The economic and real estate market recovery cycles have been delayed but appear to be following a predictable recovery pattern. Normally these recovery cycles stretch for five to seven years. We’re now in year five of this current recovery, but because of the slower pace, the cycle might be extended. Then again, it might not.
We’ve not really been here before.
In light of that, I think it’s important to keep an eye on where we are and where we are going. Picking up on some themes I highlighted recently, here are some key economic factors to watch:
- The Federal Reserve’s stimulus program has not triggered much in the way of consumer demand growth, but it certainly has stimulated a new round of asset inflation. Although it doesn’t appear to be at bubble stage yet, money supply growth still continues, despite Fed tapering. (M2 is up 6.8 percent since July 15, 2013.) The fact is, the U.S. government has inflated the money supply by nearly 60 percent since 2008. Much of these newly minted dollars has found its way onto the balance sheets of financial institutions and large corporations. Many market watchers are worried that inflation could come back to haunt us with a vengeance — they’re just not sure how soon. It’s a particularly challenging time for CIOs and other asset allocators who are groping to come up with sustainable strategies
- The CPI is in fact up 2.1 percent from June 2013. But that’s not the whole story — you really have to look back further to put things into perspective. The fact is, one dollar today buys 42 cents in goods and services when expressed in 1982 dollars. Since 1982 — how many of you were alive and economically engaged in 1982? — your money has lost more than 58 percent of its purchasing power.
- Consumer credit is also on the rise, up 6.6 percent since May 2013. Personal savings rates are at 4.8 percent — not far off the bottom of June 2005, when it was hovering around 2 percent. We continue to be an economy driven by credit and spending.
- Consumer spending in fact is up 3 percent since May 2013, at around $11.8 trillion. And it has been on a steady rise since it bottomed in 2009 around $9.8 trillion.
- The good news is, the U.S. economy apparently still has room to grow. The housing sector is still in early stages of recovery. Industrial capacity utilization is still below 80 percent.
- Along the lines of “be careful what you wish for …” — we may be facing a labor shortage threat should the economy heat up dramatically. Unemployment currently is at 6.1 percent and falling. Although the median duration of unemployment has fallen dramatically, it still has room to drop to pre-GFC levels. In other words — unemployment statistics are more favorable, but still not quite as stable as the folks at the Fed would like. On the other hand, many worry that the current unemployment stats may mask a much higher real unemployment rate, when you adjust for those frustrated job seekers who have stopped looking and those who effectively are underemployed.
- Federal debt levels also are still a concern. The debt is up 13.2 percent since 2011. (The deficit had been shrinking as a result of the GFC, but has been on the rise again since 2009.)
- The banking system appears to be as sound now as it appeared to be going into the GFC, if not sounder, according to the St. Louis stress index. The Fed funds rate currently is hovering around 9 basis points — meaning nearly as close to “free money” as possible for banks and their preferred prime borrowers continues. This, too, has been fueling asset price inflation.
- Corporate profits after-tax are up 6.8 percent since first quarter 2013.
- Despite a continuing trade deficit, the dollar remains strong against most foreign currencies. This does not bode well for correcting trade imbalances. Americans are addicted to cheaper foreign-manufactured goods, and American goods remain relatively expensive in foreign markets.
- Advances in horizontal drilling and fracking technologies and the resultant increase in oil and natural gas reserves is leading the United States in the direction of energy independence. This has critical implications, both for economic and foreign policy in the United States. But surpluses/reserves, should they begin to accumulate, could drive prices down, which could change the economics for drillers and wildcatters.
The bottom line: The economy appears reasonably strong, which augurs positively for continued healthy space market demand growth. Development activity for new commercial space has been constrained but appears to be heating up in response. Development activity in many markets (Toronto, San Francisco) also appears to be heating up in response. But economic growth is still not robust, and some areas of vulnerability need to be watched.
Vulnerabilities
What could undermine or reverse the current economy recovery? One clear area of economic vulnerability would be a dramatic and unexpected uptick in inflation and/or interest rates:
- Treasury rates are hovering around 2.49 percent right now. Most people expect to see an eventual uptick in the 10-year rate, but no one expects a dramatic uptick, and most don’t expect an uptick of any kind any time soon. Those who fail to recognize the possibility that such an uptick could occur sooner and more dramatically than most expect could be caught flatfooted. (Do I really think that’s likely to happen? Not really. But it clearly is an area of vulnerability, precisely because so few are baking the possibility that it could occur into their forecasts and contingency plans. [Don’t forget — while some did actually predict a housing collapse going into the GFC, no one predicted housing prices would drop so fast or so dramatically. Even CS First Boston, which was one of the first to call the crash, predicted that housing prices could fall as much as 25 percent — not the 45 percent to which they actually tumbled in many markets.])
- Today, corporate AAA bonds are yielding somewhere in the neighborhood of just shy of 4.25 percent. If rates did rise dramatically and started to approach 8 percent (close to the typical return assumption underlying the underwriting of many public pension plans), that almost certainly would reshuffle the asset allocation deck, steering capital that has been steadily drifting into higher-yielding alternatives such as real estate back into the bond market. And that would place immediate upward pressure on capitalization rates.
I’ve said it before and I’ll say it again: another area of vulnerability is the equities markets. A strong market correction would place many institutional investors who are already at or above their target real estate and infrastructure levels into a seriously overinvested position (the denominator effect). If the markets corrected severely, it could and almost certainly would put the brakes on institutional capital flows to the real estate equity and infrastructure equity markets. And that most definitely would deflate the current real estate asset bubble that’s in the process of building.
Another possible vulnerability: Political conflicts that easily could escalate and spread globally including the current conflicts between Russia and the Ukraine, Russia and the West, conflicts between various Sunni and Shiite Muslim factions in the Middle East (Iraq, Syria and ISIS; the Syrian civil war; Iran and its nuclear threat), as well as continuing tensions between Japan and China, between India and Pakistan, between North and South Korea and its western allies, and between various factions battling for control of several sectors in sub-Saharan Africa.
Other potential threats include a nuclear terrorist event, global climate change effects, bio-terrorism or an unanticipated pandemic such as a new killer flu strain or an Ebola breakout.
Then there are also several long-term threats — including the proliferation of the automation of everything, and its impact on the job markets. Many jobs will be disappearing or altering dramatically as technological innovations continue to unfold. The investment property brokerage function, for example, almost certainly eventually will change dramatically as the use of automated auction platforms eventually become standard operating procedure for marketing or bidding on real property investments. Space markets — same thing. The role of journalists like ours at IREI — same thing. Financial advisers — same thing.
We’re speeding toward a world where machine intelligence meets or exceeds the power of human intelligence, and where virtually everything is connected and governed electronically. In that kind of a brave new world, what, indeed, will be the meaning of “work”?
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Geoffrey Dohrmann is president and CEO of Institutional Real Estate, Inc.
