I’m back from vacation in the English countryside, away from the hurly burly of life in our capital markets. While I tried hard not to obsess on the news whilst away, bad news has a way of slithering into your peripheral vision, doesn’t it (I stuck to the English papers which are great fun, and are way better than ours… “Emergency biscuits flow into UK due to national shortages”)?
A few weeks back, I was talking about the superfluity of bad economic news, and I was suggesting that the debt capital markets were now waiting for capitulation from the borrower community in a market that is no longer as fun as it was before.
Big Picture, where are we? Some (many?) say that we are on the cusp of a deep, almost GFC-type of recession from which it will take years to grow out of. Others are backing the short and sweet version. Others say we are looking at a market that has now absorbed and discounted all the bad news and is poised to continue to grow, perhaps more slowly, but grow. All (most all) used as a predicate for these views, the notion that the current inflationary spike will be tamed by the Fed in the short to medium run causing some level of diminished economic vibrancy. What matters, of course, is what you mean by “some.”
I don’t want to bury the lede here. Generally, while it surely is a time to test presuppositions, revisit verities and watch for the proverbial canary, the watchword for the moment is: Stay Calm and Carry On.
The problem with getting any conviction around where the economy is going is that the data doesn’t reveal an obvious pattern. Crosscurrents abound. Who’s ever heard, or even modeled, a full employment recession?
We really need the Albert Einstein of economics to deliver the unified field theory of economics and give us THE ANSWER (for Sci-Fi wonks, where is Hari Seldon?). Absent such a Hail Mary, collecting the views of smart people about what they think is likely to happen seems like a pretty good idea. I’ve spoken to people with balance sheets, people who lend, people who borrow, advisors, and yes, I’ve even spoken to economists. Notwithstanding the well-earned derision heaped upon economists because of the congruity of their profession with both astrologists and alchemists, they’re some pretty smart people. (While gently disparaging the profession, let me take a moment here for a callout to Jamie Woodwell of the MBA, because conversations with him are always useful. I recommend his Trepp Talk “3 Pillars of Commercial Real Estate in Transition” for a balanced view of what the commercial real estate market is up to at the moment.)
To rationally embrace a view that my hair is not on fire, I surely must take a hard look at the bad news which abounds, take it on board, discount it and move on. So, let me try.
The bad news:
- Inflation is not transitory. While officialdom continues to maintain that it will come down rapidly during the course of the year, does anyone really have conviction here? Short term interest rates are up materially. After the Fed’s action this week, the yield curve is seriously inverted (a circumstance which has predicted 11 out of the last 7 recessions).
- While consumer balance sheets are stronger than they were at the time of the Great Recession, they are weakening and credit debt is skyrocketing. As the consumer is 70% of the economy, that’s meaningful.
- Transactional activity is, duh, slowing. That’s what happens when market participants are confronted by discontinuous, rapid increases in cap rates, increasing coupons, a withdrawal of (cheap) liquidity and little conviction around underwriting and credit. There remains a pouty nostalgia for the old days (e.g., a couple months ago when coupons were low, valuations were high and liquidity was plentiful), which adds a psychological impediment to getting on with things. The ubiquity of a general risk-off psychology seriously and negatively impacts markets.
- There’s still a wounded supply chain out there. A considerable amount of that supply chain originates in economies that are themselves wounded or broken and/or controlled by regimes more than a tad hostile to US interests.
- Equity markets remain volatile. Right now, we’re seeing markets move higher. Is this a little bull in a bear market, or the start of real, new bull market? In the latter case, why, for heaven’s sake?
- With the GDP Q2 print, we now have two quarters of reduced economic activity. Notwithstanding what some have said about the technical definition of recession, large segments of the market will (reasonably) take a view that we are in one now.
