Year of the Earth Pig

February 5th marks the first day of the Year of the Earth Pig

Let’s hope this ancient Zodiac symbol, which dates to the Han Dynasty in 200 BCE, portends a positive year ahead in the real estate markets. In December and early January, the global capital markets woke up to all the risks and challenges that have been around for some time. Slower global economic growth going forward, rising interest rates, unwinding of QE (quantitative easing), and rising debt levels in several countries are all known risks. Unknown risks are also looming. The US and China launched a critical round of trade talks on January 30th. The two sides are far apart on a wide range of issues including Chinese requirements for technology transfer, US demands for IP (intellectual property) protections, and follow-through on reforms pledged by both countries, but not yet carried out. A meaningful breakthrough before March 1st, when the US has said it will raise tariffs to 25%, is unlikely. Yet incentives to make serious progress are strong on both sides as both China and the US work toward establishing new trade agreements.

A similar looming deadline faces the UK and the EU in the next chapter of the Brexit saga. Economists estimate that the global economy has more at stake in the US-China trade dispute; nevertheless, the outcome of the Brexit negotiations is of vital importance to both the UK and the European Union. A third risk is the stability of the US economy. A record-long government shutdown has just ended, but there is no guarantee that the government will remain open after February 15th. The result of all this uncertainty is falling consumer and investor confidence. As the headlines on these economic and geopolitical events evolve, we won’t be surprised to see volatility increase this year.

Meanwhile, as we noted in the 2019 ISA, global economic growth is cooling. Major central banks globally are now walking on a tightrope between loose and tight monetary policies. Key messages from major central banks suggest that rate hikes are now on the back burner, as concerns over economic slowdown or recession risks rise. The “R” word seems to be on everyone’s mind. Most economists are not projecting a recession in the next 12 months (they also didn’t in early 2008). If investors can Keep Calm and Carry On, one of the longest economic expansions can be extended. Eventually, the much-feared “R-factor” will show up in several major countries, but we believe this to be a much lower risk than during the Global Financial Crisis (GFC). Labor markets in major global economies are healthy. Bank, corporate and household balance sheets are generally healthier than the pre-GFC period, with notable exceptions such as China’s corporate debt, Italy’s financial sector, Australia’s household debt, pressures to align with Basel III directives in Europe, and US student debt.

If a recession comes, leased real estate will not be immune, but it will be a “low beta”, or less sensitive financial asset. Also, portfolio managers can prepare for a downturn. In 2019, investors will be making investment decisions in an environment of rising volatility and uncertainty. We recommend that investors set realistic return targets, shift their focus to narrowing the dispersion of return outcomes, and re-set their blend of offense and defense strategies. In real estate terms, that means focusing on location/asset strength and using stringent underwriting criteria. As volatility increases, quality assets and flexibility become more important. Holding period and floor plan flexibility, early loan extensions, or early lease renewals all represent the types of optionality needed to survive a downturn.