John Authers

Real Estate Is the Crisis Risk to Watch Now

As you will doubtless have been informed, world equities are now in a bear market. What happens next?

The most excessive speculation has already been washed out of the system. Those warning of bubbles in bitcoin and other cryptocurrencies, meme stocks, or the growth tech companies owned by the ARK Innovation ETF certainly seem to have had a point. By last November, meme stocks were so exciting that their own benchmark gauge, the Solactive Roundhill Meme Stock index, was initiated. Since then, that index has dropped 70%. The same is true of ARK and bitcoin — this looks like a wave of speculative excitement that flowed into the same things together, and has now flowed out again.

These investments still matter, and it’s possible that they have further to fall. In the case of bitcoin and the crypto sector, it’s also possible that they are big enough for losses to create systemic effects, as their falls force sales of other assets. But they are not central to the questions that confront us now.

What we need to know is whether further accidents lie in the future. And that to a large extent depends on leverage. When unleveraged investments fall, the people holding them lose some of their wealth. That probably has some effect on spending in the economy, but broadly speaking that’s that. Relatively well-off people who hold investment assets are now relatively less well-off. End of.

When leveraged investments fall, companies and their lenders can go bust. The need to pay off the debt can prompt fire sales elsewhere. So, we have our higher rates, and the financial system is now discounting significantly increased borrowing costs into the future. This should bring inflation down — but the risk is that it will create crises for leveraged investments that cause further damage. So, the question, as ever when weighing the risk of a financial crisis, and doing some violence to the French language, is: “Cherchez le leverage.”

Office Property
If there is one asset that should come under scrutiny, it is real estate, whose life blood is credit. For a double whammy of higher rates and the lasting effects of the pandemic, look to office property. Remarkably, Bloomberg’s index of US office property real estate investment trusts, or REITs, is slightly lower now than it was 20 years ago, and almost back to the lows it hit during the worst of the pandemic in 2020.

For anyone who has beheld the growth of the Manhattan skyline in recent years, barely even slowed by Covid-19, this is alarming. The travails of Vornado Realty Trust, one of the biggest developers in New York, whose share price is 59.5% below its high from five years ago, suggest the scale of the issue; the fact that a number of developers only narrowly fended off industrial action by building staff earlier this year also indicates the pressure. There is a lot of capacity which was planned on the assumption that demand for office space would continue at pre-pandemic rates. That no longer looks a good premise. The fall in REIT prices shows that the concerns are already covered to an extent in the price, but the impact of a large office property developer defaulting on its loans would be painful.

The issue isn’t restricted to the US. European office property isn’t so overblown, and hasn’t suffered quite so much since the pandemic, but the FTSE indexes for euro zone and UK office REITs, denominated here in euro, show similar problems at work.

Many holders of office property, like endowments and big pension funds, are exactly the entities that can swallow a big loss without causing a systemic cascade. But rising supply of offices, plus falling post-pandemic demand, all funded with lots of leverage, is a combination that needs to be monitored closely.

That brings us to housing. Rates in the mortgage-backed bond market are surging, as would be expected given the move in Treasuries, while the rates actually offered to US borrowers are even higher. Typical 30-year mortgage rates are now a whisker below 6%, and approaching the pre-crisis high of 2006.

This is another market that has been churned by the pandemic. Demand is shifting. Some locations are no longer so appealing in the WFH era — others are suddenly much more exciting. But the key point is that prices have taken off. The S&P Case-Shiller index of houses in 20 major cities topped in 2006, and had lagged behind inflation ever since — until earlier this year. New York and Miami, which were both the subject of particularly excited action during the property bubble 16 years ago, have also seen prices surge.

This is uncomfortably reminiscent of the conditions that triggered the global financial crisis. Mortgage lending hasn’t been so loose this time, and the main commercial banks aren’t as exposed. So the systemic implications aren’t as profound. But the prospect of suffering leveraged losses on assets that people cannot afford to be without is still painful.

Meanwhile, in the UK, where housing has always been more central to the economy and to animal spirits, there are also reasons for concern. House prices in London, although not the country as a whole, are now higher in real terms than they were at the top of the last boom, according to the Nationwide Building Society house price index. London housing has benefited from the perception that it offers a haven for Russian or Middle Eastern fortunes, so the downward pressure from here could be severe.

Capital Economics Ltd. also points out that new sales instructions to property agents now exceed new expressions of interest by potential buyers. This has been a great leading indicator of falling house prices in the past.

British housing is less exposed to the rates market than it used to be as homebuyers have steadily lost their taste for variable-rate mortgages over the last generation. But if there is one further pocket of speculation in the world that could cause damage when it bursts, it’s British housing, particularly in London.

Emerging Markets
When US rates rise and the dollar strengthens, it's generally made sense over the decades to assume that emerging markets will sustain the worst damage. Compared to previous cycles, they aren’t in the grip of a major bull market, so are less likely to cause systemic issues. But there are reasons for concern.

If we look at emerging market government debt, as measured both by Bloomberg and by JPMorgan Chase & Co., we see that it’s taken a nasty fall. The main indexes are no higher now than they were in the wake of the 2016 presidential election, when the arrival of Donald Trump briefly roiled the emerging world. This selloff is now almost on the same scale as the decline that accompanied the arrival of Covid-19 in March 2020.

Looking at emerging markets outside China, which now generally needs to be treated as a law unto itself, the Institute of International Finance finds that flows have turned negative. China, for all its problems and for all the controversy generated by its clampdown on the private sector, is still attracting inflows.

Despite the turn in international sentiment, however, non-Chinese emerging market stocks are holding up relatively well. According to the MSCI indexes, they have sustained their value better than the developing markets outside the US covered in the EAFE (Europe, Australasia and Far East) index. So far, emerging markets do seem to be weathering the storm better than they have in the past.

Can this last? The example of the 2013 taper tantrum, the incident most similar to this year’s sharp rise in US rates, suggests problems ahead. Currencies of emerging countries with high budget deficits came under severe pressure. But the IIF says that this time around emerging markets may actually benefit from their history of inflation, and the fact that international investors still don’t trust them to keep it under control. As a result, several big emerging market central banks started to raise rates last year, at a point when Western counterparts now wish they had been hiking as well.
It looks for now as though emerging markets have benefited from investors’ distrust in them. The same discipline might have helped in the US and western Europe, but their central banks were strong and credible enough to thwart it. To quote the IIF:

Global hiking cycles and inflation shocks are traditionally tricky for EM, but we’re not that negative. This is because most of the major emerging markets started hiking well ahead of advanced economies, which has pushed up real rates well above G10 levels. Indeed, the normalization in longer-term real rates is something that is mostly a story for advanced economies, while longer-term real yields – in much of EM – normalized in 2021. Of course, there are exceptions. Emerging markets where inflation is running well ahead of monetary policy have real rates that are deeply negative. Those EMs now face increasing challenges and will likely experience further – perhaps substantial – depreciation. However, we see such countries as idiosyncratic and not emblematic of a broader vulnerability across EM.

There are still plenty of issues for emerging markets, as always. Part of their health can be attributed to strong commodity prices. If the hiking cycle successfully slows the economy and brings down raw materials prices, that will be difficult. Further dollar strength would put even more pressure on their debt. And the intense activity shorting the Japanese yen is probably providing an artificial prop for some of the more popular emerging currencies, such as the Brazilian real. They would be vulnerable if the yen were to strengthen sharply.

But at this point, it looks as though the emerging world remains in reasonable shape to deal with the financial quakes ahead. Sadly, it’s not possible to say the same of global real estate.