One reason for the rise in US socialism

Should we be surprised by the rise of socialism in the US? No, if you look at the numbers. This is important because changes in the regulatory or tax environment will affect the return on capital, which will, in turn, impact the valuations of all companies. In an already overvalued world, a change in the government regime can be a catalyst for a downturn.

The evidence is in the changing percentages of profit to GDP and of employment compensation relative to GDP. Historically, employment compensation was always higher than profits, but that shifted in the post-2008 period. What happened? The cost of capital fell as rates approached zero. This allowed profits to increase as capital costs fell. Coupled with a change in industry structure, with the most profitable companies in the tech sector and not as heavily concentrated in labor-sensitive companies, the dynamics of profits to employee compensation flipped. There was no diabolical plot driven by greed, except to say that monetary policy assumed a trickle-down effect from lower rates that may not have worked as expected. Now we will have to live with the consequences.

Death of despair and macroeocnomics

 

There has been a change in society since 2000. Drug deaths, suicides, and alcohol deaths are up significantly. Society is different, and this is being reflected in consumer confidence numbers and views on economic optimism. This has been documented in the book Deaths of Despair and the Future of Capitalism, by economists Case and Deaton, which focuses on the crisis in the American working class. Their argument is that the loss of manufacturing jobs in the US, especially after China joined the WTO and the pandemic, was a major driver for this change. We may be seeing a reversal in the pandemic effect, but the loss of manufacturing is unlikely to be reversed. 

The optimism in the country has a lot to do with spending and with policy choices, and the current despair is not helping to solve any gap between the optimism of the lower middle class and wealthier individuals.

The single most important driver of the current housing market

The housing market has stalled, with sellers not finding buyers at current prices. There is a logjam, with sellers unwilling to lower prices after the steep run-up during the COVID pandemic. Buyers are being selective because not only do they have to pay a high price, but the financing is at levels above 6%.

Perhaps this is the market just finding an equilibrium price, but the real reason for any gridlock may be past mortgage interest rates.  Right now, 50% of mortgages are below 4%. 20% is at rates below 3%, and 30% is between 3 and 3.99%. There has always been a gap between current mortgage rates and the rates that homeowners have locked in. Unfortunately, the gap may be larger than normal. In real terms, homeowners in the post-pandemic period have negative real mortgage rates. There can be a gap of over 500 bps between those low mortgages and current real rates. 

Homeowners are not stupid. They know they got a great deal and do not want to move to a home that may not be significantly better and financed at a much higher rate. They will stay in their existing home or only leave if there is a significant gain from switching.

 

Equities at the half year mark

 

Even with the Iran War, the equity markets are generally up double digits for the year, with the only laggard being the S&P top 50 firms. June seems to be seeing a notable rotation out of information technology and communication services and into other sectors, such as industrials and health care. There also seems to be a rotation from growth into quality, although momentum was still a market leader. The rotation theme also seems to indicate a shift from large-cap stocks to small caps. In fact, small caps have been the best-performing sector. 

US stocks are still performing well versus the rest of the world in June and for the year. Nevertheless, international equities showed strong performance for the quarter. Fixed income showed slight gains for the month and quarter, but commodities have continued to slide. 

Our biggest concern for the second half of the year is the risk of a correction from high valuations. A rise in rates or a slowdown in credit growth to stop an inflation surprise is a likely downside surprise.