Coming into December provides a good opportunity to review November/YTD 2023 performance. The chart below summarises both across a selection of assets measured from the perspective of a US$ investor:
There’s no denying it, we have witnessed some strong rallies across virtually all asset classes driven by a combination of (1) slowing inflation (headline and core), (2) a pausing sentiment around global rates and (3) a decline in geopolitical risk premia (Israeli-Hamas ceasefire/hostage exchange). Amongst the few that have declined (the energy complex: CRB, Brent & WTI) these are indirectly a good sign in so far as it implies further downward pressure on headline inflation ahead considering the lagged effect of pricing. How long for is debateable as this is entirely a function of global demand which itself is correlated to the global economy picking up. Some key highlights:
By FX, the Yen appreciated some +2% over the month, the GB£ +4% as the risk-on theme continued. By contrast, the EUR -1% given the perceived woes in Europe, especially Germany and warnings about reviewing credit ratings for France. The US$ Trade-Weighted index is down some -3.4% on the month.
It was the best month for the Bloomberg US Bond Ag Index which gained +4.35% since May 1985. This index includes all Investment Grade fixed debt as well as Treasuries and spread products.
It was the best month for Global 60% (Bonds) to 40% (Equities) portfolios posting +9.6% for the month, the most since Dec. 1991. It was as sweet as it comes – equities and bonds rising – a rare treat seeing as they are usually inversely correlated.
Gold seems to be gaining traction. It is now up some +12.50% YTD (+3% in November).
In last week’s commentary, I mentioned “these markets have legs for now” given the prevailing optimism building around global rates remaining paused and the possibility of rate cuts starting middle of next year. In my weekly of 16th June, I referred to the debt mountain and when it might crack in terms of debt rollover. Whether we face a recession or glide through depends entirely on two things:
The state of the employment market: The labour market remains tight AND wages continue to rise ahead of inflation giving rise to REAL gains. It would take something catastrophic (e.g. a major geopolitical event) or a sudden and rapid advancement in AI to displace workers. The former is unpredictable while the latter is not easily quantifiable.
Where rates are: The corporate and consumer debt calendar is interesting. Below is a recent chart looking at re-financing profiles of US$ Speculative Grade debt (i.e. Leveraged Loans + less than BB-rated High Yield debt). For instance, as of Nov. 2023 (chart on left), 1.4% of these loans were due to mature in the next 1y, 9.2% in the next 2y and 22.3 in the next 3y. The chart on the right shows these re-financings in $bns. Next year (2024) is not really the issue. The real issue starts in April 2025. If, by then, rates have not come down in time for the first big block of re-financing, then we have a problem. Between now and then is a long time to go – and there’s an election next year as indeed there are elections across many parts of the globe.
The above is a high-level picture. What of sectors? The sector that is arguably under most stress is Real Estate, specifically Commercial Real Estate (CRE), which has had to deal with (1) the aftermath of covid, (2) a change in working habits, (3) a change in office design space and facilities, (4) diminished credit being made available from banks and (5) higher rates. Sticking with the US, borrowers there in the CRE sector face challenges for re-financing. The recently originated loans have come with very strong underwriting standards and are an attractive entry point for new investors. It’s a different story however for existing lenders who will most likely have to settle for conversion to equity. This is not an unfamiliar story for CRE and makes it the big elephant in the room. This is the one central banks will be watching most closely as they gauge what comes next. Consider the charts below courtesy of a GS study:
For the most part, CRE has managed to weather the challenges faced in re-financing existing debt thus far. However, going forward, some $1.2tn of debt is due to mature in the coming two years – that’s about one-quarter of all outstanding commercial mortgages, the highest since 2008 (right hand chart). As the chart on the left shows, Banks are the largest lenders of this maturing debt (40%). What happens next will be down to how lenders and borrowers cooperate. Different options include:
Maturity extensions: this is a common practice and is always in the interests of parties involved (“Extend and Pretend”).
Paydown principal: this is fine if you have a strong balance sheet.
Accept a mortgage default: …..and hope it doesn’t trigger off a wave of defaults!
Central bank action: we have seen this before. In fact, you only have to look back to March this year (SVB, FRB, etc.) to see how the authorities (FED, FDIC, Treasury) stepped in to alleviate stress and make liquidity available. And this was done without lowering rates. Even rules around valuations were changed to effectively do away with mark-to-market valuations and going back to cost till maturity! Essentially, it’s all about buying time – a Lender’s best friend!
Most of the stress in CRE is in the Office sector where the share of troubled loans, being worked in special servicing, has increased some +5% y/y vs the non-office sector where it is +0.5% y/y. 80% of maturing loans in the office sector have failed to fully pay off the principal over the past four months resulting in restructurings rather than foreclosures. There is also some comfort when looking at CRE debt across other regions – see chart below:
Across Europe and Asia-Pacific, the picture is far less severe. This is evident by the vastly smaller amounts of debt. The significance is that the US is more an idiosyncratic event that would only become systemic IF the above options are disregarded. Office space has been hit from all angles (especially hybrid working) as alluded to earlier. The result has been a “flight to prime” with the share of “A” grade take-up increasing from 75% (2009 to 2019) to 84% (2022 to 2023) in London (West End and City), New York and Singapore. A study by Savills revealed “most organisations continue to need an office – they just want a good one” and “good” means access to amenities (bike racks, showers, medical facilities, gyms, etc.), decent locations, ambiance and so on. All this impacts rents and, ultimately, returns.
None of the above is in any way to downplay the stress and severity of what CRE is going through… but neither do the sums involved justify an outright bear case both for the sector and the economy as a whole. Meanwhile, if the world economy continues to gain steam (a view I certainly share – and which we are increasingly starting to see), then so too will CRE - despite the cultural changes in working habits from covid.