Three Situations Warranting Investment Caution

Three Situations Warranting Investment Caution

November 28, 2023

The Fed has spent much of the last year and half raising interest rates in an effort to tame inflation.  Essentially, the plan is to slow the economy sufficiently to bring the inflation rate back to the Fed’s 2% target rate.  As a result of these efforts, there has been a notable amount of media attention on whether the Fed can maneuver a “soft” landing.  In this regard, the question is whether the Fed will be able to hit its 2% inflation target without also sending the US economy into a recession as a result of its efforts in doing so.  Because it typically takes 6 – 12 months to feel the economic effects of interest rate increases, we likely will not be able to assess how the Fed did with its landing for some time.  There are, however, a number of issues percolating both in the US and globally that, regardless of whether the US enters a recession, warrant investment caution right now.

For starters, the commercial real estate market appears to be teetering on the edge of serious trouble.  Commercial real estate loans typically are of a shorter duration than residential mortgages, which can run for 15 or 30 years.  As a result, these loans need to be refinanced more frequently.  Because the Fed has been aggressively raising interest rates, the cost of borrowing capital is now much higher than it was a few years ago.  With many commercial real estate loans having to be refinanced more frequently than their residential counterparts, this has led and will continue to lead to higher borrowing costs for landlords and building owners.

At the same time, during the pandemic, many people were not required to go into the office on a daily basis.  Companies and industries have chosen to handle a return to the office differently, but, as a general matter, there are far fewer people going to work in offices on a daily basis than there were previously.  Some businesses have moved entirely to a work-from-home regime, and thereby given up their rented office space altogether.  Others have adopted hybrid work schedules, which has allowed them to reduce their office “footprint” and rent less space.  This shift has led to increased office vacancies and decreased rental income for landlords. Coupled with rising interest rates and mortgage payments, it poses challenges for commercial real estate owners.

Moreover, much lending for commercial real estate is handled by regional banks.  The banking industry struggles earlier this spring were precipitated by issues affecting these same regional banks.  If commercial lenders start defaulting (due to their own financial insolvency or an unwillingness to refinance at higher interest rates to salvage a property arguably worth less and providing a reduced income stream), these regional banks are very likely going to suffer as well.  The banking instability earlier this year was relatively quick and resolved without much apparent lasting consequence.  Broader based damage to the industry potentially caused by commercial real estate delinquencies, defaults, and instability, however, may not be as easily resolved.

China is also a significant concern. Much of its recent economic growth relied on real estate expansion, but this sector is now troubled.  Major developers like China Evergrande have filed for bankruptcy and defaulted on substantial debts. China's largest developer, Country Garden, faces substantial losses and bond payment negotiations. China's economy has stagnated, and its high debt levels limit government intervention without risking creditworthiness, debt obligations, and currency value. As the world's second-largest economy, issues in China will have global repercussions.

Which brings us to Europe.  Much like the rest of the world, Europe has experienced high and concerning inflation, and the Bank of England and European Central Bank have been raising interest rates aggressively to combat this problem.  However, they face a challenging dilemma as inflation remains stubborn while many European economies hover on the brink of recession. European central banks must decide whether to persist with rate hikes, potentially pushing much of the region into recession, or maintain rates to mitigate the recession risk, even if it means letting high inflation persist or worsen. This delicate balancing act warrants close monitoring and caution.

Of course, there always seem to be numerous issues and concerns that could potentially send investment markets into a tailspin.  Much like storms that form in the middle of the ocean, many of these don’t rise to the level of a hurricane, veer off and don’t make landfall, or otherwise don’t produce the significant negative consequences that they potentially could.  Accordingly, it is far from time to panic.  But, it might be time for a healthy dose of caution, and, as often is the case, prudent investment diversification and management is warranted.

 

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