- The Rest of the World is a Mess, Part I. China is fessing up to a 0.4% growth rate in Q2, but does anyone take that at face value? Wanna bridge? It’s surely worse. The US is exporting inflation around the world, creating chaos in dollar denominated assets, particularly amongst the emerging markets. Not good for the supply chain issue. Not good for our economic growth.
- The World is a Mess, Part II. The European Central Bank has now finally begun to raise rates because they feel they have to, but are clearly deeply conflicted about recession risks. Notwithstanding all the happy talk about the new Transmission Protection Instrument (what a beautiful euphemism for a bailout…almost as good as the “Inflation Reduction Act of 2022”) the northern Europeans are not going to go all that terribly far in mutualizing debt. The Italians are going to have an election and there is a real risk a new government will be extremely hostile to Brussels. The English don’t know who’s in charge. The French know that Macron says he’s in charge, but it’s not entirely clear. Schultz in Germany seems clueless, and the war continues. You can tell the Euro project is in trouble because of the volume of assurances that is not.
- The World is a Mess, Part III. Don’t forget all those muscular dictators, chubby dictators, dictators who absolutely don’t look like Winnie the Pooh (with greatest sincerity here), and dictators who think they have a hot line to God, all with some sort of an inferiority complex, a chip on their shoulder and all with, or about to get, nuclear weapons.
- The World is a Mess, Part IV. Taiwan and Ukraine. Geopolitically, the world looks pretty fragile. As much as some folks might regret it, the world economy is highly interdependent and a sickly and fraught world is bad for a healthy US economy.
- Notwithstanding the fragile US economy, business is continuing to confront a, shall we say, muscular regulatory posture which seems less focused on fixing the economic problems of the here and now and more about by a set of “Big Ideas.” Are Big Ideas a luxury when economic performance degrades?
- The folks are very negative about the economy. I saw someone’s stats the other day that said 90% of Americans think we’re on the wrong track. I don’t think I’ve ever seen that level of pessimism. Up on the heights, there’s a sort of similar psychology; no one seems to think things are going to get better fast, even those who are very committed to pretending it will. Psychology is important. We can and have talked ourselves into recessions in the past.
- US politics remains fraught, and that’s being charitable. The country is pretty much split in two and has become increasingly tribal — tribes that can’t agree on anything and heartily loathe each other. Gridlock might be periodically tolerable, but this status is not. If the Republicans take the House (their grasp of the Senate seems increasingly enervated), don’t expect a boost for business issues, it probably won’t happen. I suspect the Republicans will be more focused on retribution than good policy. Good God, we’re actually discussing “the survival of our democracy.” The two sides mean that in wildly different ways.
- The Fed’s toolbox on fighting recession is pretty damn empty. With a $9 trillion balance sheet and interest rates still low by historical standards, what’s in the tank to facilitate growing out of a recession if it happens? Not much. On the other side of the coin, the Fed certainly has tools to fight inflation, but they tend to be blunt instruments. Do we really need a lot of demand suppression right now? A betting man would say that whatever the Fed does, it will overshoot in whichever direction it goes.
If the news were unremittingly bad, while that might be awful, it would make planning easy. Grab the go-bag and jump into a hole. But it’s not all bad. There are many important countervailing data points to be considered.
Employment has stayed strong and continues to grow (albeit there are some troubling data sets inside the marquee numbers). As I’m writing this, we just got a good month-over-month inflation print, and while a month does not make a trend, an optimist might say that inflation has peaked. July was the best month for the Big Board and the other indices since some time in 2020 and it would seem that after a thoroughly unamiable first half of the year, markets are considerably more constructive. Also, the current earning season is not that awful. Some on the Street say we are making a bottom…bring out the bulls! Commodity prices are easing, the bond market is predicting Fed funds cut by the middle of next year. Balance Sheets of both the consumer and business remain relatively strong and vastly stronger than they were at the beginning of the GFC and that gives everyone some extra gas in the tank to weather economic distress. Consumers are spending to beat the band. Apparently, we don’t feel as bad as we think we do. Senator Manchin and Senator Schumer have engineered another whopping infusion of governmental spending into the economy. The ludicrously named Inflation Reduction Act, and the lollapalooza of the so-called CHIPS Act, are likely to be positive for GDP growth at least in the short run (an impressive act of inflative sneakiness which really pantsed the Republicans).
