Tariffs and the rise of protectionism

International trade has been steadily rising at a faster rate than global economic growth since the end of World War II. Yet, 2019 marks the end of this 75-year trend–the equivalent of a massive container ship slowing to a crawl.

Cross-border trade represented 6% of world GDP in 1946; it rose to 23% last year, and in 2019 this ratio is falling. New trade policies initiated by the world’s largest importer of hard goods (the US), together with tariff retaliation and the rise of nationalism and protectionism in several other countries—these are the driving factors behind the end of a seven-decade trend.

After signaling progress toward resolving the China/US trade dispute, President Trump surprised markets by raising the tariff rate on $200B of Chinese imports to the US from 10% to 25%, effective May 10, and reiterated the potential to extend 25% tariffs to the remaining $325B of imports not currently subject to taxation. This latest increase is in addition to the $50B of imports previously subject to a 25% duty. Moreover, on May 15, the US further raised stakes by issuing an executive order effectively banning US companies from doing business with Huawei, the world’s second largest smartphone maker. And on May 30, the US issued another tariff threat for Mexican imports.

Markets reacted negatively, with the US S&P 500 declining 6.6% and the Shanghai Composite declining 5.8% in May (see page 7). The US yield curve has also inverted (page 12). Unsurprisingly, China retaliated with tariffs on an additional $60 billion of US imports effective June 1 and has threatened to curtail exports of rare earth elements, a key industrial input.

If trade continues to stay stalled, the impacts on global economic growth rates could be significant, albeit with meaningful variation by country. The theory of comparative advantage is among the oldest and best established in classical economics – developed by David Ricardo in 1817. It states that producing goods based on local strengths and resources and trading for other products produces higher global production and wealth. Many economists also acknowledge that the benefits of free trade can be uneven and subject to manipulation by some countries. In other words, unfettered free trade increases the size of the global economic pie—but it does not necessarily lead to larger pie slices for all.

Oxford Economics expects global trade growth to slow to 1.8% in 2019, down from 5% in 2018 and down from an average of 7% annual growth in the last two decades. Although the direct dispute has mainly involved the US and China, many other countries and technology firms will be affected as they export intermediate goods to China, which China will curtail due to declining exports. Countries most exposed to the global trade slowdown include Korea, Taiwan and Germany, while less open economies, such as the US, Brazil and India, are better insulated.

How should real estate investors react to the recent trade news?

• Core real estate, consistent with its low beta profile, will likely be less impacted than most sectors of the economy, as operating buildings have little or no imported inputs. Harsher treatment of off-shore real estate investors vs domestic capital could be a retaliatory risk, but has not yet risen to the top of the saber rattling list.
• Real estate demand will suffer to the extent that GDP and jobs are impacted. Current forecasts are for modest impact on GDP in most countries — erosion of 50bps (or less) growth. A further escalation of the trade war would worsen the impact.
• Tariffs on materials (especially) will modestly increase the cost to deliver new buildings and upgrade existing ones. At the margin, this will reduce new construction and increase the value of existing buildings, although the impact can be muted by currency moves, lower developer profits and lower land costs.
• The warehouse/logistics sector will experience the greatest impact among property types to the extent that tariffs reduce imports of retail products and business equipment. Supply chains will be interrupted if/when the UK leaves the EU or as import substitution occurs in the US as goods from Korea, Japan, Vietnam and Mexico take the place of Chinese-made imports subject to tariffs.
• The cost savings from e-commerce and other technological improvements may offset the rise of tariffs, so that consumers and businesses are not slammed by higher costs, causing final demand to plummet. Within China and India, the fast-growing domestic economies and lack of modern logistics buildings should support the growth of the warehouse sector for the foreseeable future.

In summary, the current US/China trade dispute is a reversal of many decades of free and growing trade between countries. A few observers expect that the dispute will be resolved by the end of the year, although recent actions and remarks by both the US and China create doubts about that outcome. The impact on real estate demand and values should be modest compared to other sectors, although unforeseen consequences are certainly possible.

In addition to this month’s Macro Deck, LaSalle’s Research & Strategy team published four new briefing notes over the last month:

• Completion Strategies for Real Estate: Bringing together authors from LaSalle’s public and private real estate investment team’s, this paper illustrates how institutional investors can use publicly traded real estate securities to efficiently “complete” their real estate allocations by adding niche property types.
• Urbanization Reimagined: In this note, we look beyond the simple story of more tenant demand in urban places and consider how land prices and rents will change in different parts of the metro area going forward.
• Proptech and Predictive Data Analytics are Changing Real Estate Investment: This note expands on our 2019 ISA, examining how predictive data analytics tools and proptech companies could change how we invest, as well as how we seek to see through the hype that surrounds the growing proptech sector.
• The 2018-19 Investable Universe Update (forthcoming): This is LaSalle’s annual review of the size of the professionally-managed stock of investment real estate, whether held by a listed company, a REIT, or a private equity investment pool. Using new estimation techniques, we also rank the top 40 metros in the world in terms of the total value of their income-earning real estate.

