By Todd McNeill
Last year my colleague Charley Babb wrote about Inverted yield curve and its historical significance in predicting recessions. To refresh, what is an Inverted Yield Curve? An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is a predictor of economic recession. (A partial inversion occurs when only some of the short-term Treasuries (five or 10 years) have higher yields than 30-year Treasuries.)
Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in 2000 just before the U.S. equity markets collapsed. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are being demanded, sending the yields down. This indicates an environment in which higher short-term rates reflect tightening monetary (Federal Reserve) policy and lower longer-term rates signal potentially weaker expectations for inflation and growth.
To save the suspense, the U.S. Treasury yield curve just inverted for the first time in more than a decade (sort of) to be technical the 2/10 spread is currently a minuscule 12 basis points, and thus the margin for error for an upward-sloping yield curve is basically nonexistent.
There are several reasons for many to feel this is the start of an upcoming recession.
- Stocks pull back – U.S. stocks turned lower with the S&P 500 & Dow free-falling over the government shutdown, trade wars, algorithmic trading and a general feeling of slower economic growth returned.
- Flattening yield curve back in the spotlight – Market anxiety was further heightened by renewed flattening in the yield curve. In particular, two-year U.S. interest rates are now above five-year rates and the two-year and ten-year are almost on top of each other.
There has been market panic over the flatter yield curve several times in the past few years. Traditionally, a flattening yield curve is a sign of a maturing economic cycle, not the end of it. In fact, in the past, even when the yield curve has inverted, a recession did not emerge for an extended period of time. I sure would not dismiss the risks that are prevalent in today’s investment environment however the risk of a recession in 2019 is quite low. I would expect ongoing volatility but not the imminent end of this bull market.
Positive fundamentals haven’t changed overnight – This bull market is mature, in our view, but not out of gas. The flattening yield curve reflects the changing complexion of the investment backdrop, in which the central bank stimulus is fading and economic growth is likely to tick down a bit next year. That said, the fundamental backdrop remains solid. Following a year of roughly 3% GDP growth in the U.S., the pace of growth in 2019 is likely to slow modestly but remain positive. The unemployment rate is near a 50-year low and wage growth is at its highest level in years, two key pillars of support for the consumer and thus the U.S. economy. In addition, corporate profit growth – while not likely to match this year’s very strong 20% pace – should remain healthy next year. The combination of positive GDP and earnings growth has traditionally been a sound foundation for market performance over time.
After summarizing some of the broader reasons for optimism, as it relates to the Commercial Real Estate environment, I would like to point out a few factors that are positive and why we expect it will remain stable.
- No overbuilding in this cycle in commercial or residential, we have great supply/demand conditions and the economy is supporting sustained space demand.
- No overleveraging in this cycle!
- New capital flow from private sources coming into the sector, there is compelling yield with cap rates ranging from 5% to 8% range.
- Long-term Borrowing rates are still historically low.
- The positive impact of tax reform has yet to materialize. There are a variety of provisions in the new tax code that exist that make commercial real estate a “tax friendly” vehicle for investing. These impacts have not been felt yet.
The upcoming showdown for the Government Funding should be interesting to watch unfold once the Democrats take full control of the House of Representatives and are most certainly contributing to the near-term volatility. Once this is behind us, for reasons outlined in this article, I would expect another solid year for commercial real estate, despite a bit more overall market volatility than we have seen in the past.
The author, Todd McNeill, is a Senior Director and Co-Principal of MCA. Todd can be reached at 972-267-0600 and [email protected].
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