Research Update: June 2022

Contributors

Will McIntosh, Ph.D
Global Head of Research

Jay Johnston
Senior Associate, Research

Mark Fitzgerald, CFA, CAIA
Executive Director, Research

June 2022

Given that the pace of financial market dynamics quickened since last month’s update, we would like to provide our view in the following areas:

A 75 Basis Point Hike… How to Tame Inflation?

With the U.S. headline CPI hitting 8.6% in May, the Federal Reserve (Fed) raised the Federal Funds Rate by 75 basis points (bps) on June 15th, the largest such move in almost 30 years, as well as reiterating a strengthened commitment to reducing inflation back to its 2% target.

Simultaneously, the Fed is implementing quantitative tightening (QT) by allowing bonds and other securities that it holds to mature as a means of reducing its balance sheet size.  This could effectively represent another 50 bp hike.  So far, financial assets have been negatively impacted to varying degrees by this news.  The 30-year mortgage rate and other key interest rates have consequently risen, as prices react to the latest events.  As of late June, the U.S. 10-Year Treasury yield was 3.13% and the 30-Year fixed mortgage rate had risen to 5.83% (Exhibit 1).  Following this month’s interest rate hike, the latest median year-end projection for the Federal Funds Rate is 3.5%, which would be the largest 12-month increase since the 1980’s.[1]

EXHIBIT 1: U.S. Interest Rates Have Risen to Recent Highs (December 2020 to YTD 2022)

Source: Bloomberg LP

Many are hoping that the Federal Reserve will be able to achieve a soft landing for the economy.  However, the last time the Federal Reserve was able to do so was back in 1994, when interest rates rose by roughly 3% in just over 12 months (Exhibit 2).  Since that time, their track record of hiking rates without tipping the economy into a recession has not been impressive.  Therefore, we believe recent events have increased the likelihood of a potential slowdown in economic growth, as measured by real U.S. GDP, and heightened the risk of stagflation if inflation continues to run above average despite such hawkish actions from the Fed.  Some market participants believe the Fed may have already thrown the U.S. economy into recession vis-à-vis a hard landing.  However, we will not know until the National Bureau of Economic Research (NBER) declares there was a recession.  Given the sell-offs occurring across a large number of disparate financial markets and sectors, it certainly adds strength to a recessionary argument.  To note, commodity prices have tumbled nearly 11% since their early June highs, while rising mortgages rates led to a 3.4% monthly decline in existing homes sales.[2]

EXHIBIT 2: Federal Funds Target Rate – Upper Bound (Trailing 30-Year Period)

Source: Bloomberg LP

Softening CRE Property Values and The Amazon Factor

As we indicated during last month’s Research Update, there was already anecdotal evidence of softening transaction activity for commercial real estate assets.  The most recent datapoints now confirm our initial hypothesis that a steep decline of -16% occurred in April’s transaction volume versus a year ago.[3]  Additionally, based on the aggressive velocity of Federal Funds Rate hikes, it would logically follow that asset sales have slowed even more over the past few weeks as investors wade through increased price opacity and more difficulty in securing attractive financing, likely leading to further price and activity deterioration.  The Industrial sector posted the sharpest drop in sales volume, negatively impacted by the recent earnings release by Amazon and comments from the company’s management around their intentions to cut back on personnel and property spending.[4]  While strong rent growth may offset rising property yields for new properties in the sector, in our experience buildings with long-term leases have seen cap rates increase in the order of 50 to 75 bps.  As provocative as the headlines may read, our internal analysis suggests that the U.S. Industrial market has a resilient and vibrant tenant base outside of Amazon (Exhibit 3), with a record 423 million square feet of non-Amazon net absorption in 2021.  On the positive side, Amazon’s decision to pull back on spending has led to a decrease in hard costs, namely steel prices given the company had effectively tied up 50% of next few years’ U.S. steel supply, and helped to normalize development timelines for the Industrial sector.  In the near future, we will be publishing a new research report on the current state of the U.S. Industrial real estate market that details our views around the implications for the sector.

EXHIBIT 3: U.S. Industrial Net Absorption (2015 to 2021 – Amazon vs. Rest of Market)

Source: MWPVL, CoStar, USAA Real Estate Research

Elsewhere, residential property prices have declined in reaction to this renewed and aggressive hawkish posturing by the Federal Reserve.  And there is strong evidence to indicate that consumers – consumer spending represents roughly 70% of U.S. economic growth –  intrinsically feel the impact of home equity declines to their personal balance sheets, even if they only represent paper losses to wealth in the near-term.  The same can be said for their stock market portfolios.  Growth in apartment rents continued in the first quarter and into the spring, positively impacted by the current inflationary environment yet susceptible if and when a recession occurs.  We believe the current market dynamics are setting up for period of new opportunities that prudent investors that are well-capitalized will be positioned to capture, leading to a period of outsized performance relative to peers.

 

[1] Capital Economics. Global Markets Update – New Forecasts for US Treasuries & the S&P 500. Published June 17, 2022.

[2] Capital Economics. U.S. Housing Market Data Response – Existing Homes Sales (May). Published June 21, 2022.

[3] Real Capital Analytics.  US Capital Trends Report – April 2022.

[4] Ibid.

 

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