Three Threats We Had Forgotten About-Chris Kuehl, Ph.D.
Over the past year there has not been much room to worry about anything other than the pandemic and the lockdowns. The economic carnage has been obvious enough – economies falling into recessions that were unprecedented in their severity. There is not much to be gained from rehashing this debacle as there are clear signs that a corner has been turned. This is now the year of transition but at this point it is not clear what the economy will be transitioning to. There are those that suggest that everything will return to the patterns of the past and those that assert that nothing will ever be the same. The reality lies somewhere in between as it has been obvious that patterns have shifted as people and businesses adjust to the new realities in the world. Along with these new challenges and threats have come some old familiar issues and these are especially significant for those in the real estate investment business.
The most threatening and perhaps the most immediate is the renewed threat of inflation. It has quite literally been over twenty years since this has figured prominently in any kind of business conversation. It was in the early 1990s when the Fed saw the core rate above 2.0% for more than a few weeks and it is the core rate that matters as far as setting interest rate policy. The “real” rate of inflation includes the price of food and fuel while the core rate does not. The reason for the difference is really down to statistical analysis. The price of fuel and food can be very volatile and this makes it all but impossible to make year over year comparisons (even month over month gets tricky). The volatile prices are excluded and that allows some real comparisons over time. The assumption is that core rates will eventually reflect these changes as there will be differences in things like freight rates and air travel as well as restaurant meals and so on. The core rate has not climbed above 2.0% for over twenty years while the real rate has sometimes spiked to between 3.0% and 4.5% before settling back. The Fed (and other central banks) prefer a rate around 2.0% and strive to keep inflation in that range. It is not high enough to create issues but it is enough to allow some producer flexibility on prices.
So, why is inflation an issue now after two decades? It is not entirely clear that it is – at least not yet. The problem is that it could be setting up to be an issue and that is enough to trigger the Fed to take action as their moves do not have an instant impact on the economy. It takes anywhere from 12 to 18 months for a rate hike to slow the economy and that forces the Fed to take preemptive action long before many people notice that inflation has become an issue. The very fact that inflation is now considered a possibility has had an impact on the bond market. Yields are going up and are expected to continue on that path. The logic is that the Fed will push rates up at some point and that will make investing in the US that much more lucrative – it becomes something of a self-fulfilling prophecy. The real estate investor sees these bond yields rising and realizes that interest rates are likely to follow suit and therefore mortgage rates rise and so on. The one thing that has been sustaining the growth in the housing market has been mortgage rates as there have been price hikes that should have been enough to slow down demand. Now the sector suddenly appears beset with problems. If everything breaks in a negative direction the housing sector is looking at higher mortgage rates, more expensive homes (existing and new), housing shortages, labor shortages and more expensive commodities (lumber is just the most obvious). Pile on top of that the fact that employment rates have not recovered and probably will not for the bulk of the year.
This all assumes an inflation surge that goes unaddressed. To trigger all the downside of higher mortgages and higher bond yields will require the Federal Reserve to reverse course and engage in the rate hike that people seem to expect. At this point the Fed governors and regional Fed Presidents are saying nothing of the kind. Not even the hawks have weighed in with suggestions that rates need to go up. They do acknowledge there is growth in the economy visible but they also hasten to add the caveat that growth will have to be impressive to undo the extreme damage from last year and they still assert the economy needs all the help it can get. There have been some voices of concern regarding the connection between the stimulus and inflation but at the moment the Fed and the Treasury are on the same page as they assert the stimulus is a good thing.
The indicators are generally pointing in a positive direction but there are plenty of caveats. At the top of the list is control of the pandemic. There has certainly been substantial progress but it was promised that vaccines would be distributed en masse by early March and now the promise is for May or maybe June. Will there be further delays? What about variations that make the virus more transmissible? What if variants prove resistant to the vaccine? These developments have not slowed economic progress much as yet but the possibilities are certainly present.
What happens if the consumer doesn’t respond as many have predicted or estimated? The polls suggest there is considerable pent-up demand but is that really the case? There will certainly be many eager to resume old patterns but there will also be many that remain cautious for months and perhaps years. Business and other institutions assert they will resume activity but that will not always be easy. Teachers are refusing to go back to work even when required to. People are being ordered back to work but they have the right to sue the company if they fall ill. Will that keep companies from bringing workers back? Will people continue their behaviors over the past year? Will they continue to avoid mass transit or multi-family apartments? Will they demand the ability to work from home?
The real estate sector is in a quandary when it comes to the future of the office building and other forms of commercial construction. If people continue to work from home will that kill demand for the traditional office building? The enthusiasm for working from home has faded to some degree but is still considered a viable option by many employers and employees. What is the future of the shopping mall and the Big Box store? Have people embraced the online option to the exclusion of the brick and mortar? What will retail have to do to bring those consumers back? What happens with lodging and hospitality? It was an assumption by economic developers for years that hotel space was necessary to attract conferences and meetings. Will these resume or will the virtual meeting take over? Will people vacation at resorts again? Attend concerts and events again? There are no simple answers to these questions. It is obvious that many people will indeed return to their old habits but will it be enough for the businesses that were low margin to begin with.
The flip side of the risk is that all of these old consumer behaviors are resumed and with gusto. There is an enormous pile of cash on the sidelines at this point. It is held by the business community and by investors and by consumers. There is an estimate that consumers have socked away over $6 trillion in excess savings. Due to the nearly $2 trillion stimulus/rescue plan the US now has roughly 10% of its GDP in excess consumer savings. That money is just waiting for an opportunity to come into the economy. So, we are back to the discussion of inflation which started this piece. If all or most of that money comes cascading out there will be far more demand than there is ability to meet that demand and prices will rise as a means to control that demand and because in an environment like this there will be far more tolerance for higher prices – at least from those who have the ability to keep up with the hikes. This sets up a whole other issue for real estate investment – too many people chasing too few opportunities and driving prices higher in any market that could be considered hot (or even warm).
Chris Kuehl, PhD., is an economist and Managing Director of Armada Corporate Intelligence. Visit www.armada-intel.com for more information.