Shiller price index

Real estate is the crisis risk to watch now

As you have no doubt been informed, global equities are now in a bear market. What happens next?

The most excessive speculation has already been washed out of the system. Those who warn against bitcoin and other cryptocurrency bubbles, meme stocks, or growth tech companies owned by the ARK Innovation ETF certainly seem to be right. Last November, meme stocks were so exciting that their own benchmark, the Solactive Roundhill Meme Stock Index, was launched. Since then, this index has fallen by 70%. The same goes for ARK and bitcoin – it feels like a flurry of speculative excitement that has flowed into the same things together, and flowed out again.

These investments still count, and it is possible that they have to go down even further. In the case of bitcoin and the crypto sector, it is also possible that they are large enough that losses create systemic effects, as their falls force the selling of other assets. But they are not at the heart of the issues we face today.

What we need to know is if more accidents will happen in the future. And it depends to a large extent on leverage. When non-leveraged investments fall, the people who own them lose some of their wealth. It probably has some effect on spending in the economy, but basically that’s it. Relatively affluent people who own investment assets are now relatively less affluent. End of.

When leveraged investments fall, companies and their lenders can go bankrupt. The need to repay debt can lead to fire sales elsewhere. So we have our higher rates and the financial system now discounts significantly increased borrowing costs in the future. This should lower inflation – but the risk is that it creates crises for leveraged investments that cause further damage. So the question, as always when we weigh the risk of a financial crisis, and we do a little violence to the French language, is: “Look for the lever”.

Office building

If there is one asset that deserves to be scrutinized, it is real estate, of which credit is the blood. For a double whammy of higher rates and the lasting effects of the pandemic, look to office real estate. Remarkably, the Bloomberg Index of U.S. Office Real Estate Investment Trusts, or REITs, is slightly lower now than it was 20 years ago, and is almost back to the lows it hit at its worst. of the pandemic in 2020.

For anyone who has seen the growth of the Manhattan skyline in recent years, barely slowed by Covid-19, this is alarming. The woes of Vornado Realty Trust, one of New York’s biggest developers, whose stock price is 59.5% below its peak five years ago, suggests the extent of the problem; 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 that has been planned on the assumption that office demand will continue at pre-pandemic rates. That doesn’t seem like a good premise anymore. The drop in REIT prices shows that concerns are already covered to some extent by price, but the impact of a large office developer defaulting on its loans would be painful.

The problem is not limited to the United States. European office property isn’t all that overblown and hasn’t suffered as much since the pandemic, but the FTSE indices of eurozone and UK office REITs, denominated here in euros, show similar issues at work.

Many office building holders, like endowments and large pension funds, are exactly the entities that can swallow a big loss without causing a systemic cascade. But the increase in office supply and the drop in post-pandemic demand, all funded with a lot of leverage, is a combination that needs to be watched closely.


This brings us to housing. Rates in the mortgage-backed bond market are rising, as might be expected given the evolution of Treasuries, while the rates actually offered to US borrowers are even higher. Typical 30-year mortgage rates are now slightly below 6% and approaching the pre-crisis peak of 2006.

This is another market that has been upended by the pandemic. The demand is changing. Some places aren’t as appealing in the WFH era anymore – others are suddenly much more exciting. But the key point is that prices have taken off. The S&P Case-Shiller index of homes in 20 major cities peaked in 2006 and has lagged inflation ever since – until earlier this year. New York and Miami, both of which saw particularly exciting action during the housing bubble 16 years ago, have also seen prices soar.

It is uncomfortably reminiscent of the conditions that triggered the global financial crisis. Mortgage lending has not been as loose this time around, and major commercial banks are not as exposed. The systemic implications are therefore not as profound. But the prospect of incurring leveraged losses on assets that people can’t afford to be without is always painful.

Meanwhile, in the UK, where housing has always been more central to the economy and the spirits of animals, there is also cause for concern. House prices in London, although not in the country as a whole, are now higher in real terms than they were at the peak 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 could be severe.

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

UK housing is less exposed to the rates market than before, as homebuyers have gradually lost their appetite for variable rate mortgages over the past generation. But if there’s another pocket of speculation in the world that could wreak havoc when it breaks out, it’s UK housing, particularly in London.

Emerging Markets

When U.S. rates rise and the dollar strengthens, it generally makes sense over decades to assume that emerging markets will take the worst damage. Compared to previous cycles, they are not in the throes of a major bull market and are therefore less likely to cause systemic problems. But there are reasons to worry.

If we look at emerging market government debt, as measured by both Bloomberg and JPMorgan Chase & Co., we see that it has suffered a bad fall. Major indexes are no higher today than they were the day after the 2016 presidential election, when the arrival of Donald Trump briefly shook the emerging world. This clearance sale is now almost of the same magnitude as the drop that accompanied the arrival of Covid-19 in March 2020.

When it comes to emerging markets outside of China, which should now generally be treated as a law in itself, the Institute of International Finance finds that flows have turned negative. China, despite all its problems and despite all the controversy generated by its repression of the private sector, continues to attract capital.

Despite the shift in international sentiment, non-Chinese emerging market equities are holding up relatively well. According to the MSCI indices, they have held their value better than the developing markets outside the United States covered by the EAFE index (Europe, Australasia and the Far East). So far, emerging markets seem to be weathering the storm better than in the past.

Can this last? The example of the 2013 taper tantrum, the incident closest to this year’s sharp US rate hike, portends trouble ahead. The currencies of emerging countries with large budget deficits came under severe pressure. But the IIF says this time around, emerging markets could actually benefit from their history of inflation and the fact that international investors still don’t trust them to get it under control. As a result, several major emerging market central banks began raising rates last year, at a time when their Western counterparts now wish they had risen as well.

For now, it seems that emerging markets have benefited from investors’ mistrust of them. The same discipline might have helped in the United States and Western Europe, but their central banks were strong and credible enough to thwart it. To quote the IIR:

Global bull cycles and inflationary shocks are traditionally tricky for emerging markets, but we’re not that negative. Indeed, most major emerging markets started to climb well before advanced economies, pushing real rates well above G10 levels. Indeed, the normalization of longer-term real rates is something that mainly concerns advanced economies, while longer-term real yields – in much of EM – have normalized in 2021. Of course, there are has exceptions. Emerging markets where inflation far exceeds monetary policy have deeply negative real rates. These emerging markets are now facing increasing challenges and will likely experience further, possibly substantial, depreciation. However, we view these countries as idiosyncratic and not emblematic of broader vulnerability in emerging markets.

There are still plenty of problems for emerging markets, as always. Part of their health can be attributed to high commodity prices. If the bull cycle succeeds in slowing the economy and driving down commodity prices, it will be difficult. A stronger dollar would put even more pressure on their debt. And the intense shorting activity in the Japanese yen is likely providing artificial support for some of the more popular emerging currencies, such as the Brazilian real. They would be vulnerable if the yen strengthened significantly.

But at this point, it looks like the emerging world is still in reasonably good shape to weather the financial jolts ahead. Unfortunately, the same cannot be said for global real estate.