In our little CRE corner of the world, revenue is holding up pretty well in the major food groups. Retail continues to confound its obit notices, industrial remains strong. The multi and SFR sectors are on fire (but I hear that rent growth in the multifamily space is beginning to slow), even though there is a lot of supply coming online (maybe bad news in the resi mortgage market is good news for the multi and SFR space…who knows?). Office, what to do about office? Current period revenue continues to hold up as the office sector is characterized by longer term leases, but it does have more than a passing resemblance to the famous chicken with its head cut off strutting around the barnyard before it flops over dead. But, hey, for the moment, as long as you keep your eyes on the road right in front of the car, it doesn’t look so bad.
So, there are cross currents in the data. I really struggle to connect the dots, to make sense of this, to find a pattern (cue our dismal science Einstein). But again, one has got to have a view.
The majoritarian opinion is that while things have slowed and perhaps will continue to slow, this is not a cliff edge moment, more of a pause. Market participants will reconcile themselves and become inured to the increased price of risk, reduced valuations and reduced and more expensive leverage. Capitulations on both the buy and sell side of money will usher in a new moderation. From a remove, this all might just seem to be a flickering moment in a volatile movie, but in this moment, the illusion of stability will give rise to renewed market vitality.
That all seems right to me. It seems to me in this case the wisdom of the crowds is spot on.
So, for the moment, KEEP CALM AND CARRY ON.
All good then? Not so fast! Look down the road, beyond the next couple of quarters, and there’s something at the edge of our vision that continues to look a bit alarming. Here’s the alarming case: After a little bit of good inflation news, but with continued signs of trouble in the broader economy (the most recent job print, might begin to look like a false dawn) and with an election looming, the Fed will lose its political will to fight inflation aggressively. (Chairman Powell’s recent comments suggested a certain dovish predilection, didn’t they?) Before the year is out, we may have a meeting or two without any increases in the Fed fund rate and we’ll feel like we dodged the recessionary bullet. But it’s unlikely that the economy will grow strongly, just too many headwinds. Economic conditions simply won’t be good enough. “More please,” will be shouted by the multitudes.
Our political class, including the Fed, may have precious few commonalities, but all possess a reptilian brain focused on political survival. This will translate into keeping the candy bowl on the table far too long, satiating the multitudes’ demands for more growth, more jobs, higher salaries, more free stuff. The pressure on the Fed and the rest of the political class to do something, to turbo charge growth, will be compelling.
Inflation will not have gone away. It might moderate a point or two as the economy continues to slow in the next quarter or two, but it will remain far removed from the Fed’s long-term 2% target and the Fed will lose its passion for controlling inflation as the candy bowl gang continues to lean in, inflation simply won’t come under control and the government elites, writ large, taking their eye off the ball will focus more on rapid growth than stable prices.
But, in that scenario inflation will eventually become a crisis, a potentially fatal disease of the body politic and not just an ongoing annoying condition to be managed and the butcher’s bill will come due. In a 1982 redux sort of way, some adults in some room (the room where it happens?) will finally do what is necessary. The recession we then get (and deserve) will be far worse than the one we are obsessing over right now.
But hey, that’s late 2023 or 2024. It’s probably after the next presidential election. In the meantime, things might not be terrible. We can, for a bit, largely keep the party going.
So, in the moment, it’s not time to hunker down. It’s not time to shed staff or resources. It’s not time to turn off the capital spigots and withdraw capital from the market. Not time to choke off liquidity. We have some runway ahead of us still. The world might be ending, but not today. There will be plenty of time to panic later.