ARCAN CAPITAL MARKET UPDATE

Macroeconomic Outlook

Overall, 2019 was a good – but not great – year for worldwide economic performance. While the U.S. continued to grow, headwinds in Europe and Asia led to near-recession in the former and significantly slower growth in the latter. Europe, and particularly Germany, flirted with recession throughout the year, as the Eurozone grew only 0.2%.[i] Manufacturing on the continent has been in a recession for nearly all of 2019 as the European consumer continues to keep the Eurozone economy afloat. We believe that there is a strong possibility that the Eurozone will fall into recession in 2020.

In China, growth has been more subdued than forecast at 6.1%[ii] with weakening manufacturing, auto sales and U.S. tariffs holding back the economy.[iii] We suspect that these trends are likely to continue as China’s growth continues to slow more[iv] than expected due to both endogenous factors as well as exogenous, particularly the new Wuhan coronavirus. Indeed, the longer China contends with the fallout from this novel virus, the more it will impact the global economy, including the U.S. A weakening economy in China will have a direct impact in direct investment in the U.S. as well as potentially upending existing manufacturing supply chains of U.S firms.

In contrast to the rest of the world, the U.S. economy continues to defy expectations and has continued its resilient, consumer-driven expansion. Nearly 130 months have passed since the 2009 recession and as of January 2020, the U.S. unemployment rate is near an all-time low with nearly 1,000,000 more job openings than job seekers.[v] The good news is that the consumer has proven to be a quite resilient and wages are finally starting to pick up for the average worker. Indeed, the consumer is going strong and driving nearly all growth in the U.S. There are serious concerns going forward, however, as many consumers are relying on debt to fund their consumption. As of the end of 2019, consumer credit card debt was at its highest number ever – $930 billion – and delinquency rates are rising to levels not seen since just after the 2008 financial crisis.[vi] Additionally, the job opening to job seeker mismatch could potentially have a detrimental effect on business expansion as firms have a harder time finding workers.

Headwinds on the Horizon

Trade is an issue

One sign of potential worry for 2020 is that worldwide trade volume has declined significantly as China and the Eurozone slow and the U.S. continues to impose tariffs on goods from a number of other countries. This has the effect of further dampening economic growth in the U.S. as well as increasing costs to both American businesses and consumers.[i] 

Business investment is a major economic drag

Declining trade is certainly an economic headwind, but it is compounded when business investment declines as well. Moreover, it is likely that the decline in business spending in 2019 is directly linked to decreased international trade flows.[i]

If we look at capital spending from another perspective: the IHS Market index reveals that the U.S. purchasing managers outlook is actually improving slightly, especially relative to other major economies:

Digging deeper, however, it becomes clear that there is a significant divergence between the  manufacturing and nonmanufacturing outlook. This is particularly concerning, as manufacturing tends to produce durable goods designed to increase long-term productivity of businesses. Our concern is that a decline in manufacturing could affect medium-term productivity and ultimately the growth of U.S. firms. This would likely put downward pressure on wages.  

Indeed, we can see this decrease in manufacturing activity and slowing of global trade has likely already had a tangible effect on the profits of U.S.-based firms.

Concerns in the credit markets

We are also begin to have concerns in the debt financing markets, as we watched the repo market seize twice in 2019. While the repo market has a negligible effect on commercial real estate, it was one of the first markets to experience major issues leading into the financial crisis.[i] As such, we regard it as an important bellweather as to the health of the U.S. financial system. Indeed, prolonged distress in the repo market often drives up U.S. government borrowing costs, which will very much affect other rates as well, particularly the 10-year treasury yield that is so closely tied to most commercial real estate debt. While the Federal Reserve is focused on preserving liquidity in this market, we will be watching it closely.   

Multifamily Market

Within the Southeastern mulitfamily property market, Arcan remains concerned about rent growth and value appreciation in the short-term. As the U.S. economy cools, we expect to see this cycle’s torrid rent growth flatten considerably. This would have real effects on revenue and net income and is likely to substantially affect property values. For long-term owners, this may reduce their IRR and real income slightly, but most should weather a downturn relatively unscathed. For those investors who have bet heavily on continued rent growth and ever-increasing asset values, we think that many will begin to see some distress in 2020 as their modeled increases fail to materialize and cap rates either stagnate or rise slightly as the balance between buyers and sellers shifts.

