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Market Commentary, January 20, 2017

Great Expectations…Great Uncertainty

Third quarter GDP grew a robust 3.5%, benefiting from business investment turning positive as well as a material increase in the contribution from net exports of goods and services.   However, the magnitude of these contributions is likely to be unsustainable as business investment was driven primarily by inventory changes and exports should come under increasing pressure from the rising dollar.  As anticipation of economic growth builds, business equipment investment will be a key metric to monitor for signs of whether rising confidence is transformed into expansionary business investment.  The second key metric to watch will be the rate of increase in the value of the dollar, which will largely be dependent on Federal Reserve and foreign central bank action.

Employment growth finished the year with a moderate addition of 156,000 jobs in December, capping 2016’s 2.2 million jobs compared to 2.7 million in 2015.  This moderation is a natural occurrence as a tightening labor market makes it increasingly difficult for employers to find qualified candidates.  The increase in fourth quarter average hourly earnings growth to 2.75% from the 1.93% seen in 2014 is further evidence of labor market tightening.  Growth in average hourly earnings should continue to be a key bellwether metric going forward as continued growth would both further boost consumer confidence and support future spending growth.  

During the current cycle, government spending has been neutral to negative in its contributions to GDP. With the election of Donald Trump, this is expected to change, although the level of certainty is not as great as the equity and fixed income markets seem to believe.  As we wrote in our research piece, “Will 1600 Pennsylvania Avenue Return to Economic Relevance, Or Is It Merely Rhetoric?”, we do not know what the President-elect will propose, whether he will be able to persuade deficit hawks within his party and/or Democrats to support his fiscal policies, or the economic outcomes.  The first 100 days of the new administration – especially Congressional response to his fiscal and trade policy proposals – will be the first true test of whether market expectations for a highly expansionary economic environment will be met. 
 
Questions and concerns remain for economies outside the U.S.  One-third of the world’s GDP continues to operate under negative interest rate policies.  Brexit will likely come to a head in 2017 with the potential to create market and economic disruptions in the Eurozone, where banks generally remain undercapitalized.  On the other side of the world, Chinese foreign currency reserves continue to dwindle at a material rate, causing officials to take steps to stem the decline of the yuan.  Significant fluctuations in emerging market currency levels and the attendant swings in capital flows are increasing investor concerns in the face of expectations of a rising dollar. 

While equity and fixed income markets seem certain that we are entering a highly expansionary economic environment that will result in a significant increase in both inflation and interest rates, this is only speculation at this point. The uncertainty of fiscal policy direction applies to trade policy as well.  Finally, monetary forces remain an important factor – although the 10-Year Treasury rate rose subsequent to the election, as of this writing, the rate is only nine basis points above the level on the day before the Federal Reserve announced a rate increase on December 15, 2016.  As a result, in spite of two 25 bp increases in Fed Funds target rate, the 10-Year Treasury rate is barely above the rate at the Fed’s initial increase.  Where the effects of Fed action can be seen is in the LIBOR rate – from December 2015 to December 2016, the 3-month LIBOR rate increased 45 basis points.  

Commercial real estate returns have often fared well during periods of rising interest rates, due to the increase in economic growth often accompanying rising rates.  From 1978 to 2016, average quarterly NFI-ODCE returns during periods of rising Treasury rates averaged 3.2% as compared to 1.6% during periods when rates were not increasing. This should not be surprising when one considers that employment gains during periods of rising rates were twice that of gains during periods when rates were static or falling while growth in business investment was 2.5 times.  While speculation makes for good press, it remains just that: speculation.  What impact fiscal and monetary policy actions may have – positive or negative – on the real estate markets remains to be seen, but the environment signaled by today’s uncertain fiscal and trade policy suggests that maintaining a conservative approach with quality assets and strong credit tenancy continues to be a wise course of action as opposed to changing course based on speculation.

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