Dazed and Confused?
When Led Zeppelin sang, “Been dazed and confused for so long, it’s not true,” I bet they never imagined it would serve as the opening line for a 2024 economic outlook, but it captures the spirit of the moment.[i] A combination of factors makes 2024 a difficult year to forecast because so many issues—supply chain kinks, interest rates, commercial real estate, inflation, and recession– are intertwined into a knotty mess. Many years ago, Gordius, king of Phrygia, is said to have tied a knot so intricate that it could only be untied by the future ruler of Asia. Alexander the Great took a shortcut to untying the knot by just cutting through it with his sword and went on to quickly become the ruler of Asia. If only bankers had an Alexander to resolve all the big issues they will confront in 2024. So, where to begin?
1) Supply Chain Kinks: Release Me from My Chains?
Many observers would have started with inflation, but supply chain kinks are still driving up prices. Just three years ago, the container ship Ever Given got stuck sideways in the Suez Canal and blocked traffic for six days and queued up 369 ships. About 12% of world trade flows through the Suez Canal, and as the COVID pandemic raged around the world, factories shut down in response to labor shortages as well as material delays. Over the past three years and right up to the present, supply chains continue to be disrupted by weather, trade tensions (USA vs. China, trade restrictions), embargos on Iran and Russia, labor shortages (truck drivers and plane pilots, etc). Bankers need to be aware of how dependent their borrowers’ products and services may be on key inputs and the difficulty of finding alternatives.
2) Interest Rates: What’s the Usury?
The obvious problematic outer layers are the Federal Reserve, interest rates, and declining CRE values at a time when approximately $1.5 trillion of CRE faces refinancing by early 2025. The Federal Reserve started a steep rate-hiking cycle beginning in March 2022 after figuring out that COVID-induced inflation was not so transitory. Interest rate hikes commenced modestly with 25 basis points (bps) in March 2022, followed by 50 bps in May, and then four successive 75-bp hikes. The hikes finally stopped in September 2023 after 11 consecutive hikes. [ii]
So, 2023 saw the return of rising interest rates after more than a decade of low rates. Higher mortgage rates have home sellers reluctant to give up their cheap mortgage financing only to buy another home and take out a much more expensive mortgage. Buyers have been priced out of the market, anyway. Homebuilders have slowed down production, and the result is a shortage of affordable new and used homes. Other pricey durables are caught in the same supply-demand conundrum—autos, appliances, etc. The Fed has used its interest rate tool to slow down inflation, but, ironically, higher interest expense has pushed up prices as well. Then, there are bank investments at under-market rates and consequent losses if the banks try to sell them in a rising-rate environment. That makes rising interest rates a damper on mortgage loans, consumer loans, and investment portfolios going into 2024.
Household debt is also hurting housing and retail real estate. According to the New York Federal Reserve Bank’s Quarterly Report on Household Debt and Credit, household debt continues to increase to new levels. In the third quarter of 2023, total household debt rose to a record $17.29 trillion, and credit card balances rose to $1.08 trillion. Households are already being challenged by inflation, but even more so by the higher interest rates on that increasing debt, and that will dampen consumer spending and reach down into retail and industrial CRE as well as reduce the amount consumers have available to cover housing costs.[iii]
3) Commercial Real Estate: Tumbling Down?
The Fed’s interest rate hikes have led to declining CRE values just in time for refinancing of about $1.5 trillion by early 2025. Remember that rising interest rates reduce net operating income (NOI) and push up real estate cap rates, resulting in a lower value. For example, an office building generating a $1 million NOI, and appraised using a 4% cap rate, works out to be a $25 million property. But what if higher interest rates reduce the NOI to $900,000 and boost the cap rate to 5%? Now the building is worth only $18 million, a 28% drop in value. Commercial real estate appraiser and economist KC Conway has suggested watching these trends:[iv]
1) More CRE value contraction, as maturing CRE debt gets repriced with interest rates in the 7% to 8% range, and cap rates 200 bps to 400 bps higher than when those loans were originated.
2) More equity in transactions to offset the debt contraction.
3) Development of new capital relationships such as credit unions, family and friends’ funds, private equity, and even sale-leaseback structures to retire debt and salvage the operations of assets (used by resort and luxury hotels during the early days of COVID when banks panicked).
4) Less new supply as construction lending by banks continues to decline.
So, what is working?
