Are We Having a Soft Landing on a Minefield?
DESCRIPTION
Chris is back on the podcast this week, joining me to discuss recent market shifts. Our overall assessment is that the year started with uncertainties but seems to be stabilizing, with tech companies performing well and equity markets thriving. However, despite positive signs, there's concern over a potential commercial real estate crisis, as refinancing becomes challenging. The Fed is cautious about rate cuts, waiting for labor market weakening and lower inflation. While the economy seems close to a soft landing, the looming commercial real estate issue remains unresolved. Chris shares insights into the commercial real estate market, indicating a significant drop in rental rates. The episode concludes with plans for future discussions on wealth management.
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TRANSCRIPT (this is an automated transcript):
MPD: Welcome, everybody. I'm Mark Peter Davis, Managing Partner of Interplay. I'm on a mission to help entrepreneurs advance society. And this podcast is definitively part of that effort. Today, we've got Chris Zhang back on to talk through the market shifts and changes that have happened basically in the first part of this year so far.
It's a story of a continued swing of what we were seeing at the end of Q4. But very fascinating in that we may be close to finally sticking a soft landing, but despite all that, there's still this commercial real estate bomb sitting out there somewhere, and we don't know how that's going to shake things out.
So here's Chris with his take.
All right. Welcome, Chris.
Chris: Good to have you back. Good to be back, Mark.
MPD: So our last stop. A view on the pod was December 23, so things have changed for a few months beyond a fair bit to catch up on. Do you want to bring us
Chris: up to speed? Yeah, Mark, it's I, a lot has happened, but at the same time it's the best way I can frame this is Mark has been pretty one way street and really the reactions all happened pretty much around our last call and it's been a sort of same trend following trade pattern ever since in, in really global markets.
And I'll dissect all of that and I won't dive into it a bit more. But basically the last time we chat, the Fed just had a meeting. And the whole market was waiting on whether they're going to cut in January market was clearly jittery and uncertain go leading into it. And which is why it ultimately became a bit of a shock.
Maybe a few weeks before the January meeting that it was clear that the Fed is signaling that it wasn't going to cut. There was a bit of a letdown and disappointment. It was very short lived. In the, at least in the equity market in the interest rate, really outside of any outside of equity market, fixed income market what seems to me, the participants, they're a bit more rational.
The rate cut expectations has been dialed down significantly. If you remember last time we chat market, we're really expecting about 6 cuts this year. Now the expectations came down to three, which I think is just, that's way more reasonable. And if you just plot out how many meetings are left in the year and which ones are generally considered active meetings, three seems very reasonable.
But equity market didn't really care because sure the macro wasn't macro side, wasn't as supportive as people were hoped for. But at the same time, key for earnings start to come out and all the big tech companies beat expectations. Not just on revenue, a lot of my earnings and our forecasting weaker rebound this year, but still very healthy outlook going forward.
So that really boosts the market. And on top of that, we all know as participants in these markets. There's just so much money on the sidelines, so much money and people are waiting for a signal from the Fed for real turn. To start deploying this cash into riskier assets. And it's almost felt to me that people just don't want to wait anymore and they need to deploy something.
And and instead of maybe locking it up for a longer term, this is, I just deploy into maybe some fixed income assets and equity markets for liquidity reasons. And that really supported the market. So overall, it's been a very positive, let's say, year to date. And with the FOMC guiding very cautiously around a potential cut in March or May, assuming two things happen and these two things, I'm just going to quote Truman Powell directly.
One is a weakening in the labor market. And two is a very, and he used two verys. Persuasive lower inflation if those two happen, we're going to see a more dramatic move from the Fed. And the headline on that is we haven't seen it yet. The most recent labor market and inflation data that came out are opposite of what the Fed really wanted.
Labor market is still very strong. We're a historically low unemployment rate. Earnings are hourly earnings are increasing on pace with inflation. So your spending power is not dropping. So that's why people are still spending despite piling on more debt with the expectation that race will come down.
