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CRE losing its hedge edge?

​Tame inflation and spending challenge Fed's outlook for rate increases

Many people were surprised by how strongly the Fed adhered to its guidance on a third rate hike in 2017. The inflation, income, and spending data from August will not make those people any more certain of the Fed's course. Data from the personal consumption expenditures (PCE) price indexes show that inflation remains tame. The core PCE index grew by 1.3 percent on a year-over-year basis, down from 1.4 percent in July and below consensus expectations. The headline PCE index grew by 1.4 percent year-over-year, in line with the reading from July but also below consensus expectations. The Fed prefers to use the PCE inflation indexes as guides when setting monetary policy.

Some of the weakness seen in the inflation data was reflected in the income and spending data from August. Income and consumption both grew in line with expectations, but were generally weak. Even if some of the weakness is exaggerated by the impact of the recent hurricanes, when adjusted for inflation both measures slowed significantly in the third quarter versus the second quarter.  These slowdowns indicate something beyond the impact of the hurricanes is affecting income and spending data.

The Fed sticks to verbal-driven guidance

Despite these trends, it appears that the Fed will stick to its verbal guidance on rate increases. Last week Chair Yellen reemphasized the points she made after the Fed's meeting two weeks ago. But as we have previously mentioned, this comes at the expense of data-driven guidance. 

Inflation data remains stubbornly below the Fed's 2 percent target rate and continues to slow. While we expect an acceleration in 2018, we do not expect core inflation to reach 2 percent soon.

The Fed appears to be managing interest rates ahead of a surge inflation, but such a surge is highly uncertain and even if it occurs the timing is unknown. If tame inflation persists as we expect, it will jeopardize any potential rate hikes in 2018, particularly if the Fed raises in December. We are not arguing against another rate hike in 2017. The economy has grown over the last 8 years and can clearly handle it. We are just highlighting that another hike does not appear to be fully in line with the Fed's data-driven guidance.

Why has inflation been so stubborn?

The Fed appears somewhat confused as to why inflation remains so weak. There are a number of reasons why, including longer-term inflationary impacts such as globalization, outsourcing, international trade, etc. But for the U.S. in the short term, the key cause is likely excess bank reserves. In macroeconomic theory, when a central bank increases the currency in circulation, as the Fed did with successive rounds of quantitative easing (QE), inflation typically accelerates because currency increases faster than the supply of goods and services, which pushes up prices as more money competes for relatively scarce goods and services. But in this cycle, that did not occur because the banks who received these funds did not lend them to customers who would then go out and spend that money – the exact mechanism by which the money circulates through the economy. 

Banks did not lend as many expected, likely because of increased risk aversion in the wake of the recession, limited investments opportunities, and increased regulation. 

The money the banks received from selling bonds to the Fed remained on their balance sheets as excess reserves, not loans.

What are the implications for commercial real estate?

As we have stated numerous times in the past, we are not overly concerned about the impact rate increases will have on cap rates and valuations. As the economy grows, so do cash flows and valuations of commercial real estate (CRE) assets, even as rates increase. We do not see slow, steady rate increases reaching the point where they impede economic growth soon – the Fed would need to raise a number of times before we reach that point. 

Nonetheless, one potential risk to highlight for CRE investments concerns the inflation hedge. CRE power is well known as an inflation hedge due to the inflation clauses embedded in multi-year leases. But if the Fed continues to raise rates faster than inflation increases, that will weaken the CRE hedge.

Cash flows will grow relatively slowly while the rates used to discount the value of CRE cash flows will increase relatively quickly. While we wouldn't expect this to have a large impact on valuations, it could undermine the effectiveness of the inflation hedge.

What else happened last week?

Economic growth for the second quarter was revised marginally upward because of an increase in private inventory investment. At 3.1 percent, the economy grew at its fastest pace since the first quarter of 2015. Durable goods orders in August increased after contracting in July, reflective of the impact that civilian aircraft sales have an overall durable goods data. The underlying trend (excluding aircraft orders) shows slow, but steady upward momentum. Consumer confidence and consumer sentiment both declined slightly in September, predominantly due to the impact from recent hurricanes. New home sales for August declined more than expected. Although declines occurred across the country, the largest decline was in the South due to the impact from Hurricane Harvey. We also expect the new home sales data for the next couple of months to be distorted by hurricane effects.

What we are watching this week

The employment situation for September should show that job growth slowed because of hurricane impact, not due to any change in the underlying labor market dynamics. We expect any hurricane-related distortions to reverse over the next few months. The ISM manufacturing and non-manufacturing indexes for September will be released and we expect the manufacturing index to show an increase because a weak dollar and stronger global growth should more than offset any hurricane-related impact. We expect little change in the non-manufacturing index due to new orders and ongoing hiring. Lastly, in a sign of things to come for some of the other economic data points, we expect a decline in weekly unemployment claims as the hurricane-related effects fade over time.

Thought of the week

Norway's sovereign-wealth fund, the world's largest, recently surpassed $1 trillion in total assets.

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