Charting The Course

Into Thin Air

By Mitch Siegler, Senior Managing Director

Mitch SieglerDizzying heights. Intense peril. Practically no oxygen. An extreme need for caution: one false move and you could lose everything. We’re not talking about the new film, EVEREST, the docudrama starring Jake Gyllenhaal and Josh Brolin about the simultaneous expeditions in 1996 resulting in the deaths of eight climbers. We’re talking about the Thursday, September 17 meeting of the Federal Reserve’s Open Market Committee where, as we had predicted, the FOMC agreed to again leave the key Federal Funds rate unchanged at 0.0% to .25%. And, we’re talking about the more than $6 trillion in stimulus central bankers have injected into the economy these past several years that, by all accounts, hasn’t really turned the economy around (or, you might say, has vanished into thin air).

Percent DecreaseIn one week in August, China’s woes manifested in a collapse of the Shanghai Stock Exchange, pushed down the S&P 500 by nearly 10% and increased the S&P’s Volatility Index to its highest level since 2011. Like climbers on Everest, the economy remains on thin ice and the Fed’s unwillingness (inability) to boost rates is just the latest glaring sign. The Fed’s key rate has been near-zero for 6½ years and the last time the Fed hiked rates was nearly nine years ago.

Investors and traders were not amused by the failure of rates to ascend once again following the Fed’s September meeting. Overseas markets immediately fell 2% to 3% and Wall Street followed suit the next day with major indices down 2% and oil tumbling nearly 5%. The Alice in Wonderland reaction – good news about interest rates staying low is bad news for the markets – may be explained by the fact that the Fed is essentially out of bullets (climbing without an ice ax may be the more appropriate metaphor) and we’re starting to hear more cocktail party chatter about QE4 (yet another round of quantitative easing, Fed-speak for stimulative monetary policy).

The markets took notice of the Fed’s accompanying dreary statements about a weakening global economy, especially the references to the great China slowdown of 2015. China, heretofore, the global economic engine, is suffering from altitude sickness as its steady and stellar (or shaky and suspicious – depending on your point of view) economic growth rate of 7% has plummeted – with profound implications for employment and political stability. Commodity prices continue to free fall.

Fed Chairwoman Janet Yellen’s wait-and-see approach might be driven by the markets or by her desire not to repeat the mistakes of other central bankers, who tried raising rates after years of accommodative policy only to reverse course after acting too soon. The European Central Bank, which raised rates in 2011, turned a recession into something critics call a near-depression. U.S. Federal Reserve governors remain loathe to commit career suicide by raising rates too early and then having to reverse course.

SluggishThe Fed has long focused on two important metrics in guiding its interest rate policy – unemployment and inflation. Even though the unemployment rate has returned to 5.1%, the economy remains decidedly sluggish. Inflation has shown no sign of moving closer to the Fed’s 2% benchmark, in part because of the China slowdown and declines in the prices of oil and other key commodities.

But, a major contributor to higher cost/price inflation remains pressure on wages – which heretofore has been invisible. The most logical explanation for workers not getting bigger raises is that there’s still plenty of slack in the labor markets exacerbated by the “shadow unemployed”, those millions who have given up searching for work or can only find part-time jobs.

So, is higher inflation just around the corner? Well, those who follow the Fed’s policy statements don’t think so; the Fed’s latest musings suggest we won’t see the 2% target rate of inflation again until 2018. And while a move up in rates at the Fed’s next meeting, in October, remains a possibility, it’s hard to call the first economic sedative in seven years this month (or even in December) a slam-dunk. The September tally showed ten Fed governors calling for a zero to 0.25% move up in 2015, six calling for.50%-.75% moves up before year-end and one super-dove calling for rates to be reduced.

A move up in rates is inevitable and odds are the Fed will act this year but global markets are a slippery slope. And the Fed’s decision not to act could pressure foreign central banks to raise their rates. “It puts pressure on the European Central Bank to act and pressure on the Bank of Japan to act” to stimulate growth says Andrew Balls, Chief Investment Officer for global fixed income at Pacific Investment Management Company (Pimco).

Smaller Real Estate Not Highly Correlated with Equity Markets

Meanwhile, commercial real estate continues to outperform, according to a recent Marcus & Millichap report, driven by increased investment, declining unemployment and generational trends. The shift in retail spending from brick and mortar stores to the Internet is driving demand for industrial space; industrial vacancy rates have fallen to 6.9%, per M&M. Increased hiring is driving down office vacancies, 15.3% in the second quarter; office space absorption should continue further given the dearth of new office construction. There’s similarly limited construction of retail real estate so any growth in demand swamps fixed supply. And, more than two-thirds of Millenials live in rental households, which explains the 97%+ occupancy rates Pathfinder is enjoying in many of our apartment properties.

So, if you expect the volatility and downdrafts in global equity markets to continue, one sector that has historically been loosely correlated, real estate, might be a good place to increase exposure. In 14 of 15 previous U.S. equity bear markets dating back to 1956, the home price index rose. During the Great Recession, of course, real estate markets collapsed together with stocks. But, that was an anomaly caused by subprime lending and CMBS securitization according to Yale University’s Robert Shiller, co-creator of the Case-Shiller Home Price Index.

Real EstateAs we reflect on the downdraft and emotional angst facing traditional investors, we’re reminded of why we’re so keen on Pathfinder’s strategy of buying smaller properties – those below-the-radar of the larger institutions – where we can add value through renovations and upgrades and “manufacture income.” Another benefit of the asset class is that these types of investments are not highly correlated with broader equity markets, especially emerging markets – so they should provide a nice buffer (and cash flow) during periods of high volatility.

Markets ascend and descend – this is part of the natural order of things. As we look out over the next few months, higher volatility and more choppiness look like part of the landscape. And a Fed rate bump could be around the next bend in the trail. Whatever surprises global markets and central banks may throw at investors, we remain bullish about a real estate component – especially smaller, value-add properties – in an overall investment portfolio. Think of a real estate allocation as your support team on your next expedition – it’s easier to make the summit with their help.

Mitch Siegler is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. Reach him at msiegler@pathfinderfunds.com.