August 22, 2019
August 2019 Market Commentary
We may be in the dog days of summer, but the activity in the market has been anything but sluggish. Below are some quick market takes from what has been a volatile summer:
- Over the past year, the Fed has gone from “four rate increases in 2019-2020”, to then, “just kidding – two increases”, to now, “just kidding again – let’s cut now and cut again in September”
- We’re waging an “on again, off again” trade war/game of chicken with China
- The yield curve recently inverted, which is an indication of heightened nervousness in risk markets and has predicated nearly every recession over the past 50 years
- About 30% of the global tradable bond universe is negative yielding (a record), according to JP Morgan
- Due to the prevalence of negative yielding bonds overseas, we now have US economists speculating on the possibility of this phenomenon reaching the US (this might be our biggest risk, discussed further in this letter)
- Yet, as a backdrop to all of this, unemployment remains very low (we’re essentially at full employment), corporate earnings season has gone better than anticipated, and the consumer confidence index remains high (albeit off the 2018 peak)
Welcome to today’s investment landscape, where investment challenges abound – High valuations, low/going lower interest rates (kills savers), low/no inflation, and massive political discourse.
Let’s take a step back and look a little closer at what’s going on.
The US Economy: The best in the world, the current economy is good. Asset values are strong, corporations are printing cash and people are employed, confident and spending money. Ask several people how they are doing, and I expect they will tell you they are having their best year ever.
Global Economy: This is more concerning. Trade tensions are rising. The UK has fumbled Brexit and may be in for a crash landing. The German economy contracted in the second quarter and data out of China is getting softer. This is driving investors to seek security, reflected in the record amount of negative yielding bonds and the inverted yield curve in the US. Interestingly, a lender in Denmark recently introduced a negative 0.5% interest rate mortgage. If this trend extends to the US, we expect cascading negative implications particularly for pension funds and retirees (remember, we have an aging population), as well as central banks who ultimately lose effectiveness in a negative interest rate environment (creating uncertainty, decreasing economic activity, etc.).
Interest Rates: We surrender; rates will be lower for longer. This does not mean that we are taking more risk in our underwriting; however, it does mean we feel great about our existing portfolio and upcoming realizations.
The Banking Industry: Rock solid. We think there will be little to no distressed real estate at the bank level.
Real Estate Equity Investments: Be careful out there. “Lower for longer” doesn’t mean there isn’t risk of cap rates increasing within the next five years, never mind 5-10 years. In fact, cap rates are heavily tied to the flow of funds in the capital markets and there is a lot of nervousness out there. We expect there will be losses in equity two to four years from now even if there is not a recession. A lot of investments being made today require underwriting to perfection and assume the next four years will be like 2018.
As a reminder, stock market volatility is not a recession. We recognize that the bears are increasing and there is a migration towards safety. The inverted yield has certainly been a reliable predictor of recessions, but the timing of a recession post-inversion varies (the average is 17 months). To us, it does not feel like a recession. Not that we would mind one, or that it would be so bad. A little economic slow-down would not be a bad thing, unless the Fed brings us into negative interest rates. If we were to have a recession (technically two consecutive quarters of economic decline, as reflected by GDP), we think it will be mild and nothing like 2008.
How and When Does This End?
The how is the easy part: asset values are artificially high due to years of low interest rates and cap rates below historic averages. At some point the air comes out of this balloon and things change. When this happens, the equity will lose.
When? That is the hard part. We feel like a weatherman predicting rain. As stated above, we’ve typically seen a recession within 17 months (on average) after the yield curve inverts.
It’s a confusing and challenging time to invest. From a real estate perspective, JCR is doing well. We are finding interesting pockets to invest. In the middle market there is always opportunity somewhere, and it’s our job to find it.