Industrial real estate is top of the list, but even this property type is undergoing change. Tenants are conveying to developers that they want to pause on big development in favor of 100,000- to 300,000-square-foot warehouses to hedge their long-term risks. However, the tenants/occupiers want this new “small-size-it” warehousing to be flexible, located in industrial parks that have additional land for expansion, and located in proximity to ports and key logistics infrastructure, especially along rail– near emerging inland ports such as the newest port in Montgomery, Alabama, and the most overlooked port in Little Rock, Arkansas), and with connectivity to the Gulf and Southeast ports in Georgia (Savannah), South Carolina (Charleston), Florida (Port Everglades), Alabama (Mobile), Louisiana and Texas (Port Freeport). The ports of Mobile and Port Freeport south of Houston are two of the most notable ports to watch.
Industrial Cold Storage
The average age of a cold storage warehouse is 37 years, and most of these assets are functionally obsolete. New cold storage development represents less than 2% percent of all new industrial development, so there is little risk of overbuilding. However, the costs are high and tenant requirements vary substantially.
Twelve of the top 15 MSAs in year-over-year rent growth are in the Midwest, according to RealPage’s first-half 2023 data. Fueling this growth are migration toward affordability and MSAs with skilled workforces. Affordability and skilled workforces have raised the appeal of Midwestern locales such as Wichita, Kansas. The PODS Moving Trends report tracks current workforce and population migrations. According to the August 2023 report, the Myrtle Beach, South Carolina/Wilmington, North Carolina, area was the No. 1 place people moved to in 2022. Sarasota, Florida; Orlando, Florida; Ocala, Florida; and Houston rounded out the top-five destinations for PODS (Portable On-Demand Storage) containers in 2022. The report also noted that 2022 was “the second year in a row that southern states have seen a larger influx of residents compared to any other region, with more than 80% of the destinations on the list being in the south.”
Other CRE areas are still working–new homebuilders are able to sell new homes with interest rate buy-down programs that existing homeowners don’t have access to. Manufactured housing is working but faces NIMBY (not in my back yard) resistance in every state. Amenitized, well-located suburban office buildings are far outperforming urban and central business district buildings in large MSAs because they are close to where the workforce lives and wants to work. The Midwest and South are the two regions performing best from a geographical perspective because they offer affordable lifestyles, educated workforces from nearby universities, and CRE inventory at affordable prices. Be careful–the data and metrics we have relied on in previous down cycles and CRE recessions (e.g., unemployment and vacancies) may no longer be insightful and valid. Instead, start looking at household debt and fresh industry data from the likes of PODS, the National Center for the Middle Market, and entities such as the NAIOP (National Association for Industrial and Office Parks)
4) Inflation: Up, Up, and Away?
Perhaps still too early to declare victory over inflation, the Fed has indicated that it may curb its interest rate strategy in 2024. Inflation’s primary and most pervasive effect is that its overall rise in prices over time reduces purchasing power. Worse, lower-income consumers tend to spend a higher proportion of their income on necessities than those with higher incomes. This means they have less of a cushion against the loss of purchasing power inherent in inflation. Further, expectations of future inflation will begin to rise if the inflation rate accelerates sharply and stays high. Then workers start demanding larger wage increases and employers pass those costs on by raising prices on output, setting off a wage-price spiral. In the worst-case scenario, a bungled policy response to high inflation can end in hyperinflation. In the U.S., rising inflation expectations during the 1970s lifted annual inflation above 13% by 1980 and the federal funds rate to more than 20% by 1981, while unemployment topped 10% as late as mid-1983 following the ensuing recessions. The Fed’s approach has been to manage inflation using monetary policy–when inflation threatens to exceed a central bank’s target, typically 2% in developed economies and 3% to 4% in emerging ones, policymakers can raise the minimum interest rate, driving borrowing costs higher across the economy by constraining the money supply. As a result, inflation and interest rates tend to move in the same direction. By raising interest rates as inflation rises, central banks can dampen the economy’s risk appetite and the attendant price pressures. The expected monthly payments on that boat or that corporate bond issue for a new expansion project suddenly seem a little high. However, although new borrowers are likely to face higher interest rates, those with fixed-rate mortgages and other loans get the benefit of repaying these with inflated money, lowering their debt service costs after adjusting for inflation. Elevated inflation discourages saving since it erodes the purchasing power of the savings over time, and that prospect can encourage consumers to spend and businesses to invest. As a result, unemployment often declines at first as inflation climbs. Historical observations of the inverse correlation between unemployment and inflation led to the development of the Phillips curve expressing the relationship. For a time at least, higher inflation can spur demand while lowering inflation-adjusted labor costs, fueling job gains. Eventually, though, the bill for persistently high inflation must come due in the form of a painful downturn that resets expectations, or else chronic economic underperformance.
Say you borrow $1,000 at a 5% annual rate of interest. If annual inflation subsequently rises to 10%, the annual decline in your inflation-adjusted loan balance will outweigh your interest costs.
5) Recession: Coming Soon?
