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By Adam B. Landau
Permit Capital Advisors, LLC

The technique of jawboning has been used by officials from a range of pulpits for many years, often but not always with the desired result as an outcome. Defined as “to try to influence or pressure through strong persuasion, especially to urge to comply voluntarily”, it has been an arrow in the quiver of presidents ranging from Hoover (who used it to successfully convince employers to keep wages high as prices fell during the Great Depression) to LBJ (who discovered its limitations when he tried to talk down inflation and avoid higher interest rates while simultaneously spending for a war). George W. Bush criticized outgoing president Bill Clinton for not attempting to lower oil prices by jawboning OPEC to increase supply.

Within the halls of the Federal Reserve, Alan Greenspan was never shy to jawbone. He did so in 1994 after a small rate hike when he told Congress that further increases were inevitable, hoping that the mere threat would restrain inflation. He famously did so in December of 1996 when he flexed his credit tightening muscles and discussed the dangers of “irrational exuberance” in the market, and then again in early 1997 when he testified before Congress and spoke of “excessive optimism (that) sows the seeds of its own reversal in the form of imbalances that tend to grow over time”.

Most recently, Ben Bernanke, with a number of assists from his colleagues at the Fed seems to have perpetrated an inadvertent jawbone gone awry. In the months following the June FOMC meeting where tapering was formally introduced, Fed officials provided visibility that they were likely to cut back the pace of the $85 billion per month bond purchases which had blown up the central bank’s balance sheet while having a myriad of direct and indirect effects. Presumably their rationale for doing so was to ease the investing public into the idea of a diminishing presence from the market’s most prolific buyer, and to keep rate movements muted when the time to act came. What happened instead was that the ongoing discussion of Fed tapering at public appearances caused 10-year interest rates to rise from 1.6% in May to 3.0% in early September. Mortgage rates trended higher in similar fashion, which in turn led to refinancing applications heading in the opposite direction. This was likely one of the factors that kept the Fed from actually tapering, perhaps causing them to miss an opportunity to do so at the point where it was most anticipated and thus least likely to create a significant disruption in global financial markets. After printing closeto $1 trillion over a twelve-month period, the Fed decided that the economy under a higher rate regime couldn’t withstand even a nominal reduction in bond buying.

So, QE continues unabated and the dust is left to settle amidst its intended and unintended consequences. Among the latter is a wealth effect that has continued to widen the gap between the wealthy and the non-wealthy in this country, as the top one percent have captured 95% of the wealth gains since the recovery from the recession began. In addition, incomes for the middle class have largely remained fl at while the wealthy have seen increases. Fortunately, the business sector is healthy and employment gains continue to be made. Unfortunately, our leaders in Washington are doing their best to unravel whatever positive momentum is being created.

Funding a new budget for our federal government has predictably become a game of political football, with the onset of the Affordable Care Act (or Obamacare) and an included tax on medical devices being the primary points of contention. While one could get vertigo trying to follow the bills and continuing resolutions that were buffeted back and forth between chambers of Congress, and that led to what is as of today officially a shutdown of the US government, the reality is that this isn’t the paramount threat to investors. There were 17 such shutdowns between 1976 and 1996 and most often the pullback in the market was short and shallow. Ultimately, the economic impact will depend upon the length of the closure. Macroeconomic Advisers has estimated that a shutdown of all non-essential federal services for a two week period would reduce Q4 GDP growth by 0.3 percentage points on an annualized basis. The number would jump to 0.7 percentage points if the closure were to last an entire month. Ironically, we won’t know the magnitude of the impact as quickly as we might otherwise since the shuttered government statistical agencies would delay releasing key data.

That’s what happens if the government temporarily shuts down. What happens if it stops paying its bills? The real fight in D.C. will likely be over the latter issue – the debt ceiling, which the Treasury says it will hit on October 17th. At that point the debt limit will need to be either extended or suspended, and for better or for worse, both options will presumably be on the table. While it is tempting to worry about one manufactured crisis at a time, in this case the two issues are so related politically and chronologically that they need to be considered in tandem. It’s hard to fathom, given the consequences, that the threat of a default will fester. But we’ve seen the damage that even a near-miss can cause.

