Getting a handle on prior economic circumstances is hard enough, but predicting future conditions is virtually impossible. There are too many unknown and dynamic variables that go into a market economy, not to mention any unforeseeable circumstances. Putting too much weight on the forecasts of “experts” can be hazardous. That’s why, in making financial decisions, I feel it’s much more important to think in terms of probabilities and minding downside risk than it is to think in absolutes.
One of the economic debates that carries great weight for real estate investors is the inflation or deflation question. Its answer has significant consequences for the direction of interest rates and related real estate values. Unfortunately, its answer is fleeting, with much of its outcome and consequence lying somewhere in the wrestling match between markets and the world’s central banks.
I’m no apologist for the Federal Reserve’s (Fed) past actions and the unintended consequences it has produced, but we play with the cards we are dealt so we might as well understand them. The financial and monetary structure of the world, especially since the 1970’s, is dependent on credit expansion. Right or wrong, the popular economic philosophy in recent history has gravitated towards demand-pull spending solutions in order to mitigate any economic downturns. The Fed and other governmental entities have attempted to generate activity today in hopes of spurring continued growth. Remember Cash for Clunkers? That’s just one of the programs implemented, along with the various iterations of Quantitative Easing and related interest rate policies enacted to have the desired effect.
Unfortunately, artificially low interest rates and easy credit lead to a misallocation of capital throughout the economy. Rates are really a reflection of how much one values a dollar today versus in the future. Because interest rates represent a time preference, low rates pull economic activity forward, leaving a gap to deal with in the future. Rates should act as a financial discipline on economic decision making. Using too low of a hurdle can make poor economic decisions appear correct. The consequences are a perpetual cycle of credit expansion leaving us a certain fragility in the underlying financial structure we have today. The financial news media in recent years has had to report on concepts like taper tantrums, repo market crashes and inverted yield curves, just a few of those fragility symptoms.
What remains is a situation where deflation would have dire consequences and the Fed and other central banks know this and have pledged to fight that condition by any means necessary. As long as they maintain control over the market, we can expect more of the same. The question becomes “when do they lose control and what are the consequences?” The answer may rest in the inflation/deflation question.
Fortunately, for their policy prescriptions, we’ve been in a nearly 40-year fixed-income bull market with continually declining interest rates. There have been many deflationary factors over this time. Conditions like aging demographics, technological progress, globalization, and an increasing debt overhang with its related declining money velocity have provided deflationary pressure. Many think this will continue, hence the numerous forecasts of continued low interest rates. The problem comes if the script flips and inflationary pressures take over.
The Fed and other central banks may have painted, or printed, themselves into a corner. They have been undermined in any previous attempt to normalize rates given the large debt overhang they perpetuated. The economy simply cannot handle a large increase in rates, which is why a move to any significant inflationary condition could be dangerous given their lack of ability to fight it. This would likely spook the markets and they would wrestle control of rates away from the central banks, with potentially devastating economic results.
What could lead to these pressures? Look no further than the unheard of levels of money and credit creation. Many thought inflation would result from some of the same prescriptions coming out of the 2008 crisis. We have not seen significant consumer price inflation the last decade, at least if you believe official measures. What did result was asset price inflation as this is where the created money was first deployed. That solution was more about recapitalizing an over-levered banking system and many of those funds never left the system with enough bank credit creation and money velocity to stoke consumer price inflation. Instead, it became an underpinning of asset price inflation.
This time, however, and because of some of the inequality resulting from last time’s attempted solution, we could expect to see more funds going directly to the populace, as in the current stimulus checks and more calls for Universal Basic Income. If related money velocity follows, we could experience significant upticks in consumer price inflation. The continued melding of the purse strings and the financing of government is no longer a hidden phenomenon. The illusion of independence between the Fed and Treasury has been thrown out the window as the Fed stands by to create the money and finance whatever it is the government finds politically popular. Nothing symbolizes this more than former Fed Chair, Janet Yellen, now as Treasury Secretary.
We are already in a situation where there is no mathematically viable way to pay our existing debt and future entitlement obligations with the present purchasing power of the currency. The existing political climate shows no inkling of moderating these spend and borrow habits. Increasing taxes, reducing government spending, or outright default are not viable options. The only politically feasible solution is to continue the attempt to inflate them away, hoping it doesn’t evolve into an unmanageable currency devaluation or debt-deleveraging depression. Remember, when the Fed says they are targeting 2% inflation, they are really saying they are cutting the purchasing power of your currency by roughly half over the course of a generation, or to the benefit of real estate investors, the value of the debt owed.
So, what does this all mean for today’s investment environment? There is no question that financial assets are at elevated levels as the central banks have propagated a disconnect between asset prices and underlying economic fundamentals. We often see bad economic reports met with increases in equity market levels as those markets cheer the hopes of further stimulus and artificial support in lieu of organic economic growth. We now have $17 trillion of negative yielding debt across the globe. Step back and think about what that says about the financial structure when one must pay another to loan them money. What used to be risk-free return on government debt has been turned into return-free risk.
Retirees and the traditional 60/40 stock and bond portfolio have been sacrificed in the name of propping up the current environment. For the past 40 years, this portfolio has performed well as bonds have been in a long bull market. They’ve provided extra juice in times when the two asset classes were moving in tandem, and diversified support when they were diverging. We can hardly expect the same returns going forward. With interest rates at minimal level, the math needed to achieve the 7-plus percent real (inflation-adjusted) rate of return many pension plans need to remain solvent just doesn’t compute. Further, the level of equities is very much a function of those low rates, as the lack of return on low-risk assets has pushed investors into other risk assets, bidding up their prices beyond normal levels.
With financial assets at elevated levels, tangible assets become a very important part of a well-rounded portfolio with a chance to minimize the impact of this financialization. The closer we can get to the ultimate price level reflecting underlying economic fundamentals, the better off we are. It provides a measure of safety in lieu of the complete dependence on the attitude of future buyers in providing a return (aka: Greater Fool Theory). Real estate provides a very important role here, but one must stay cognizant of the risks. While the risk of an outright debt-deleveraging depression is still relatively small, it has certainly increased, making high-leverage recourse debt all the more dangerous. Remember to mind your downside risk.
That said, investing in a product providing a critical human need, such as shelter, helps provide a level of safety. It is a necessity that will never disappear. It may just fluctuate in value along the inflationary/deflationary spectrum. It is that spectrum which the central banks attempt to manage, further complicated by the political environment. The most politically feasible way of giving the voters what they want and still dealing with its cost, is to borrow and subsequently inflate it away. Why not hitch your wagon to that force? Buying a cash flowing basket of tangible commodities, like an apartment building, with a moderate amount of long-term, fixed-rate, non-recourse debt is a fantastic solution. Allow inflation to increase net operating income and related underlying asset value, while at the same time, inflate away the value of the debt used to purchase the asset. As long as you have the right financing and staying power to weather the inevitable economic storms, the Fed’s policy prescriptions will provide the tailwinds for wealth creation.
Tom Borger is a real estate investor and developer in Northern Indiana.
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