is because residential investment as a share of gdp, it's still very depressed by historical standards. So there's room for more construction spending in housing. House prices have been growing about 5% year over year.

Stable.

That's sustainable. That's kind of healthy house price appreciation. The challenge for housing moving forward is that interest rates are moving up and that does tend to correlate with fewer mortgage applications and a downturn. My sense, however, is that there's still enough pent up demand to compensate for higher interest rates in the system. And while we might see some temporary softness, there's room to run in housing.

Right. And the problem with that is that, you know, when you say 5%, of course we're taking into account three basic types of real estate markets. The linear markets, the cyclical markets and the hybrid markets. And in the cyclical markets, I mean, prices have shot up, you know, far more than that. It's really well into bubble territory, I would say, in some of those markets. But the problem with that is just because it's, you know, way out of whack with fundamentals in say, Los Angeles, San Francisco, Miami, Boston, New York. Right, etc. Etc. All those type of cyclical markets, it doesn't mean it can't go on for another two, three years. That's the problem with that.

Exactly. We've seen that in several housing markets. Canada is a very good example. People have been trying to short the housing market in Canada since 2012, saying it's overvalued, but sometimes it can become more overvalued. But your point is a salient one, which is that we tend to talk about housing on a national level, but frankly there are really regionalized housing markets that demand particular attention. There's also tiers of housing. So in the past, particularly following the financial crisis, we would look at tier one, tier two, tier three types of housing. And that is to say tier one being the larger, the more expensive homes, they suffered less in the crisis than the cheaper homes. Now, only recently have we been talking to people who are seeing themselves come out of being underwater. There's still a lot of healing happening in the houses housing market in certain regions in the country. So I certainly take your point that talking on a national level can be dangerous. But when we're aggregating up to kind of growth forecasts and what it means for Washington, those national numbers are what are going to be presented.

Yeah, well, there's an old saying in real estate, all real estate is local. All real estate is local. So I completely agree with you on that statement. You know, in a country as Large and Diverse as the US you have about 400 real estate markets. And I believe, as I've been saying for so many years, they can be categorized into one of three types, linear, cyclical and hybrid. And that just, you know, simplifies an analysis of it when you, when you look at it that way, I think. But you know, it's interesting, Francis, and I wonder if this is meaningful, you know, or is it just sort of an anecdotal thing. But I've been saying ever since the election, Donald Trump is our first real estate president. You know, he's a real estate guy. I mean, you know, you might have been thinking of him from the Apprentice, but real estate is like in his blood. His father was a real estate developer, you know, and he's obviously done incredible things in real estate. Love him or hate him. Does that mean anything to the real estate market? That he's our, as I say it, our first real estate president?

The way I look at it is that we're seeing a president that's unlike those that we've had in the past and falling in lockstep in with that. We've seen an unprecedented rise in consumer sentiment, in small business sentiment and CEO sentiment. So you could probably segment that into real estate and other sectors. But what we're seeing is the expectation among business owners, among investors, among consumers, of a more favorable environment moving forward. Now, as I mentioned earlier, all of these remain hypothetical, so there is downside risk to these confidence metrics. But even at the margin, if a small company is feeling a little bit better about their future prospects, even if they hire one additional person, if the real estate sector feels just a little bit more optimistic about a certain investment, that can have a self fulfilling prophecy as well.

Yeah, no, that's a very good point. You know, you said earlier, Francis, you talked about how by historical standards, real estate, I guess you were talking about development, maybe real estate was a relatively still at a relatively small proportion of the overall gdp. Can you give us any numbers on that or just a sense of the scale on that, you know, in terms of where we are now versus where we have been historically.