The trouble with the trade-off between inflation and unemployment is that prolonged acceptance of higher inflation to protect jobs may cause inflation expectations to rise to the point where they ignite an inflationary spiral of price hikes and pay increases, as happened in the U.S. during the stagflation of the 1970s. The Fed was then forced to raise interest rates much higher and keep them high for a longer period of time. That, in turn, caused unemployment to soar, and to stay high for longer than would likely have been the case had the Fed not allowed inflation to spiral so high.[v]
So, what’s going on now? Well, the NACM (National Association of Credit Managers) Credit Managers’ Index (CMI) ended 2023 just 0.7 above where it started the year. In December, the Index gained 0.3 to a reading of 52.6. The CMI continues to show considerable weakness but remains above the contraction threshold. “It points to considerable decline in credit conditions that are leading indicators of economic activity,” said NACM Economist Amy Crews Cutts, Ph.D., CBE. “The Fed’s aggressive stance to fight inflation has hit businesses through increased borrowing costs. The CMI is showing these stresses with higher delinquencies on accounts receivables and increasing business bankruptcies.” The index of favorable factors reported its sales factor as the most volatile in 2023. The index of unfavorable factors improved a little but remained in contraction territory for the past six months. “Collection referrals continue to rise,” Cutts said. “The index for accounts placed for collections has been below 50 for an astounding 19 months and we saw bankruptcies rise quickly this year—these two trends are clearly indicating a recession in business activity heading into 2024.”[vi]
Expectations for a recession among small- and midsize-business leaders have moderated following a year of better-than-expected economic growth, but overall economic optimism remains low by historical standards, according to JPMorgan Chase’s 2024 Business Leaders Outlook survey released yesterday. Forty percent of midsize and 51% of small business leaders anticipate a recession in 2024 or believe that a recession has already begun, down from 65% and 61%, respectively, from one year ago. Despite the decline in fear of a recession, midsize business leaders were nearly evenly split in their outlook on the national economy, with 31% optimistic, 34% pessimistic and 36% remaining neutral. While this year’s optimism was higher than the 22% reported a year ago, it remained at historically low levels for the survey, according to JP Morgan. More than half of midsize business leaders (54%) cited labor-related issues—including shortages, retaining, recruiting and hiring—as one of their most significant challenges, followed by uncertain economic conditions (47%), revenue/sales growth (39%) and rising interest rates (36%). More than one-third of small business leaders (35%) reported inflation as one of their most significant challenges, with rising taxes (19%) and the ability to grow sales/revenue (18%) also top concerns.[vii]
Writer Dorothy Parker warned, “The only dependable law of life—everything is always worse than you though it was going to be.” Parker’s law seems to be holding up in 2024. Just when you think the supply chain kinks have been worked out, the Panama Canal runs out of water, and the route to the Suez Canal has become a shooting gallery. Thinking that supply chain disruptions were a transitory Covid problem fueling a temporary inflation, the Fed finally figured out it wasn’t so transitory and after a decade of flat interest rates, it pumped up rates to cool off inflation only to wreak havoc on bank bond portfolios and freeze loan production. One major lending casualty has been real estate, especially home construction and income-producing real estate which has already been suffering declining valuations from the COVID work-from-home option and rising vacancies. Now the specter of recession still haunts our economy as we enter an awkward election year.
This discussion provides you with a little background on some key issues—supply chain, interest rates, lending, inflation, and recession—that are likely to be issues you will have to resolve in your own organization. At the very least, consider these steps:
- identify your client’s vulnerability to supply chain kinks,
- calculate your exposure to variable rate loans,
- review real estate collateral securing your loans.
- pay more attention to your borrowers’ break-even sales and stress-test their debt service ratios with higher interest rates, and
- monitor more closely your borrowers in industries vulnerable to recession.
May 2024 give you the chance to live in more interesting times!
[i] “Dazed and Confused,” released by Led Zeppelin in 1968
[ii] Taylor Tepper, “Federal Funds Rate History 1990 to 2023,” Forbes Advisor, October 17, 2023, https://www.forbes.com/advisor/investing/fed-funds-rate-history/ (01/04/24)
[iii] KC Conway, “What’s Working and What’s Not Working in CRE,” Development, Winter 2023-2024, https://www.naiop.org/research-and-publications/magazine/2023/winter-2023-2024/perspectives/whats-working-and-whats-not-working-in-cre/, (01/04/24)
[iv] KC Conway, “What’s Working and What’s Not Working in CRE,” Development, Winter 2023-2024, Ibid.
[vii] “Bank Survey: Business Leaders Mixed on 2024 Economic Outlook ,” ABA Daily Newsbytes, January 4, 2024 https://mail.google.com/mail/u/0/#inbox/FMfcgzGwJccLMsXtHPcDZCRhGBScRLKg (01/05/24)