Good morning. Alphabet reported a 14 per cent jump in revenue yesterday, while Tesla fell short of expectations with just a 2 per cent increase. Google fell a little and Tesla fell a lot in after-hours trading. Maybe a sign that we will soon be using Stupendous 6 instead of Magnificent 7. Email us: robert.armstrong@ft.com and aiden.reiter@ft.com.
Reits and CRE
Suppose you bought a broad index of US real estate investment trusts on the eve of the pandemic in February of 2020 and held them until now. What would your total return be today?
As it turns out, you would be up 16 per cent, if dividends are included. This is not great: about 3 per cent a year, hardly enough to keep up with inflation. But Reits might be the most rate- and inflation- sensitive sector of the market. Many investors treat them as bond substitutes, and the underlying properties are generally leveraged. So to find that returns are flattish since everything went sideways is surprising, at least to me.
Even in pure price terms, the broad MSCI US Reit index is almost flat, after the sector leapt in recent weeks on lower inflation and rate expectations:
The most unloved of Reits have risen. Office and retail, besieged by work from home policies and online shopping, have gained 9 per cent in two weeks.
Are Reits — and commercial real estate more generally — over the hump? Of course, a resurgence of inflation would take expected rate cuts off the table and push the sector back into crisis. But let’s assume, as the market is doing, that rates are now on a glide path downward. Surely indebted asset owners can play for a little more time with their lenders and refinance when lower rates have restored the value of their buildings and the financial logic of their capital structures?
The problem is that even assuming rates are falling, the speed at which they fall matters if you are a building owner with a loan coming due, especially if you have already extended and renegotiated about as much as you can. In many ways, the broad data on real estate debt looks pretty benign. Here, for example, is the delinquency rate of commercial real estate loans held by banks. It is rising but still well below 2 per cent as of the end of the first quarter:
Similarly, the Fed’s loan officer survey shows that while more banks are still tightening CRE lending standards than are loosening them, that majority has been diminishing since the middle of last year:
But commercial real estate loans don’t get into trouble slowly. They get in trouble all at once, when they suddenly can’t be refinanced. It is probably worth noting in this context that the volume of bank CRE lending fell in both May and June.
Imogen Pattison of Capital Economics estimates there are $1.2tn in CRE loans coming due this year and next. Those borrowers may not have time to wait for the return of low rates. She points out that delinquency rates on bonds backed by commercial mortgages are much higher than for CRE bank loans — approaching 6 per cent, compared with a financial crisis peak of 10. She expects CRE distress to increase in the months to come.
Reits have recovered remarkably well. But CRE seems likely to provide a few more ugly surprises before the rate cycle bottoms.
More on dollar devaluation
In yesterday’s newsletter, we said:
Dollar devaluation would have serious downsides. It would be inflationary, as the price of imports would rise.
The argument was that dollar devaluation is inflationary because of what economists call “exchange rate pass-through”. The US imports more than it exports. A weaker dollar makes those imports more expensive, driving up inflation in the short term.
Michael Pettis of Peking University wrote to us to push back. He said:
Inflation occurs when total demand rises relative to total supply, and of course it is the way the two are forced back into balance. While devaluation would certainly raise the cost of imported goods, the important question is what it does to supply and demand in general. Because the whole point is to expand domestic production, if it is done over in a non-disruptive way, it could very well be disinflationary. In fact even when it is inflationary, that might only be temporary and the overall impact might be disinflationary.
We agree that the trade balance would eventually reach a new equilibrium — one where, in a protectionist’s vision, America is more prosperous, less indebted and enjoys lower prices to boot. We would only suggest that reaching that new equilibrium could be very disruptive, spurring inflation that could last years as domestic production ramps up.
We also suggested that a tax on foreign holding of US assets, one of the ways to force devaluation, would be a “doomsday” scenario for the market. Pettis argues that a tax on holding the US dollar is the most practical way to close the US trade deficit. He reasons that the US trade deficit is fuelled by its much larger capital account imbalance, and resolving the gap between investment and savings in the US by restraining capital flows would in turn resolve the trade deficit. Tariffs would not be nearly as effective.
It is a logical economic argument, apparently accepted by people in Donald Trump’s orbit and by policymakers such as Senators Josh Hawley and Tammy Baldwin. But discouraging foreign capital flows at the scale necessary to close the trade deficit and boost American savings removes one of the biggest tailwinds supporting the very high valuations of US financial assets. It might be the right thing to do for the long-term economic health of the country and the world, but it would likely be a major shock to investment portfolios. Does Trump have the stomach for that?
One good read
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