April showers and May … flowers?

The weather is now ideal for a May stroll, or even a random walk, as April showers fade from our macro view. Positive news on the Chinese and US economies, a buoyant equities market, and a Brexit extension have all brought more sunshine into the outlook. Our macro deck is filled with financial data series – and many real estate metrics – that appear to be random walks. Global stock market indices, bond markets, and even property prices do not always revert to a stable long-run average. Nobel prize-winning financial economist, Eugene Fama, described such time series as “having no memory.” This makes them inherently unpredictable using even the most advanced econometrics.

Fortunately, this does not mean it is impossible to predict real estate prices or rents, thanks in part to the special case when random walks are cointegrated with each other. Think of this like going for a ramble with your dog. The path you take might be random, but it would be a safe bet that you and your dog would stay close to each other along that unpredictable path, albeit with variations depending on whether you are using a leash. Cointegrated time series behave much this way. For example, while recently listed Lyft and Pinterest’s stock prices (see page 13) are a random walk, analysts can price information on New York exchanges to predict the price movement of Rakuten shares in Tokyo, which has stakes in both companies. If market prices do not reflect this, then it can create an opportunity for arbitrage.

For real estate investors, the key cointegrated pair of time series are real estate values in the public and private markets: page 3 in this month’s deck. The difference between these series – the NAV premium or discount – has varied significantly over time, but has been near parity over the long-run. However, since October 2016, the implied value of real estate based on public REIT and real estate security pricing has been below the values implied by transactions in the private real estate market. This significant global NAV discount had some observers wondering if this particular “leash” had snapped entirely in two, especially for office and mall REITs.

LaSalle’s conviction that public and private real estate values must be similar over the long run – based on their cointegrated relationship – has been borne out so far in 2019. In early April 2019, the NAV gap – based on the EPRA/NAREIT global index – reached its narrowest level in 31 months. The way the gap has been resolved is meaningful. Private values did not decline to meet the public market, albeit with some exceptions, such as for US mall retail. Nor did public and private meet in the middle. Instead, public values have recovered and the gap has been resolved largely in favor of private real estate values. Underneath these headline figures, there continues to be significant variation in NAV discounts and premiums across individual countries and sectors – leaving many opportunities for LaSalle’s Securities team to make accurate, high conviction predictions of relative value changes.

We recommend that investors focus their forecasting efforts on three key areas where high conviction predictions are possible: cointegrated data series like those described above, data series that are not random walks but are mean-reverting (like the vacancy rates shown on page 23 of this month’s deck), and real-time information predictive of the near future – such as when competitive projects are scheduled to break ground. Technology and improved data frequency is changing how we do these kinds of forecasts. Not unlike taking a Fitbit or smart watch on our next ramble, real estate investors benefit from the collection of more granular and geolocated data.

A New England terms feels appropriate around the world

In the New England countryside, April is known as Mud Time¹ or Mud Season. In 2019, this coarse nickname applies to a much broader geographic area.

Many macro indicators show impeded economic progress as countries spin their wheels in the mire. Yet, a few indicators like REIT prices and tech stocks are surprisingly robust. Thus, the April outlook for property markets is as clear as, well, mud. Structural and political shifts – the fallout from the Mueller investigation, the countdown for the Brexit negotiations, and the next stages of the China-US trade disputes – are all incontrovertibly caught up in the ooze of April as well.

The Brexit deadline of 29 March was averted with just days to go. Instead, this date became the occasion of a failed third attempt to pass a Withdrawal Agreement in the UK. At first glance, the short April 12th postponement becomes the default base case. This story is not yet over. Here’s what we know: The vast majority of Parliament wants to avoid a “crash-out” scenario. The EU leadership does not want to be seen as a villain and have called for an emergency summit on April 10th. Parliament is running out of options with just 12 days to go. The Tory party is effectively without a leader capable of exercising party discipline. The capital markets (FX, FTSE 100, EuroFirst 300) are taking the latest Parliamentary setback in stride. All these facts lead us to conclude that a protracted Brexit process is still the most likely case, even though the odds for a hard Brexit have gone up and a crash-out is still possible.