So the best way to think about it is that residential investment as a share of GDP is still running about one standard deviation, but below the long term average. So of course, following the financial crisis, housing peaked around 6.5%, 7% of the total economy. It tanked all the way down to about 2.5 to 3% if I'm not mistaken. And it's really having trouble coming back into Play. So the caveat to that is that we often tend to say, I remember in 2007, it was very common to hear there's no way that housing could cause a financial crisis. It's only 6% of the economy. Well, we learned from there that there are all sorts of tentacles that run from real estate to the breath economy, but in terms of sheer construction activity, in terms of investment in residential activity, it is still at depressed levels. There is room to run.

And you know, one thing, this is something that I predicted many, many years ago when I was telling people, you know, our clients and talking at my live conferences and so forth. I was saying that there was going to be a real estate market crash in Southern California in 2003, 2000, 2004, and into 2005. And people were arguing with me. I mean, I would get in these huge arguments with Realtors. And one of the reasons I knew that was coming is not because of the overall financial crisis, if you will, and all of the gamesmanship that Wall street was playing behind the scenes, the way they were packaging loans. And, you know, we all learned a whole bunch of, well, maybe not you, but the rest of us learned a whole bunch of new acronyms after, after the work.

We learned to gather data. We learned about data we didn't even know we should be gathering. Certainly even the experts were caught off guard.

Yeah, yeah, but, but what? My point in saying that and, and so that, that's good, good to know that makes me feel a little better. But my point in saying that was I did know that the mortgage lending was way too liberal, you know, and I knew that a lot of people got 31 arms and 51 arms at certain points in, you know, 2000, the year 2000 or so, and then 2002, you know, there were these big swaths of those loans that were made, and you knew there would be adjustments three to five years later. Right. So that was, in hindsight, you know, kind of pretty easy to see and predict. But one of the things I really want to caution people about is how you mentioned construction and how many tentacles the real estate market has. So, yeah, it's 6% of GDP, but it's so important to politicians because every time someone buys a home, I, you know, I remember years ago, and I'm sure this is higher now, at least adjusted for inflation, if not in real dollars versus nominal, but at least in nominal dollars, that they, on average spend $15,000 more on other stuff, appliances, organizers, you know, gardening, I don't know, whatever they spend, it On, Right. There's all these add on effects. Right.

Definitely consistent with what we've seen. And one of the challenges is that because we're seeing depressed home ownership rates and there's a lot of reasons for that. We see more rental market. Well, there's fewer multipliers to growth from a rental market than there are from a housing market. People are not so excited to tear down walls in their rentals or invest in the garden out in front. So that's a longer term concern that probably weighs on the multiplier effects in house housing and something economists have been watching very closely.

Yeah, that's a, that's a good point. But just to finish my thought there and then I got a question about that. I would say that you need to be especially careful in areas. And I saw this happening in Southern California. I knew this would be like the double whammy is because when the housing market softened a lot, all that construction would go away. And there were so many construction workers and so much investment in construction that that was like an another. It was, you know, it was a one, two punch. And too much of the economy was based on all of this construction. And then make it even worse. In Orange County, California, where I was at the time, you. That's ground zero for the mortgage industry. So all of those mortgage people too, you know, became unemployed or underemployed. Yeah, it was like a 1, 2, 3, really not a 1, 2. But when, when you mentioned the multiplier effect, and I totally agree with you that it happens in housing. And this is why the government and central bankers always want to, you know, pump money into housing and support housing any way they can. They're really fans of real estate because of that multiplier effect that you get out of it. But if people, if more people rent, and I'm one of these weird people that probably a lot of people disagree with me, I think the housing, the homeownership rate should actually be lower. You know, I don't think we should have a 69% or even a 62% homeownership rate. I think it should be about 55%. But you, whatever, we can debate that all you want, but doesn't that money go somewhere else? I mean, just because someone didn't buy a house and they chose to rent instead, and certainly the rental market strengthened and investors benefited from better cash flow on their rental properties. As the rental market strengthens, doesn't that money go somewhere else? It's not like they don't spend it or use it or invest it, right?

