I hope everyone had a great Thanksgiving. Unfortunately, the market plunge hasn’t helped get many folks into the Holiday Spirit! What is driving the recent market correction? Is this a bump or a real problem? Is this all driven by the fed? Is real estate the next asset class to take a hit? What should you do and not do in this market? What two decisions do you need to make in this market; will you make the correct choice?
Why the big fall?
First why are the markets “suddenly” hitting the reset button. There are two primary drivers of the recent market decline. Interest rates and uncertainty in the market. Both are indicative of the recent market turmoil. This has recently led to huge swings in asset prices like stocks.
I wanted to cut to the chase and provide the answer to one major question above below details what is causing the market turmoil which is important to understand. In our fast-paced world with the holidays upon us I’m going to approach this backwards with a little advice first.
Impact on real estate:
The current selloff is a combination of market uncertainty and rising rates. Both of which have a profound impact on real estate. Rising rates reduces buying power on a purchase and raises the cost of capital. It also pushes up capitalization rates and decrease the price of commercial real estate. Along with actual “costs” associated with real estate, the bigger question is what impact this has on consumer and business confidence. Both businesses and individuals want certainty before making a large long-term purchase. With the gyrations in the stock market, I would expect consumer confidence to decrease and ultimately real estate will be “invited” to the party the stock market is experiencing.
What should you do?
There are two major decisions that are influenced by the recent turmoil; will you make the correct choice?
- Buy now vs wait:
- Residential: You hear the headlines that real estate in many markets is starting to soften so naturally you would assume that waiting is a better option. Why not wait and get a better deal in the future? Unfortunately, the advice is not that simple. The real answer depends on the price point you are looking at. If you are in a highly desired price point, for example in Denver under 500k where there is little supply, I wouldn’t hesitate to buy now. If you are in a market with ample supply and more on the way, for example a new subdivision with many unsold properties/lots you should wait as prices will likely come down as builders look to unload. If you are above that desired price point, for example if you were looking for a 750k house in Denver, I would advise waiting a little bit as the market turmoil flows through the economy there could be some opportunities.
- Commercial: On commercial real estate the answer is a bit more complicated. First, rising rates should flow through commercial real estate prices and ultimately raise capitalization rates which results in a decrease in property value. On the flip side with all the market turmoil, there likely will be a flight to quality assets, like commercial real estate, in order to escape from the market turmoil. I’m not sure which force will win out currently so if you can find a high-quality asset at an attractive capitalization rate, now is as good a time as ever!
- Lock or float?
- For Commercial and Residential property, I will give the same advice. Do not lock! Rates will be at or near their peak over the next 12 months. There will be some short-term upward movement in rates, but over the long terms rates will fall again as we enter the next economic cycle. As soon as the economy turns, just like in the last cycle, the federal reserve will lower rates in order to help “stabilize” the economy. Furthermore, long term rates will naturally drop as future growth cools. Over the long term you will have the ability to lock in a much lower rate.
What is behind the recent “market correction”?
The president is clearly putting the blame on the federal reserve that interest rates are rising too quickly. He has called out on multiple occasions that the federal reserve must be “crazy” to raise rates. It is important to note why the federal reserve is currently raising rates.
Why is the fed raising rates?
The federal reserve’s job is to help not only fight inflation but “smooth” out economic cycles. Currently inflation has been non-existent as wages have basically stagnated. The federal reserve is instead focusing on smoothing out the economic cycle. It appears that the federal reserve continues to raise rates to ensure that they have room to drop rates when the next economic cycle hits which most economist are saying is around 2020.
The president is forcing the fed’s hand
The federal reserve is viewed as an independent financial body that is outside the reach of politics. With the heavy criticism the federal reserve has received from the president, they are resolved to ensure their independence and not be swayed by politics. As a result, the federal reserve might be raising rates more than is needed to show the American people that it is an independent organization.
The federal reserve has been consistent in their messaging
Although the federal reserve has been consistent in their messaging that rates would continue to rise gradually, the market wasn’t buying into the federal reserves “plan”. The market was anticipating a slower pace than the federal reserve was conveying since inflation continues to be non existent. This mismatch led to a sudden jump in longer term treasuries which caught the market off guard and drove interest rates up substantially.
Fed should take a pause
Many economists believe (as I do) that the fed should be taking a “pause”. The Federal reserve is doing quite the opposite reinforcing their views of three more rate hikes before a “neutral” policy is achieved. Unfortunately, if the federal reserve doesn’t pause until late next year, they likely will be too late by already causing lasting economic damage.
Along with rates, there is considerable uncertainty in the market around trade, wage growth, inflation, etc… There is still considerable uncertainty in the market.
The market has become worried the trade war with China could drastically increase consumer prices due to the tariffs. These prices would be passed on to consumers. Either consumers absorb the increases which will spur inflation or consumers might not be able to absorb the price increase and demand falls. Both scenarios are not good for businesses and will drive profits down.
We’ve been hearing for the last 3 years that wage growth will pick up. Unemployment is near record lows and yet wage growth has been stagnant. The Federal reserve is predicting a pickup in wage growth which is helping drive their resolve for continued rate increases. What happens if wage inflation fails to materialize? Why hasn’t it materialized thus far? These are still open questions that will influence the market depending on the answers
The federal reserve is resolute on fighting “future inflation”. The market is beginning to question whether the future inflation will materialize or if the federal reserve is raising rates too quickly and will put the brakes on the economy before inflation occurs.
Is the sky falling?
Possibly! The answer depends on what assets you are holding. If you had all your eggs in Apple or homebuilders, taking a 20% or 30% hit feels like a bad fall! Although I don’t think the sky is falling for most people, it is a stark reminder that we are towards the tail of a cycle as volatility typically picks up at the end of an economic cycle. Although it is too early to say whether this recent stock market decline is a trend, it might not matter as the real wild card is consumer and business sentiment. Towards the top of the market, like we are in today, consumer and business sentiment can change on a dime. I suspect, with all the publicity on the recent stock market and debate on whether we are in a correction or not, sentiment will be affected. As soon as consumers or businesses “lose confidence” in the current economy, things get interesting quickly. It looks like we could be getting closer to this event. What do you think? When will consumer and business sentiment change?