Recent “risk-off” capital market trends reinforce the importance and benefits of long-term income-focussed investments. In Europe, major economies such as France, Germany and Italy are slowing. Negative-yielding bonds have surpassed $10 trillion, or about 20% of worldwide investment-grade debt. Growing economies like the Netherlands, Poland, Spain and Sweden are all past their peak expansion. And in all these countries, investors are hungry for income-generating property investments with relatively low risk.

Manufacturing PMIs (Purchasing Manager Indices) have also fallen below 50 (showing contraction) in China, Germany and Japan. This is a serious threat to the world’s three largest exporters of tangible goods. Strong momentum in the US economy contrasts with slowing throughout the rest of the G-20. But the US Federal Reserve’s recent guidance for holding interest rates steady indicates that they see trouble ahead. In short, the perception of risk today is higher, as implied by the flattened or inverted term structure of sovereign bonds around the world.

Nevertheless, investment into real estate has been high and sustained, with reports of considerable dry powder waiting to be deployed. We caution readers not to put too much faith in these “wall of capital” estimates, since the GFC showed how quickly the wall can crumble. Our macro deck does not show that another financial crisis is imminent. It does indicate that risks to fundamentals are rising, even though real estate pricing has not adjusted – probably because risk-free rates have fallen. Finally, a close look at the April deck reveals it is also a good time to relieve stress through humour.

^[1] Robert Frost’s “Two Tramps in Mud Time” contains stark economic themes; it was published in 1934—in the midst of the Great Depression.

Both are engaged in a dizzying pas de deux guaranteed to keep the markets transfixed in March.

In recent weeks, hard and fast deadlines have started to bend and break. The March 1st deadline for US-China trade tariffs was swept away by President Trump. The March 29th Brexit deadline is also turning soft, even as Prime Minister May runs out the clock. The much-ballyhooed Amazon HQ2 for New York City was a headline that was erased as fast as it appeared. The late December gloom in the stock markets, driven by fears of an economic slowdown, has lifted in all G-20 countries, ironically with the exception of the world’s fastest-growing major economy (India). So far in 2019, Donald Rumsfeld’s “known unknowns” and “unknown unknowns” should be amended to include “unknown knowns” — things perceived as certain that turn out not to be.

Private real estate investors may be more apt than others at understanding that decisions must always be made under conditions of uncertainty. By owning assets that take months to buy or sell, all private equity investors must live with their decisions for a long time — and are rarely able to re-position portfolios quickly in response to sudden shifts in policy or market expectations. To help LaSalle stay aware of the day-to-day, but still maintain a longer-term perspective, we rely on Capital Market Dashboards (CMDs). These are designed to provide a view of multiple data streams, including lead indicators that potentially signal pending changes in real estate pricing 6 to 12 months beforehand. Private real estate markets are not buffeted by every shift in market sentiment, but they are also not immune to influences from the broader markets. Recent periods of rapid swings in stock market sentiment demonstrate the value of CMDs to give an objective view of capital market conditions across several dimensions.

Looking at the CMDs in major markets today (page 4) we see caution signs, but clear danger signals are rare. By contrast, the US and UK historical data (pages 6 and 7) showed multiple danger signs leading up to the GFC. In using these dashboards, interpretation of signals is critical to understanding their meaning. For example, the decline in US CMBS issuance does not indicate the financing environment is stressed, but is driven by debt funds increasing market share and crowding out CMBS refinancing activity. This points to the challenge of separating the signal from the noise inherent in all data. Reaching high-conviction conclusions can sometimes be straightforward, but it is usually very difficult when interpreting broader capital markets or the direction of the global economy.

February 5th marks the first day of the Year of the Earth Pig

Let’s hope this ancient Zodiac symbol, which dates to the Han Dynasty in 200 BCE, portends a positive year ahead in the real estate markets. In December and early January, the global capital markets woke up to all the risks and challenges that have been around for some time. Slower global economic growth going forward, rising interest rates, unwinding of QE (quantitative easing), and rising debt levels in several countries are all known risks. Unknown risks are also looming. The US and China launched a critical round of trade talks on January 30th. The two sides are far apart on a wide range of issues including Chinese requirements for technology transfer, US demands for IP (intellectual property) protections, and follow-through on reforms pledged by both countries, but not yet carried out. A meaningful breakthrough before March 1st, when the US has said it will raise tariffs to 25%, is unlikely. Yet incentives to make serious progress are strong on both sides as both China and the US work toward establishing new trade agreements.