So the debt servicing costs will be lower and the inflation is still sticky. And I want to be very cautious around that, that we're sticky. It is coming down. Okay. It is, we're now in the solidly in the three handle for core inflation, but the fast targets too. And we're still away from that.
And of course, the gear that not to prefer according to come down 1. 5 percent into where the market expectation is, that will take a bit more maybe, slowing down in certainly slowing down the labor market and people spending less. And just hitting pause for a bit to just readjust their leverage, household leverage and company leverage.
So yeah, the Fed is not getting the signals they want to cut aggressively.
MPD: This seems to me macro taking a step back, but we've actually they're pretty close to have sticking the soft landing. There's some, there's a little more work to do, but the plane's tires are down and they're like a foot off the runway, right?
Isn't that kind of what's going on? Like we went through this multi year fate process and it's such a slow journey that it's hard for people to take in the totality of what's actually happened. But that's what the story is, right? That's the headline for this couple years.
Chris: I agree. I think the Fed has done a tremendous job in making this so called soft landing happen.
And people out there in the market really don't want to call this any sort of landing because it, the fact of the matter is, if you look at where equity is, we're back to all time highs. And yeah, and
MPD: also there's politics in this, right? Yeah. If you say something good happened, you might be giving someone credit and depending on which side of the line you're on, but taking all the politics out for a second from an economic standpoint, this kind of worked out right now.
It feels like there's still a sleeping giant. You're talking about the tech companies outperforming but the thing that everyone was waiting for the crash to get, the next implosion was going to be commercial real estate. And that hasn't been as much in the headlines in this last little spell, probably out, outshined by the stock market and everything else, but that's still there, right?
Isn't it? Isn't it like still a coming bomb or is it being diffused?
Chris: Yes, it is. I am very confident. And that is that particular market is that is not being diffused because you're you really are facing multiple problems at once. You're not only are facing a demand problem, which is what a lot of people are talking about the major, the more major problem is actually on the financing side on the liability side of these assets.
Basically, basically. Banks and private equity funds that own these assets are having a very tough time refinancing these assets out of basically bankruptcy and the math is very simple. It used to pay, you spend 10 percent locking in these short term loans that are floating and now you're trying to refinance your original refinance expectations that's going to come back down to 5 percent as rent stabilizes and rent is not stabilizing.
And on top of that, you're paying still 10 percent for the next 10 years. So the equity gets wiped out, liability gets impaired. So these things, and especially what happens, that's holding.
MPD: Once the deal crashes,
Chris: what do they do? Who the ultimate holder of these assets are. And unfortunately I have to say a lot of these, the holders are regional banks, right?
We saw the regional banking crisis last year. That's the reason why I really personally think a lot of people are saying the same thing that the regional banking crisis is not over yet. Because last year it became a crisis. Because of treasuries, because these are, treasuries that are, they're holding too much.
They're planning to hold maturity, but there's some, there's a bank runs that to sell it. And now is we're moving down in the balance sheet. We're moving into even more illiquid assets, and these assets are not being marked market yet. If they are being marked market. A lot of banks balance, you'll be upside down.
It's
MPD: a consolidation trigger,
Chris: right? Yep. And you will need some type of rescuer. Again, this time for reals in a much bigger chunks because commercial real estate, this is a multi trillion dollar sector in the economy. And it's not a blip, right? It's not something that, you know, that we'll recover next year.
It's more of a change of lifestyle situation where it could stay this way for the next 10 years. So it's very,
MPD: what do you do, what do you do if you're Powell or the government to create a soft landing in commercial real estate when you know that occupancy rates are just permanently way down with all likelihood, you got to do a whole
Chris: reset.
How do you do that? There's not much they can do on the demand side, put it that way, but what they can do is for sure on the refinancing side. So if I'm sure this enters into equation, I don't know how the weight of this, how much this matters in their overall decision, but when they think about cutting rates and the pace of cutting rates.
