If the current business cycle continues through July 2019, it will be the longest in modern U.S. history. This naturally begs the question: How much longer can this cycle continue?
Bull markets do not die of old age. Rather, they die from excesses that lead to economic shocks, which, if large enough, can lead to a recession.
Despite the U.S. unemployment rate standing at 3.7%, the lowest level in nearly 50 years, the current expansion does not have the makings of a boom and bust cycle. Real GDP has only grown 18% since the prior market peak, compared to the 40% in the 1990s and 50% in the 1960s. Put another way, this cycle’s average annual real GDP growth rate is only 2.3%, almost half the 4.2% annual average witnessed during the prior ten cycles.
Cumulative U.S. Real GDP Growth By Expansion Cycle
Clarion Partners believes that this slow and steady pace of expansion may in fact prolong the current business cycle. For one, there are no huge imbalances or signs of overheating in the economy. Secondly, tax reform (Tax Cuts and Jobs Act of 2017) and increased government spending (Bipartisan Budget Act) have significantly strengthened corporate and household spending power. We believe that 2019 U.S. real GDP growth will be in the 2.0-2.5% range, a decent pace but a moderation from 2018. For commercial real estate (CRE) investors, we prefer this slow and steady pace of growth: demand for commercial space is strong, but not so robust as to spur excess lending and speculative new development.
Potential risks to our outlook include protectionism, the record level of corporate debt, rising interest rates, the gradual end of monetary stimulus, and global political uncertainties. In particular, a full-blown, prolonged trade war with China would significantly dampen financial market sentiment and lead to slower economic growth in the U.S. and globally. Conversely, a swift resolution and a new trade agreement between the world’s two largest economies would boost investor optimism and propel the financial markets even higher.
The Federal Reserve’s current dot plot points to three federal funds rate increases in 2019. In our opinion, this interest rate path projection is far from certain due to the recent global slowdown both in developed countries such as Japan and Germany and in emerging countries, especially China. Furthermore, there are soft patches domestically, including auto manufacturing and the for-sale housing market. The Fed might take a pause by mid-2019 after reassessing the U.S. economy’s moderating growth trajectory.
Going into 2019, the U.S. commercial real estate sector remains attractive to global investors seeking income and low volatility late in this cycle. Healthy supply/demand fundamentals are likely to continue to benefit from a relatively solid U.S. macroeconomic backdrop, mainly in five ways:
1. Steady GDP and job growth: approximately 2.4 million new jobs were added to the economy over the past year amid accelerating wage growth. Property owners should have a greater ability to increase rents
2. Strong demographics – over 1.4 million new households were formed over the past 12 months, generating substantial new demand for housing and commercial space
3. Higher replacement costs – rising construction materials and labor prices have significantly escalated replacement costs, providing room for additional asset appreciation
4. Elevated cross-border capital inflows – high foreign inbound investments have improved capital availability and overall liquidity, thereby creating greater competition for high-quality properties
5. A rising interest rate environment – the potential rise in interest rates is generally viewed as a negative for cash and fixed-income bonds, which may prompt investors to rotate more capital into inflation-hedging asset classes including CRE
Clarion Partners expects sustained investor interest in warehouses/e-commerce supply chains, rental housing, creative offices, strategically located retail assets, and health care properties within top employment and retirement hubs. Investment themes in which we see potential include socioeconomic diversity, urbanization, demographic demands, and high-growth industry clusters (e.g. high-tech, new media, and life sciences). Institutional managers generally favor institutional-quality properties and build-to-core strategies. Based on our 2019-2021 outlook, Clarion's near-term strategy favors industrial, urban multifamily, and central business district (CBD) office, with a focus on selective value-add opportunities, especially in top secondary markets and premier suburban submarkets outside the major markets.
The global quest for steady and high-yielding financial instruments has driven a long-term shift from conventional investment types to alternative asset classes, of which CRE is the largest category. U.S. institutional-quality real estate cap rates remain attractive on a relative basis to both domestic and international real estate investors. Overall, global investors have been satisfied with CRE performance amid favorable property-level fundamentals and historically low levels of new supply (except for a few markets/submarkets). Both institutional and retail investors have continued to allocate more capital into CRE, with target allocations across portfolios rising steadily. The newly released 2018 Institutional Real Estate Allocations Monitor Survey indicates that the average target portfolio allocation to real estate among global institutional investors continues to rise, up from 10.4% in 2018 to 10.6% in 2019.
Overall, Clarion Partners holds a cautiously optimistic U.S. commercial real estate market outlook for 2019. Pro-growth policies are likely to extend the current business cycle, which is on track to become the longest on record. U.S. property fundamentals are expected to remain healthy as well. CRE same-store net operating income (SS NOI) growth remains strong at 3% year-over-year, well above the long-term average. Attractive total returns will be driven, in our opinion, by stable cap rates, solid NOI growth, and accretive financing. As occupancy rates approach 90-95% in most U.S. markets, we believe there are plenty of opportunities to create value through disciplined, active investment strategies.
2019 Investment Outlooks
The Limits of U.S. Growth
An Extended Business Cycle
Liquidity is the Question
A Plethora of Risks
Current Volatility, Long-Term Opportunity
Choppy Markets Ahead
Time to Get Defensive?
Royce & Associates
A Shift Toward Cyclicals
Focus on Growth
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The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Federal Reserve’s dot plot shows the projections of the 12 members of the Federal Open Market Committee (FOMC) on where they think the Fed funds rate should be at the end of the various calendar years shown, as well as in the long run—the peak for the fed funds rate after the Fed has finished tightening or “normalizing” policy from its current levels. The dot plot is published after each Fed meeting.
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time. Real GDP is a nation's total output of goods and services in constant dollar, or inflation-adjusted terms.
Net operating income (NOI) is a calculation used to analyze real estate investments that generate income. NOI equals all revenue from the property minus all reasonably necessary operating expenses.
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