Well, it depends what the drivers of rentals are. So it seems right now that there's kind of two drivers for rentals. One is that, you know, before 2007, 2008, there was a common conception that home prices always went up and that housing was the best investment you could make, and that's dissipated. So preferences have changed. Fewer who want to go into housing, but there's also the ongoing issue of those who can't get into housing. And in part, that's fueled by incomes not rising in real terms as quickly as they should be. It's also fueled by very high student loans that cap the amount of mortgages that young people can get into. So it's not necessarily that you're making the choice you could afford either, and you choose rentals and put that other money towards something else. A lot of it is being unable or unwilling to access the housing market. The other element I'd say here is because we've seen higher demand for rentals. The average mortgage price and the average rental are actually floating about the same. That's atypical. That doesn't usually happen. So it's not like we're seeing $100 per month savings from those who are currently in the rental. But I think your point is a good one, which is, what is the optimal home ownership rate? And we do see it as lower in Europe and higher in places where the preconception that investment is that real estate is always a great investment is still prevalent in places like Australia or Canada that haven't seen real estate collapses and still have that view that the best thing you can do with your last dollar is put it in your house. Americans have learned that that's not always the case. And I don't think that's a cyclical issue. I think that's going to purchase permeate for many decades.

And I think that's a good thing. You know, being a real estate guy is counterintuitive that I would say that. But I, you know, I. I think that is a good thing that they. They think that. But tell us more about the atypical nature that you just mentioned of rents and mortgage payments being about the same. What is the historical thought on that versus how it's atypical now that it's about the same?

Well, typically what happens, and it makes a lot of sense, is that, you know, the housing crisis going up, people can't afford to get in housing, so they go into rentals. Then rental prices go up. There's less demand for housing, and they sort of work in opposite directions. That's what we would call kind of a healthy rent versus buy environment. But what we're seeing now is it's taken a very long time for banks to open up their pocketbooks. Millennials are choosing to stay at home much later than they have in the past. And the student loan issue is really limiting the amount of debt that young people are willing and or able to take on. So this natural relationship of going back between housing and rental is, in my view right now broken. And it won't be fixed until we see student loan numbers come down so that young people are not carrying several hundred thousand dollars of debt by the time they want a mortgage. And it won't be fixed until we start to go back to an environment where banks are willing to, to open up liberally and provide mortgage loans to young people.

Yeah, well, I was going to ask you about that when you mentioned it before. And listen, I, I just rail on these universities and the whole student loan debt complex. It's a complete scam. It makes me very angry. You know, it's like these millennials, the Gen Y generation, they all have a mortgage. They just didn't get a house with it. It. So it's, it's ridiculous what they're, what they're going through and what they're saddled with. But even if you pay a student loan and you have to, because it's the only type of financing that's not dischargeable in bankruptcy, so these people are literally indentured servants. They are slaves. They are debt slaves. And those loans will probably not be discharged. I mean, if Obama couldn't do it, certainly Trump's probably not going to do it. They're going to pay those loans. But someone is getting that money, right? You know, there's a finance company, there's the university, so that money does flow and it has a multiplier, right?

Well, I would expect it to probably have a low multiplier effect compared to where that money could go elsewhere. So if you think, you know, you asked me earlier, you know, are, where's the extra money coming from? Those who are renting over buying? Well, I would say that where's the money not going if you're spending 250, $350 a month sending it to your student loan payments? That money historically would have gone into saving for a down payment for a home or buying a car or having children younger. So you don't see the fertility rate dropping in the past as much as it has Now, So the multiplier effects for things that would traditionally have been used for that several hundred dollars are much larger. But I think, most importantly, and these questions you're asking are so salient, is that our models for looking at the world in the 80s, 90s and even early 2000s do not function in the current environment because the entire spending appetite and needs of today's consumer have radically changed over the last 15 years. So we cannot use the same models that we used in the past to look forward into the future. And the same is true with the rent versus buy equation. We can't think of it the same way we have in the past.

