Shadows on the Horizon

By Karen Stevenson, 10 September, 2023

I’ve been reading lots of analysis of where the economy is going, and one word that keeps popping up is the word “shadow”. Shadows are things that don’t show up in the official statistics, but might be big factors to what happens next. Shadow inventories that might suddenly come on the market could turn a shortage into a glut. Missing workers that are no longer looking for jobs, might reappear. Assets that are worth less than their book value will have to be recognized if they have to be sold or marked to market. Uninsured deposits that might flee the banks can cause bank runs. There are many things in the shadows that can completely change the economic outlook.

Shadow housing inventory could affect home prices

For instance, I talked about shadow housing inventory in an earlier post, The Future of Home Prices, Partly Cloudy? That post discusses the fact that there are a huge number of homes that are not occupied by their owners. If nobody lives there, the dynamics about when and why to sell them are different than the dynamics for owner-occupied housing. Non-resident owners facing higher interest rates or flagging rental income have fewer reasons not to throw those houses on the market to get out from under their problems. Housing is “priced at the margin”. That’s a fancy way of saying that the value of all houses is based on the latest prices, the “comps”. If you have some distress sales, they are factored into the “comps” that are used to value all other houses in the area. A few distress sales can reduce the value of all the houses that aren’t for sale, and that in turn can change the calculus for anyone else pricing a sale, or a purchase, or a refinancing. This is what happened in the great financial crisis of 2008, where the value of real estate dropped into a downward spiral. Housing prices are too high now, unaffordable by most standards. If the shadow inventory floods into the market and pushes prices down it would be a blessing to people priced out of the market now but a big problem for an economy that isn’t expecting it.

Employees and jobs have to get back in balance

Another place where something is going on in the shadows are the job numbers. Ever since the beginning of the pandemic the numbers have been odd compared to what they were before the pandemic. Initially lots of people were out of work as businesses were shut down. Then business re-opened but not everyone came back to work.

There are several ways to look at the job statistics. The absolute number of people who are unemployed has stayed the same even while job openings have surged. It seems like unemployed people could have filled at least some of the increased number of jobs, but they didn’t. The unemployment rate has returned to what it was before the pandemic but the labor force participation rate never got back to previous levels. Why isn’t everyone coming back to work?

Either way you look at it, some employees have just disappeared. One theory is that a lot of older workers just retired early. Another is that it’s too hard to get daycare for children now so some parents are out of the work force until their children get older. Either way, post-pandemic, there seems to be a missing, shadow, labor force.

There are a couple ways this could resolve. One is that some job openings could evaporate so workers are again in balance with the jobs available. This could happen in a recession, for instance, or if the horror stories about AI prove true and AI eliminates hundreds or thousands of jobs. Another way this could resolve is if the shadow workforce returns. Maybe retirees decide they can’t afford or don’t like retirement and come back to work. Or maybe someone solves the shortage of childcare. Or people quit having children because who can afford them any more?

The current imbalance between jobs and workers keeps wages higher. Any resolution of the imbalance that reduces jobs or increases workers might push wages lower. Higher wages keep the economy humming and lower wages cause people to cut back on spending or maybe unable to make their mortgage and car payments. This is another shadow that makes the future uncertain.

Bank credit will be hard to come by

During the banking crisis in March we saw that many banks held long term, low interest, loans and treasuries. This didn’t look like a shadow, these were “safe” assets. After all, what is safer than a treasury note? But they were only safe if they could be held to maturity. If they had to be sold, for instance to pay out a run on the bank, they were not safe at all. Because the interest rates were so much lower than current interest rates, they were worth far less than their face value. The bank crisis pulled this issue out of the shadows. For now it is resolved. The Fed created a new program that allows banks to use the value of those treasuries without selling them at a loss. I posted about this in Banks, Shadow Banks, and Loans. The Fed fixed the valuation problem but buried in the result is another shadow, the fact that banks are now in no position to make new loans. And credit is what makes the economy go around. Small business loans, car loans, home mortgages, all will be tougher to find, and that will throw a wrench into the economy.