This directly feeding to your mortgage rates. I don't know if you saw the headline, but about a week ago, our current 30 year, 30 year mortgage rates average mortgage rates for the nation went back up above 7%. Okay. At the peak, we're almost at 9 percent and it came back all the way down because of. Expectations on rate cuts and to five handle and six handle.
And now it's back to 7%. Okay. So that, that directly impacts the refinancing options that these real estate have. So for them to feel for this entire sector to feel somewhat of a relief, they need these refinancing options to come down to mid single digits, not high single digits and missing digits.
And that a lot of it is to trigger, there's a sort of a inflection point where it will make a lot of these projects a bit more profitable again, so that it can at least become self sustainable despite the drop in occupancy rate. And, or at least give them the option, give these sort of real estate holders the option to convert, right?
Some of the commercial real estate that probably will never be needed again into residential real estate. But all of that takes time. You need financing for that to happen. So there's only so much the Fed can do in terms of helping them before it goes into default. And once these properties do go into default, then yeah, you're looking at a much bigger rescue package, potentially not coming from the Fed, but also from the Treasury, some type of collaboration, and the private sector in terms of private equity.
MPD: Do you think the US government rescues again? Or is this There's just a point where it's coming, every time we do one of these rescues, right? We build up the national deficit, debt levels go crazy. I, my understanding is the medium term byproduct is increasing disparity and wealth, right?
The richer get richer. Everyone, no one else really benefits just the way it all shakes out, or do they let something fail? We never, it's not that we never do, but we never let the big guys fail. Is that on the table or are we just about to see like the fourth cycle of the same repetitive history?
Chris: This is you have to, this is where you have to talk about politics because it's all about that. It just happens to be a lot of the holders, the ultimate, I'm not talking about the media holder of these rules, because they could be private equity funds. The ultimate holder of these funds are of this sort of potential collapsing real estates.
It's actually a U. S. pension fund, and if you're going to let U. S. The question really is, will the Fed, will the Treasury actually let pensions fail? And I, personally, my
MPD: personal view is that they're not going to fail, they'll just have a
Chris: bad return, right? No these are, we're talking about a potential Oh, you're saying they're going
MPD: to miss payments.
Yeah, so that, that means you've got a lot of folks who spent their whole life working, and they get it, and the government's going to, the pension's going to miss
Chris: payroll. Correct. Or significant, or they have to do something, right? They can, they will probably delay that. One way to do it is they delay the reimbursement age, right?
So is there paying you a 65 paying a 70? Or they pay you 70 pay you, they're not going to cut the, they're not going to cut your paycheck stop the paycheck, but they can, yeah, it's harsh, really hard. Will the taxpayers ever let that happen? I don't think so. So it is definitely snowballing a little bit here and it's making people nervous.
That this is a time bomb and really no one knows that,
MPD: right. We're close to sticking a soft landing, but there's some dynamite in the airfield somewhere. Yeah. That's what's going on. Yep.
Chris: And just give you another data point on this because I'm currently, I'm, I don't know this, but we're potentially looking at an office in, mid half, midtown Manhattan and, for maybe a couple of course down the road, but we're learning the market as we speak.
And It's currently in midtown Manhattan, class 1 buildings, class a buildings. These are top of the line. So office buildings are quilting at something around 75 80 dollars per square foot. A couple of years ago, that was at 100. And 120, right? Depending on the building, but we're talking about 20, 30 percent drop in the best market in the most supported.
Most thought after market in the U S and commercial real estate. Okay. And I can't even imagine what's San Francisco, and these markets are like so it is coming down and it's something else fast and that hit a lot of people and the returns.
MPD: All right, Chris, thank you.
Chris: Great update. Of course. Always a pleasure, Mark.
MPD: Quick reminder for everybody, Chris is an SEC registered RAA, so nothing he's said should be misconstrued as investment advice.
As always, awesome to have Chris on, get the quick update on what's been going on in major market dynamics. And I think we're looking at different ways to dive into some of his private wealth expertise as well. Might be a little bit of a topic shift and variants coming up, which I think should be pretty interesting.
Stay tuned.
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