I agree with you and that's, it's quite interesting. So the downside of a higher, a lower home ownership rate and a higher rental population rate is you don't get the multiplier. So let's say we agree on that. Although I do think you get some multiplier, you just don't get as much. I mean, the, the real reason you don't get a multiplier is you have an anemic job market and, you know, wages have stagnated in real dollars for decades now. And, you know, maybe that'll change under Trump. Well, in fact, that's a good question for you. Do you think that'll change under Trump? Look, he wants to, he wants to stop the ability to bring in low cost labor from south of the border. He wants to have a more protectionist trade policy that'll bring jobs back to the US I believe it will. I believe both of those things. Will. Those both look like wage growth to me. I mean, he won the Rust Belt. That's surprising that a Republican, although Trump is sort of not even a Republican, he's just kind of a different kind of character completely. But, you know, a Democrat did not win the Rust Belt, and that was an amazing thing. So, you know, these people have, have realized that the Democratic Party hasn't, even though they talk about supporting them, they haven't really brought home any results, you know, and, and so these sort of blue collar workers, I think, I think they're going to prosper under a Trump administration. Do you agree or disagree with that? And are we going to see some wage growth? Because that's really what we need to have a multiplier is wage growth, right?

Well, wage growth, in my view, is very difficult for federal governments to actually make any sizable changes to the exception of increasing minimum wages, which does have an effect of pushing all wages higher to a certain extent. Wage growth at the end of the day is going to come down to supply and demand of labor. And the United States right now has a very tight labor market. The labor, the unemployment rate, about 4.7%. It's going to be hard to get that unemployment rate much more lower than that. Maybe we can get more.

Which means wages won't go up just by supply and demand, right?

It should mean. It should be. It should mean that wages go higher. There are, however, some structural issues that are weighing on total wages. And one of them is as simple as demographics, and that is that we have an older segment of our population that is retiring. Now, the way it works is the older you are, the more money you make, or at least that's the idea we've all been fed. Well, the people at the top end of that wage curve are getting out of the labor force and being replaced by younger people. So that has the effect of suppressing wages across the entire country. That's very, very difficult for any government to come in and improve upon and.

Then say to you, look at Japan, right? You know, there's, there's a good example of a huge demographic problem, but that's not abnormal. I mean, granted, the size of it might be different. The baby boomer demographic, that cohort is a very large one. But Gen X is, my generation is a very small one and then Gen Y's really big again. So, I mean, that always happens, though this is not new.

So you mentioned Japan. Japan actually has some of the lowest wage growth in the developed world. And policymakers have found it nearly impossible to see even nominal wages rise, in large part because of the demographics issue, among others. Now, one additional disadvantage that Japan has over the United States is, is that Japan has extremely strong companies and unions. And these unions limit the ability of companies to raise wages or they push up wages in the short run. But companies in Japan never want to raise wages too much because they can never cut wages. So there's a wage rigidity in Japan that is not present in the United States. The United States has a much more free market of wages, but I wouldn't downplay that. The structural impacts are having a pronounced impact on the ability for US Wages to continue to rise. Now, I will say they're not stagnating. Right now, wages in the United states are growing 2.83%. That's nothing to sneeze at. And it does correspond with a very low unemployment rate. It's just that if inflation is growing at 2%, then when you adjust for inflation, you're not you're not left with too sizable a leftover. But to say that, you know we haven't seen any wage growth in the cycle is based on the data false.

Very interesting Francis. I really appreciate your insights into a lot of this stuff. Please give out your website and if you want to share any resources where people can maybe see some of your sentiment report or anything, feel free.

Yeah sure. You can head to john hancock.com we have a lot of information information posted there and you can always follow me on Twitter Rancis Donald I post all sorts of things related to the US and global economy.

Fantastic. Frances Donald thank you so much for joining us.

Thank you. Have a great day.

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