As many observers have noted, rent growth in the region has dramatically surpassed wage growth. According to CoStar, Atlanta rents have grown nearly 35% since the 2008 financial crisis.[ii]  Wages, however, have not grown commensurately. As shown in the chart below from the Federal Reserve Bank of Atlanta, wage growth has gotten stronger in recent years but it still lags its pre-financial crisis pace. Given the wide delta between rent and wage growth, we are deeply suspicious that rent growth can continue at the pace that we have seen since 2010.

Conclusion

Headed into 2020, we are increasingly concerned that global economic headwinds, particularly those in trade, manufacturing and business investment will have a deleterious effect on the U.S. economy. While many forecasters believe that the U.S. will grow at a relatively subdued pace, 1.8%[i], we believe that the economic situation could start to decline as early as Q3 of this year. This should further impact wage growth and the ability of multifamily tenants to pay increasing rents. As rent grow abates and the economy cools, we strongly believe that we will see the beginning of distress in 2020. For short-term investors, especially those in the value-add space, this will likely present a major problem as they will not hit their target IRR’s and their equity will be displeased, forcing many operators to sell. At Arcan, we believe this will present an excellent opportunity to acquire good assets as better prices than today. We are patient, long-term investors and believe that a correction could do the multifamily market some good.

[1] Dr. Boersch, Alexander. “Eurozone Economic Outlook.” Deloitte Insights, November 18, 2019. https://www2.deloitte.com/us/en/insights/economy/emea/eurozone-economic-outlook.html [1] Elegant, Naomi Xu. “The U.S. Trade War Slowed China’s 2019 Economic Growth to its Weakest Pace in Nearly 30 Years.” Fortune, January 17, 2020 https://fortune.com/2020/01/17/china-gdp-growth-2019-weakest-30-years-trade-war/ [1] Bradsher, Keith. “China’s Economic Growth Slows as Challenges Mount.” The New York Times, October 17, 2019 https://www.nytimes.com/2019/10/17/business/china-economic-growth.html [1] Tan, Huileng. “China Says It’s Economy Grew 6% in the Third Quarter, Slower Than Expected. CBNC. October 17, 2019 https://www.cnbc.com/2019/10/18/china-q3-gdp-beijing-posts-economic-data-amid-trade-war-with-us.html [1] Henderson, Tim. “Help Wanted: Too Many Jobs and Not Enough Workers in Most States.” Pew Charitable Trust. October 14, 2019 https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2019/10/14/help-wanted-too-many-jobs-and-not-enough-workers-in-most-states [1] Hayashi, Yuka “Credit-Card Debt in U.S. Rises to Record $930 Billion.” The Wall Street Journal, February 12, 2020 https://www.wsj.com/articles/credit-card-debt-in-u-s-rises-to-record-930-billion-11581442140 [1] “New Acosta Report Spotlights the Costly Effect of Tariffs on Consumers, Manufacturers and Retailers.” PR Newswire, December 10, 2019. https://www.prnewswire.com/news-releases/new-acosta-report-spotlights-the-costly-effects-of-tariffs-on-consumers-manufacturers-and-retailers-300972407.html [1] Francis, Theo and Gryta, Thomas. “U.S. Firms Pull Back on Investment.” The Wall Street Journal, November 24, 2019 https://www.wsj.com/articles/u-s-firms-pull-back-on-investment-11574591400 [1] Barrett, Emily and Hamilton, Jesse “Why the U.S. Repo Market Blew Up and How to Fix It.” Bloomberg, January 6, 2020 https://www.bloomberg.com/news/articles/2020-01-06/why-the-u-s-repo-market-blew-up-and-how-to-fix-it-quicktake [1] CoStar Market Report January 2020 [1] Kliesen, Kevin L.  “Forecasters See Lower U.S. GDP Growth in 2020 as Headwinds Continue.” Federal Reserve Bank of St. Louis, November 21, 2019 https://www.stlouisfed.org/publications/regional-economist/fourth-quarter-2019/forecasters-see-lower-gdp-growth-2020