Businesses may have credit problems

This is a big one and I don’t know if it can be measured. Interest rates have gone up a lot but many businesses and consumers have been protected from the rate increase by being locked into long term low interest loans. But the terms of loans for businesses, including commercial real estate, are not the 20-30 year terms of home mortgages, they are more like 3 years. At the end of the term the loan will have to be refinanced. If interest rates had briefly gone up and then gone back down again, the businesses would have been able to wait until rates were low again to refinance. But that isn’t what happened. Rates went up and stayed up. That means those businesses will get a proposed new loan at much higher interest rates. If their credit is bad, they’ll have even higher interest rates or even less chance of getting refinanced. If they don’t have sufficient cash flow to make the new higher payments, they won’t be approved. 

The other side of the equation is that business bank loans are backed by some kind of collateral. It may be the value of real estate that the business owns. It might be the personal net worth of the owner. It might be the accounts receivable for the services the business performed. If the business loan is backed by commercial real estate that has lost value, or if sales have dried up and customers aren’t paying what they owe, those loans may not be refinanced.

Both of these outcomes are going to hurt. Some significant amount of loans won’t be refinanced at all, and another significant amount will be refinanced but at much higher interest rates.  If the business can’t get financing they will have to make drastic cuts in their business model, or even go out of business. If they go out of business they will put their employees out of work and may also endanger their vendors. There is no telling how big this shadow is, but it could be huge.

On-shoring makes things more expensive

The housing market isn’t the only place where there are shadow inventories, or lack of inventories, that might create issues. As almost everyone has heard by now, a lack of inventory was a big reason for the spike in inflation during the pandemic. Supply chains dried up, almost every kind of product was hard to get at some point or another. Then the problems lurched the other direction. Some businesses over-ordered to compensate for potential delivery issues and ultimately ended up with too much inventory. The big story of 2021-22 was inventory shortages. The big story of 2023 has been companies trying to get rid of excess inventory. Prices went up, then they went down. If that’s the end of it and we’re back in balance, that shadow is gone. 

One place the shadow remains is around items sourced from unfriendly countries. The new trend will be finding reliable and safe inventory sources. This may mean on-shoring, or building more things in the US. We have a great country and I love to see us produce more things at home, but the reality is that we have never been and never will be the cheapest place to build things. In addition, we seem determined to charge higher and higher tariffs on goods coming in from other countries. Both of these actions will come with a price, things US consumers will pay more for many things. We haven’t seen the full impact of this yet, that’s why I still classify this as a shadow, but tariffs and on-shoring mean future prices will probably be generally higher. And higher prices means inflation will be higher. And higher inflation will fuel other impacts on the economy, and in every part of our lives. Ironically, in this situation a recession might be a good thing, since that might reduce the cost of producing things at home, at least as long as the recession lasts.

Fuel and food prices are still wild cards

The core CPI that the Fed pays attention to ignores fuel prices and food prices because they are volatile, and because the Fed’s interest rate policies don’t have much effect on them. But those prices are still important to the American economy. If they spike up and stay up it will take a big toll on most household budgets. Food prices are important because everyone has to eat, and going without food is not an option. Fuel prices are doubly critical. There are the prices that directly impact consumers, like the cost of heating fuel and the prices of gas at the pump. But fuel costs affect every stage of the production cycle from the cost of manufacturing and mining and processing to the cost of shipping. High fuel prices bleed into the cost of pretty much everything. Fuel prices dropped quite a bit mid-summer, which is a time of the year when fuel prices often drop. But there are lots of factors conspiring to push those prices up. High interest rates make it expensive to drill for oil or dig for metals. Unfriendly countries can cut production or refuse to ship fuel to the US. Green energy initiatives require huge up-front investments, and depend heavily on materials that are mostly sourced outside the US. The only thing that is likely to bring food and fuel prices down is a big recession where demand for everything dries up. If we have a soft landing, with no recession, prices will probably stay high.

Watch the shadows

The message is to pay attention to the shadows and don’t get blind sided by them. We can’t be sure what will happen or when, but we can be aware of things that might create problems and try not to be in the wrong place at the wrong time if they start to have an impact. People who don’t pay attention to things going on in the shadows are the ones that end up saying “nobody saw that coming” when things go off the rails.