China ramps up its lockdowns, which means more inflation … Fed presidents go “full hawk” … a fascinating contradiction from the housing market

The COVID- lockdown situation in China is getting worse.

Shanghai was supposed to be on staggered, nine-day lockdowns. But with a record 26,000 new daily cases being reported, the restrictions have grown more severe and have been extended to the entire city.

The 25 million residents have now been locked down for weeks. Many are struggling to get access to food and medical care.

Further south in Guangzhou, the local government is enacting new restrictions due to 20 new cases.

From CNN:

China’s unwavering commitment to stamping out Covid by locking down big cities such as Shanghai threatens to deal a hefty shock to its vast economy, place more strain on global supply chains and further fuel inflation…

Tesla, as well as many Chinese and Taiwanese manufacturers, are unclear about when they can restart their factories. 

Meanwhile, port delays are getting worse, and air freight rates are soaring, putting even more pressure on global trade.

At the heart of this problem is Beijing’s unwillingness to accept any COVID strategy other than “zero cases.” For Chinese leaders, it is unacceptable to adjust to a new world where COVID is ever-present.

Under such policy, the entire Chinese economy is vulnerable to snap lockdowns for, well, forever. Or until COVID completely disappears from the earth.

Unfortunately, global supply chains are the collateral damage.

From Bloomberg Quint:

If China continues its Covid-zero approach, expect global supply chains to remain stretched, U.S. inflation to remain elevated and for the Fed to be forced belatedly into jumbo rate hikes. That would put tremendous flattening pressure on the Treasury curve out to three years.

…we could see supply-chain disruptions from China’s lockdowns just as U.S. 2021 inflation data base effects are about to kick in, which would have lowered 2022 inflation prints.

Chinese officials understand this problem and are attempting to keep normal port and shipping operations despite the case numbers in Shanghai. The risk is that they fail.

It appears they’re already failing.

If you can’t read the tweet below, it reads:

In normal times, there are 100 ships waiting to load or discharge at the Shanghai port. It’s now 300+. Oh boy.

As long as Beijing demands zero COVID cases, global supply chains will be under pressure…which fuels inflation risk…which means you must make sure your portfolio is engineered to handle this type of environment.

Own high-quality stocks with pricing power, commodities, targeted plays like fertilizer and energy, real estate, and some elite cryptocurrencies.

***Meanwhile, bond yields continue surging as the Fed talks tough about rate hikes

Last week saw a handful of Fed members go “full hawk.”

Leading the way is Federal Reserve Bank of St. Louis President James Bullard. If he gets his way, get ready for massive rate hikes.

From CNBC:

Bullard, a voting member on the FOMC this year, said Thursday that “inflation is too high” and the Fed needs to act.

In projections released in March, Bullard called for the highest rates among his committee peers. He has said he wants to see 100 basis points’ worth of hikes by June. The benchmark fed funds rate now is in a range targeted between 0.25%-0.5%.

“U.S. inflation is exceptionally high, and that doesn’t mean 2.1% or 2.2% or something. This means comparable to what we saw in the high inflation era in the 1970s and early 1980s,” he said.

“Even if you’re very generous to the Fed in interpreting what the inflation rate really is today … you’d have to raise the policy rate a lot.”

In response to all this hawkishness, the 10-year Treasury yield has been surging. As I write Monday morning, it’s at 2.75%, the highest level since early 2019.

And if you think your stock portfolio has been taking it on the chin, have you looked at your bond investments?

From market researcher Jim Bianco:

The carnage is epic.

This is not only the worst bond market in our career (total return) but might be the worst of our lifetime.

As noted a moment ago, we’re seeing more and more Fed members turn exceptionally hawkish, upping their interest rate targets, as well as the speed with which they want to reach those targets.

The problem is that, just like driving a car, when you accelerate incredibly fast and keep your foot on the pedal, it increases the odds that a small mistake could result in big consequences.

Back to Bianco on the risk of a miscalculation:

(The Fed doesn’t) want to create the mistake in the other direction by being too timid right now. That’s out the window now.

They don’t want to create a broken market. They don’t want to create a recession. But when you go down that path and you’re that adamant about trying to rein in inflation, it makes it very likely that you will create a mistake…

It will be 50 [basis points] all the way through until the Fed basically raises rates too much and breaks something.

And, then they’ll be done.

Let’s hope it doesn’t come to that.

In the meantime, we’ve been highlighting ways to play this rising rate environment here in the Digest. Despite the risks, there are still opportunities today.

***One real world impact of these surging yields is the recent explosion in mortgage rates

Last summer, you could find a traditional 30-year fixed mortgage rate for under 3%.

No longer.

Would-be homebuyers are now looking at rates above 5%.

NPR profiled a would-be homebuyer in Tampa, looking for a home in the price range of $600,000. He says that the recent surge in mortgage rates adds roughly $700 to monthly payments. And that doesn’t include the nosebleed increase in the home price itself.

(Imagine where mortgage rates are headed if James Bullard gets his way.)

Now, this is setting up a fascinating contradiction.

To explain, let’s start with housing inventories.

As you can see below, U.S. housing inventories are at record lows.

You can’t flip a switch and suddenly flood neighborhoods with more homes.

So, you would think that this situation would be the mother of all tailwinds for homebuilding stocks, right?

After all, if supply is historically low, homebuilders should be making money hand-over-fist as they increase supply until the market reaches equilibrium.

Nope.

Homebuilding stocks are tanking.

Below, we look at ITB, the iShares Home Construction ETF.

It’s down 31% here in 2022.

Why?

Well, it looks like Wall Street is betting that soaring rates will slam the brakes on the housing market.

But this is a bit of a headscratcher.

Higher rates might slow down runaway home prices going forward. But they wouldn’t necessarily lead to a crash for a market this strong, right?

Is there another variable at work here that we’re missing?

Author and analyst Logan Kane points toward a recent, third-party influence on this situation – the government:

I think the legitimate fear here is that our grand experiment with emergency-era socialism could be distorting market signals, leading companies to make huge investments based on long-term demand that’s in fact a mirage.

After all, if many people aren’t working and the stimulus that’s giving them their income ends, they’re not going to be able to afford to live on their own…

…Millions of people are not capable of paying for their current level of housing without the government paying for them or blocking the legal system from evicting them.

So, what’s the answer here?

Are homebuilding stocks down 31% a fantastic buy (and Wall Street is wrong)? Or are they a value trap because the housing market is headed for a correction (and rabid buyers/sellers today are wrong)?

Here’s Kane’s bottom line:

Given the demographic picture, I believe the preponderance of the evidence suggests that the housing market boom is cyclical and will result in a bust. Therefore, homebuilder stocks appear to be a value trap.

We’ll be watching this closely.

Homebuilding stocks are trading at such low valuations that it could set up a great trade if we’re able to sidestep a recession. And even if a recession hits, placing our chips when economic data eventually turn from “bad” to “less bad” could handsomely reward investors.

For now, housing stocks are going on our watchlist. We’ll keep you up to speed.

Have a good evening,

Jeff Remsburg