A technical default on Treasuries would be disastrous. Beyond the obvious implications defaulted securities can’t be used in repurchase agreements, which are the lifeline of the debt market. After the debt-limit saga of 2011 and the fi scal cliff showdown coming into this year, there appears to be a presumption that some kind of last minute deal will be brokered. Collectively, policymakers are being viewed as the “boy who cried wolf”. On the positive side, beyond the tumult that we are currently facing there is good news at hand, as the fiscal drag from tighter policy should begin to fade – from 2% on the annual growth rate in the fi rst half of this year to 1% in the second half, to as low as 0.5% in 2014.

While there is little room for error in Washington, many of the other chief worries that the market faced heading into the third quarter have subsided, leaving sentiment markedly improved. The Russia plan helped to at least temporarily defuse the situation in Syria, Larry Summers withdrew his name from consideration as Fed Chairman, Iran responded favorably to a letter sent to President Hassan Rouhani from President Obama, and of course, tapering was eschewed for the moment. This systematic destruction of the market’s “wall of worry” would seem to be a good thing, and volatility has dropped materially in the past month as have expectations of future volatility. Another measure of the market’s bullish inclination is the falling CBOE Equity Put/ Call ratio. These are positive indicators, but they tell a story that has already been written. That is, the 20% gain in the S&P 500 year to date. They similarly leave less room for market moving surprises to the upside.

When thinking about the opportunities for investment going forward, the discussion of variables that are likely to have a meaningful impact has to include an analysis of what happens to stocks and bonds if the rate environment in the future is volatile to the upside. It is not a question that is likely to be a hypothetical one. Everything from demographics, to foreign investor appetite, to the idea of a zero-bound on interest rates suggest that we are facing a scenario of not if, but when, interest rates are going to move meaningfully higher. The demographic issue we are facing as a country and the impact it will have on our budget defi cit has been well documented, and largely comes down to reform of entitlement programs. To put some numbers around the generational landscape, today each American who is 65 or older is supported by a workforce of 4.4 people between the ages of 18 and 64. This “dependency ratio” will fall to 2.7 by the year 2038. The non-partisan Congressional Budget Offi ce issued a report several weeks back that had its most optimistic forecast for debt to GDPat 100% by that year, from an already high 73% today. The base case forecast projects federal debt to grow to 190% of the nation’s economic impact by 2038 – worse than Greece, with its 27% unemployment and occasional riots in the streets. Foreign appetite for US Treasuries is already shriveling, and purchases over the last 12 months have declined to $104 billion from $503 billion a year earlier.

In a world in which risk appetite is returning and yield investors need to be wary of the likelihood of market losses in traditional fixed income options, the role of real estate in a portfolio takes on paramount importance. We appear to be in the nascent stages of a recovery that has shown us an increase in confidence amongst area businesses coinciding with a pickup in leasing activity and falling vacancy rates. If unemployment continues to trend lower and states and municipalities continue to create programs designed to incentivize investment in the sector, we can also expect to see pricing power return to the market. Given the mix of risks in the public market, investor desire for cash flow, and a turn on the horizon in commercial real estate, now would appear to be the time to initiate or increase portfolio exposure.

About WCRE

WCRE is a full-service commercial real estate brokerage and advisory firm specializing in office, retail, medical, industrial and investment properties in Southern New Jersey and the Philadelphia region. We provide a complete range of real estate services to commercial property owners, companies, banks, loan servicers and investors seeking the highest quality of service, proven expertise, and a total commitment to client-focused relationships. Through our intensive focus on our clients’ business goals, our commitment to the community, and our highly personal approach to client service, WCRE is creating a new culture and a higher standard. We go well beyond helping with property transactions and serve as a strategic partner invested in your long term growth and success. 

Learn more about WCRE online at www.wolfcre.com, on Twitter @WCRE1, and on Facebook at Wolf Commercial Real Estate, LLC. Visit our blog pages at www.southjerseyofficespace.com , www.southjerseyindustrialspace.com and www.southjerseyretailspace.com.