A similar looming deadline faces the UK and the EU in the next chapter of the Brexit saga. Economists estimate that the global economy has more at stake in the US-China trade dispute; nevertheless, the outcome of the Brexit negotiations is of vital importance to both the UK and the European Union. A third risk is the stability of the US economy. A record-long government shutdown has just ended, but there is no guarantee that the government will remain open after February 15th. The result of all this uncertainty is falling consumer and investor confidence. As the headlines on these economic and geopolitical events evolve, we won’t be surprised to see volatility increase this year.

Meanwhile, as we noted in the 2019 ISA, global economic growth is cooling. Major central banks globally are now walking on a tightrope between loose and tight monetary policies. Key messages from major central banks suggest that rate hikes are now on the back burner, as concerns over economic slowdown or recession risks rise. The “R” word seems to be on everyone’s mind. Most economists are not projecting a recession in the next 12 months (they also didn’t in early 2008). If investors can Keep Calm and Carry On, one of the longest economic expansions can be extended. Eventually, the much-feared “R-factor” will show up in several major countries, but we believe this to be a much lower risk than during the Global Financial Crisis (GFC). Labor markets in major global economies are healthy. Bank, corporate and household balance sheets are generally healthier than the pre-GFC period, with notable exceptions such as China’s corporate debt, Italy’s financial sector, Australia’s household debt, pressures to align with Basel III directives in Europe, and US student debt.

If a recession comes, leased real estate will not be immune, but it will be a “low beta”, or less sensitive financial asset. Also, portfolio managers can prepare for a downturn. In 2019, investors will be making investment decisions in an environment of rising volatility and uncertainty. We recommend that investors set realistic return targets, shift their focus to narrowing the dispersion of return outcomes, and re-set their blend of offense and defense strategies. In real estate terms, that means focusing on location/asset strength and using stringent underwriting criteria. As volatility increases, quality assets and flexibility become more important. Holding period and floor plan flexibility, early loan extensions, or early lease renewals all represent the types of optionality needed to survive a downturn.

MIT Professor Paul Samuelson’s famous quip, “the stock market has predicted nine out of the last five recessions” can now be updated, since he first said this in 1982.

With a peak-to-trough 20% decline in the stock market as a possible “R” trigger, the tally is now 13 out of the last 7 (in the US). The weak predictive power of a stock market swoon for recession forecasting is similar in other countries as well. The Shanghai Composite Stock index fell 25% in 2018, while China’s growth slowed only marginally from 6.9% in 2017 to 6.5% in 2018.

The stock market is but one of many macro indicators that tend to affect confidence, whether we are conscious of it or not. A 46% “false positive” rate for these kinds of indicators is typical when it comes to separating capital market and political noise from the “real economy” signals in macroeconomics. Since real estate valuations are linked to both fundamentals and to the fickle capital markets, we must pay attention to static along with true signals that come through. Our “Year in Review Macro Deck” captures both. Aesop was a Greek slave who collected stories and proverbs in the fifth century BCE. One fable tells the tale of a mischievous shepherd who sends out false “wolf” alerts to his local village. When a real wolf shows up and the boy needs help, no one listens. The wolf gets his dinner and the boy is either shamed or eaten, depending on which version is told.

We sincerely hope that our repeated warnings of rising volatility in the capital markets are not just “crying wolf”. In the fourth quarter of 2018, the diversification power of real estate came to the rescue of many portfolios. Readers of the 2019 ISA know that we emphasized the importance of these “low beta” characteristics, even before we knew about the December stock market sell-off. Perhaps we have been like the northern-dwelling House of Stark, murmuring repeated warnings: “Winter is Coming”1. Nevertheless, our New Year message to all our Macro Deck and ISA readers is this: “After winter cometh the spring, so be of good cheer and hold fast to real estate”.

In the 26th edition of the Investment Strategy Annual, we address the five themes that will shape the real estate investment environment for at least the next three years and likely longer. Some assets and strategies amplify these trends and will deliver “high beta”, others are much more insulated from all the noise and should be considered “low beta”.

Mastering the simultaneous need for fast/intuitive and slow/careful thinking becomes an important skill to develop in the speeding-up world of real estate, in a slowing-down economy. We review techniques to help investors determine portfolio objectives. We present our outlook for the property types and countries that are the most attractive. We share our best investment ideas.

Our macro outlook for 2020 indicates that the global economy will be slowing, which means that rent growth, leasing and other drivers of real estate income could downshift to a lower gear. Yet, slow growth means that interest rates could also stay low and contribute to elevated asset valuations.