The financial media has been inundated with strong economic news lately. Now would be a good time to take a step back, put it all into context, and think about what the longer-term picture might be telling us.
Over the last few months, economic headlines suggest we are en fuego right now. March payroll numbers went up by 916,000 in the first release of the data, which was a great surprise.
Manufacturing numbers from the ISM survey were similarly impressive, with a highly expansionary 64.9 value on April 1. That’s the highest reading since March of 1983, in case you were wondering.
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Why is the economy doing so well?
We’ve got vaccines rolling out on an impressive schedule, more and more states relaxing COVID-19 restrictions, and a general optimism that people will be getting out and spending money as the year rolls on.
We’re also seeing inflation data picking up, which some suggest is a sign that consumer spending and demand are picking up steam.
All of this has been confirmed by stonks, which everyone knows will always go up forever and ever, probably without even pulling back and definitely not crashing no matter what. (Please don’t make me add a disclaimer to this statement. If you think I was serious, I have a bridge to sell you).
If the stock market is to be believed, our friendly civil servants at the Federal Reserve and Congress have erased the financial problems associated with COVID-19. It was all a bad dream, nothing to worry about. The S&P 500 has blown past the pre-pandemic highs and is right back to the top of the trendline established in 2019.
Real estate is also behaving similarly. Cap rates at everything we look at are lower than they’ve ever been. The Boulder Group recently came out with research showing that retail and industrial cap rates in Q1 were the lowest on record.
The problem is, COVID-19 did happen. Many, many people did lose their jobs and the economy was saddled with a tremendous amount of debt to try and mitigate the effects. We can debate whether or not that fiscal and monetary spending actually helped anything (it didn’t, at least not nearly to the extent some wish to claim), but for now let’s just acknowledge that it happened and that there will be ramifications.
Let’s dig a little deeper, though, and see if we can’t generate some useful insights by thinking critically about what we’re seeing.
I certainly don’t want to take anything away from the improving numbers we’re seeing, that’s not my intent. I want as badly as anyone else for the economy to be robust, for people to find work and create prosperity for themselves and their families.
But my job is to analyze, interpret, and contextualize the data so that I can make the smartest investment decisions possible. Through that lens, some issues emerge.
The right question to ask is not, “Is the economy doing better?” That answer is obviously yes. The better question is, “On a relative basis, do investment valuations and the associated projected returns make sense given the current state of the economy, and where can we invest to give ourselves the best risk/return profile available?”
What about employment data?
Yes, the sequential increase in employment for March increased by 777,000 people, which is fantastic. However, newly released April numbers show a major disappointment: 266,000 jobs created versus the expectation of one million. Let’s zoom out and become sophisticated data analysts for a moment. We’re still roughly 8.4 million jobs, or 5.5%, below the peak.
Now let’s take it a step further, projecting where employment would have been if it had continued to grow at the pace it had since 2000. Then we can calculate the gap and project when we might get back to the trend.
The average growth rate in employment, only counting expansion months, was 0.18% per month since 2000. The average growth in employment since the COVID-19 bottom in April 2020 has been 0.94%. The March growth number was 0.64%.
To give us a decent idea of how employment might progress, I’ll give the economy the benefit of the doubt—despite the April setback—starting growth at 1.25% and then walking back the growth rate by 20 basis points until we hit the long-term trend of 0.18%. That would mean adding 1.8 million, 1.5 million, 1.25 million, and 967,000 jobs in May through July, respectively. For context, million-job months are absolutely unheard of, and only happened a few times last year during the PPP-fueled re-hiring. I recognize this is only an estimate to get us thinking, but this would be tremendous job growth. That will give us something like the following chart.
I’m not claiming that my projection is airtight. This is simply an exercise to help understand the magnitude of the challenge the economy is facing. Assuming no setbacks (remember we used expanding months only), we’d catch up to the pre-recession high somewhere around May or June of 2022, and catching the trendline would take several more years.
Job growth has the potential to be really strong all year, but at the end of the day, there is still a strong chance we’re not all the way back when we close out 2021.
What liabilities is the economy creating?
Probably the most consequential factor coming out of this crisis will be the sheer amount of liabilities created throughout the economy. The clearest and most obvious is the run-up in debt of the federal government. But there are also some “shadow” liabilities to think about, including the budget gaps of state and local governments and their future pension liabilities, as well as individual liabilities in the form of unpaid rents, mortgages, or other debts that will need to be repaid at some point when forbearance programs expire.
As far as the federal debt goes, avert your eyes!
You can see above that we never really got ourselves together after the great financial crisis, which is when we reached the danger zone. Research shows that debt to GDP becomes quite problematic at around 90%. We’ve blown right past that and we’re sitting at 129%.
High levels of government debt are associated with lower rates of economic growth. The government sucks up resources that would otherwise remain in private, more productive hands. It results in less investment into capital goods and subsequently poor labor productivity growth.
While many more issues factor in here—including demographics, which are an additional economic headwind—we need to consider the negative impacts that will be associated with the debt burden over the long term. Real estate is typically a multi-year investment.
Looking ahead to the future economy
The next few months are going to come with really exciting economic statistics. We should celebrate that and factor it in, but also keep it in context. Long after the stimulus checks wear off and the exuberance from unlocking areas of the economy fades, we will still be left with a mountain of jobs to recover and a big, steaming pile of debt that needs to be paid back.
Here’s where it gets interesting, and where the key battle will play out in financial markets.
In a traditional economy, the demographic and debt dynamics associated with the U.S. would lead to very sluggish economic growth over time, and any stimulus would fade quickly and add more debt.
If you think this will continue to be the case, the outlook is for continued low inflation, low interest rates, and low labor force productivity. If we experience a shock, this scenario could find real estate prices in certain sectors and geographies declining as deflation or disinflation sets in, borrowing becomes less attractive, and the reality of a sluggish economy impacts rent growth across commercial real estate.
In my opinion, that’s what we’ll get if we maintain the status quo. However, today more than ever, there is potential for a different scenario to play out.
I think real estate investors have to be keenly aware of the potential for inflation to take hold in this market. With debt spiraling out of control and both the Federal Reserve and the federal government signaling a willingness to borrow, spend, and monetize debt for as long as it takes, we may see inflation emerge as a result of a psychological revulsion to owning dollars and bonds as they pile up at the Fed.
Fortunately, I think there are ways to invest in real estate that can set you up to perform well in either scenario. You can do this by tapping into the long-term themes that will play out across cycles with less sensitivity to economic activity.
Think about product types and regions of real estate where you’d have strong pricing power in rents while being flexible and able to manage expenses. Think about the long-term demographic trends, and the types of products that will do fine in a downturn but great if inflation is severe.