Question: When it comes to investing, what is a 90% correction?

Answer: It is an 80% correction that then gets cut in half.

According to the Financial Times, last year was the worst year since 1871 for the bond market. The trend of historically low interest rates was reversed, with rates climbing significantly for the first time in decades. This is devastating for bond holders; if you own a 30-year bond at 3% and now the government is issuing 30-year bonds at 5%, your 3% bond is worth a lot less. (If this isn’t clear to you, read the series on “Dumb Money” I wrote back in 2013.)

In 2022, if you owned bonds, you lost money.

Historically, a balanced investment portfolio (a mix of stocks and bonds) was a hedge against loss. If bonds went down, it generally meant that stocks were going up. That wasn’t the case in 2022 because, over the last year, if you owned stocks, you also lost money.

This is all happening during a year of high inflation. The official narrative is that inflation has now peaked but, even if you buy that (and I don’t), it feels like it has peaked the way that a flood peaks. In other words, you’re sitting on a mound of sandbags and the water has stopped rising, but your living room is still going to be under water for a long time. I think it could be a long, long time.

The real interest rate is the nominal interest rate minus the inflation rate. Inflation peaked at 9.1% in June when the Fed Funds rate was at 1.2%. That means the real interest rate was -7.9%, which is difficult to even understand beyond acknowledging that such a deeply negative rate is not stable. You’ll only lend at an 8% loss if there is no other good place to put your money. If stocks and bonds drop far enough, eventually there will be.

Low interest rates suggest that many investors believe stocks and bonds have a long way yet to fall. That, or the Federal Reserve is trapped and can only raise interest rates so far, so fast, without wrecking the underlying economy, especially given the number of zombie companies ultra-low interest rates have created. I think the latter explanation is closer to the mark, but certainly there is a mix of causes. This is important for local leaders because it suggests things are likely to get more difficult for local governments in the coming years.

First, we seem to be in the early stages of a significant and long-overdue housing price correction. I wrote about this last September (“What Will Housing Prices Be a Year From Now?”) and housing prices have fallen significantly since then. This isn’t because we’ve finally built enough homes to bring supply more in line with demand, but because the spigot on the pipeline of cash being funneled at the housing market has been slightly constricted. Prices going down might seem like a good thing until you recognize that it hasn’t made housing more affordable, just less expensive (people are poorer now, too).

For cities that rely on property tax, income tax, or sales tax from discretionary purchases, there is bound to be a lot of budgetary pressure on the revenue side of the ledger over the coming years. Artificially high housing prices have made our local governments feel richer than they are. The inevitable housing correction will make them feel poorer, which is closer to reality.

It seems as if this housing correction is going to be paired with continued inflation, particularly in construction-related industries, and quite possibly stagflation (high inflation mixed with high unemployment) more broadly. The paradox of using infrastructure spending as a counter-cyclical economic stimulus is that, when everyone is doing it, the money doesn’t go as far as it otherwise would. Going back to my time as a practicing engineer in the 1990s, construction inflation has been significantly above core inflation. That is even more the case today (see: pipeline of cash).

That means the price tag on that huge backlog of unfunded infrastructure maintenance each city has is growing faster than anticipated. Local government revenues are tightening just when expenses are exploding. That’s less of an unfortunate happenstance than a predictable outcome of everyone having the same development pattern and trying to do the same unproductive things at the same time.

Amid this, there is a rash of state and local governments reporting better-than-expected budget situations. This is largely due to federal COVID relief funds, one-time money that cities must spend in the next couple of years. It’s hiding the sense of urgency somewhat, creating a greater divide between the official narratives and the anxiety being experienced on the street. As I wrote last month in my annual update on the Christmas Cookie Inflation Index, “when equations and theory collide with reality, it is the former that must bend.”

Most, if not all, local governments expect significant assistance from state and federal governments over the coming years. In fact, few can maintain their essential services—sewer, water, streets, police and fire protection—without very large allocations of capital from higher levels of government. Is this a reliable gamble?

Both of our major political parties have bought into the notion that deficits don’t matter and, thus, that the accumulation of debt is of less importance than other, more urgent needs. The notion that fiscal prudence does matter, that we should prepare for rainy days despite a long period of only clear skies, has been intellectually marginalized over the past couple of decades. Maybe that will continue, but perhaps not.

In 2021, the federal government passed a $1-trillion infrastructure bill. It was the “largest infusion of federal investment into infrastructure projects in more than a decade” according to The New York Times, adding $550 billion in new spending over the next decade. That’s $55 billion in new spending each year and it took a literal act of Congress—years of debate and negotiation—to make it happen. Anchor that number: $55 billion.

The national debt is now over $31 trillion, much of it financed by short-term notes (essentially, adjustable rates). We added a quarter of a trillion to that just last month. At $31 trillion in debt, a 1% rise in interest rates creates the obligation to pay an additional $310 billion in interest each year. We can say we owe it to ourselves, we’ll just print the money, it doesn’t matter, and on and on, but none of that changes the math.

How does a country that struggles to come up with an additional $55 billion a year for failing infrastructure pay an additional $310 billion just in interest? And that’s just at a 1% rise in rates; we’re going much higher than that. Do we cut defense? Cut social security? Raise taxes?

I have no idea, but I’m pretty confident that the highest priority of federal officials won’t be spending trillions bailing out every local government that got greedy for that next strip mall, big box store, and franchise restaurant and then massively overbuilt their infrastructure without having enough tax base or users to pay for it all. Maybe it will be, but I don’t think so.

And that means we’re going to have to figure out what to do about the financial challenges our cities face. We’re going to have to do that ourselves, at the block level, with real people whose lives will be directly impacted by our decisions. The sooner we focus on them instead of obsessing over the next allocation of federal grant money, the better off we’ll all be.

At some point, there ceases to be choices and we’re left with only consequences. The sooner your community switches to a Strong Towns approach, the more choices they are going to retain when others have only consequences.

Financial Outlook for 2023 and Beyond

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