June 2012 Market and Economic Conditions
By Adam B. Landau Permit Capital Advisors, LLC
If you are a U.S. investor and you feel like the fate of your investment fortunes are not going to be sealed solely on the shores of your home country you are not alone, and you are correct. Economic and market conditions worldwide have been increasingly subject to the shifting fortunes of the Eurozone and its official currency. From the outset the euro was as much a political as an economic construct. If it were purely based on homogenous economics, the core would be comprised of France, Italy, Spain, and the Netherlands. Since the inception of the euro these countries have followed a similar path as measured by metrics including unit labor costs, explosion of debt levels, and housing prices. Germany is the outperforming outlier and Greece is the underperforming outlier.
While German political wrangling over their role as de facto lender of last resort has led to speculation that it would be in their best interest to unhinge the monetary union, the results of such efforts would be disastrous. Germany has been the big winner from the euro project, as the Deutschmark was diluted with much weaker currencies from the periphery. In the seven years prior to the euro’s launch net exports made zero contribution to Germany’s economic growth. In the seven years after the euro net exports accounted for all of Germany’s 7% growth. Such motivation is responsible for the ongoing, yet patchwork, steps that are being taken. The latest came recently with the announcement that euro zone finance ministers agreed to lend Spain up to €100 billion to help their battered banks. At best the move should provide temporary stability to Spanish 10-year yields, although trading activity on the first day after the bailout saw the biggest one-day increase in yields since December. Spain was encouraged to take the aid ahead of the June 17 elections in Greece, as a “bank jog” from Greece and Spain could turn into a stampede if the anti-austerity, leftist party, Syriza is able to put together a winning coalition.
There are potentially more significant steps that policymakers could take, such as permitting the European Stability Mechanism Fund to lend directly to banks to break the negative feedback loop between weak banks and distressed sovereign bonds. If Spain is unable to rollover debt coming due later in the year, and the government needs to refinance €82.5 billion, with a big hump at the end of October, and regions in the country have a further €15.7 billion maturing in the second half of 2012, we may see such drastic options employed. Between the U.S. elections and the Spanish debt climax, we expect October/ November to be particularly volatile. If Spain falls Italy is next, and Italy is the killer domino. With €2 trillion in debt, more as a share of its economy than any developed nation other than Greece and Japan, and economic growth lagging Spain’s, Italy represents a huge global threat. The current firewall authorities have created is arguably sufficient to cover Spain. It is unequivocally insufficient to support Italy.
As the crisis continues to traverse the continent, we must not lose sight of the investment opportunities that are created. A disciplined investment approach looks to exploit pervasive skepticism. The most obvious opportunity stems from artificially low borrowing rates that central banks have maintained as a result of the turmoil, and commercial real estate is a sector where that is readily exploitable. The 10-year Treasury yield sits today at 1.61%, less than a third of its twenty year average yield of 4.88%. If interest rates returned to that level the value of the Note would decrease by 30% – not a great risk/reward tradeoff for an investment returning under two percent. The opportunity emanating from these historically low rates is twofold: it makes commercial real estate as an income-generator extremely appealing on a relative basis, and the cap rate spread over Treasuries fundamentally supportive.
About Adam Landau
Adam Landau is Chief Executive Officer and Chief Investment Officer of Permit Capital Advisors, LLC.
He has 15 years of experience evaluating investment managers, developing asset allocation strategies, and coordinating the process by which the two disciplines are merged.
Visit http://www.permitcapital.com to see how Adam and Permit Capital Advisors, LLC can grow your wealth. Historically, investors have expected a return premium of approximately 250 basis points on real estate investments over the Treasury rate. Today, in the retail space that figure is closer to 500 basis points, and in the office sector it sits at roughly 700 basis points. Combine the support from a low-rate environment with a favorable supply and demand dynamic and you get a commercial real estate market rife with attractive prospects.