Blain’s Morning Porridge Feb 13th 2024: Commercial Property and US Bond Yields – these are things to fret around.

“Buildings feel the presence of the past, the spirit of a place, they are the reflection of society.”

Two things worry me: the consequences of a Commercial Property bust, and the potential of a US$ Bond Crash. Equities merely reflect dimly their relative value to real assets and rates – and will suffer accordingly. Not to worry though.. the IMF says no recession!

If the IMF – typically the haruspex warning us Woe, woe, thrice woe! – tells us the global economy will likely avoid recession, and congratulates central banks for guiding us into a soft landing, I can only conclude something is about to go horribly, messily, confoundingly wrong!

Two things worry me: The consequences of a Commercial Property bust and demand for Sovereign Bonds – particularly US Treasuries.

Equity markets? Tush and nonsense. No point worrying about stock prices. If folk believe the S&P justifies a near record high and Tech prices make sense in these uncertain markets, then that is what stocks are worth. More fool them. The equity markets – for all their bluff and bluster – are a function of relative value to other markets. Watch what happens to stocks if bonds crash.

Stocks are worth whatever you can convince the market they are worth, but Buildings and Bonds are real. Real assets set the relative value of financial assets – including the imaginary market-set prices we ascribe to the unknowable future values of stocks.

Losses on commercial property reverberate round markets with amazing speed. There is no swifter way to generate crisis headlines about a bank lending crises to follow than to cite their commercial property impairments. That’s normal. The reason I’m worried about commercial property is the unerring ability of so many investors to get it completely wrong – which is the real story in current losses. Over the past year, mounting concerns on the commercial property exposures of secondary banks – in the US, Japan, China and now Europe have come to the fore.

Blains 3^rd Law of Banking is: When Banks are in Trouble, German Banks will be in the Front Row. Sure enough, Deutsch Pfandbriefbank is in trouble in “the greatest real estate crisis” since the last one, according to their flollopping CEO. They needed a bail out in 2008 and maybe another one is coming as it fesses up to $5bln US commercial property book. If anyone can explain why a sleepy German bank with a name redolent of dull, boring, predictable covered bond funding of dull, boring, predictable property assets, has been playing fast and loose in the US markets… I am all ears. (Oh, because German bankers think they know better: Germans are wonderful engineers, and historically are terrible financiers. Sorry – but fact.)

Other German banks are also struggling to explain how badly they are exposed to globally weaker property markets. Germany figures large in the $30 bln collapse of Austrian property scam Signa. German cities are littered with unfinished Signa badged buildings – but Rene Benko’s sham portfolio included the Chrysler Building and Selfridges.

It’s the list of Benko’s lenders that is worth looking at. He has cost Julius Bear its CEO after a $700mm write-off. Other leading banks like Citigroup, sovereign wealth funds like Mubadala and GIC and leading family offices have all been sucked in to the story: the narrative that Benko was a property investment genius. Nope, he was a very pervasive salesman – who over-levered bad properties that could not withstand higher rates and falling footfall.

They key point, however, is it’s not just banks that are losing money in property crisis. Its banks and professional investors – confirming how risk has been transferred out the banking sectors to other lenders. It did not reduce the quantum of property risk, but it did transfer it and thus reduced the likelihood of a focused banking liquidity crisis on property lending across the wider investment sector.

There is a highly experienced property investment sector – funds with real expertise and knowledge of the property markets and how the manage their risks. They like property crises – opportunities to acquire assets on the cheap as the property-investment tourists flee the market.

To illustrate: One of my other Blain’s market mantras is “When a bank builds a new Corporate Headquarters…sell the stock.” Although Bear Stearns was the best firm I ever worked for, I dumped most of my stock in 2005 when they announced they were building a European HQ in Canary Wharf. That building has had a chequered history – if you look carefully, you can still see where the Name Badge logo was supposed to go. It was bought by Chinese investor Cheung Kei in 2017 for $300mm, but recently scooped up by an Israeli firm for $110mm. I’m not sure how good a trade that was: 16% of the buildings in Canary Wharf are empty, and HSBC’s will exit it’s Temple of Gloom HQ within 3 years.

As Western economies continue to evolve post pandemic – it’s clear the need for large city offices has changed. The money will be in the most modern buildings that best meet stringent environment regulations – but much of the office stock will prove surplus – which in some cases could convert to apartment space, but otherwise may have to go. That has property opportunity writ large across it – but who will lend on property following losses among less expert funds?

(There is a Genesis song from the 1970s:

“Many too many have stood where I stand. Many more will stand here too

The thing what I find strange is the way you build me up, then knocked me down again.”)

I dimly remember a dull old building just north of Moorgate in the City in the 80s. A few years into my City career I was invited to the launch party for Merrill Lynch’s swanky new HQ at Ropemaker Place. (It rained, and the roof leaked on to the canapes in the foyer.) Just a couple of decades later I found myself working in a brand new building on the same site. 3 buildings on the same site during my short City span.

The fact is a commercial property bust may not kill as many banks as quickly as we fear, but it will leave markets battered and bruised towards property lending – at a time when the global property stock needs re-investment.

Bonds:

The second issue that concerns me even more is the continuing expectation bond yields will continue to fall, and fall fast as The Fed, Bank of England and the ECB ease rates. We’ve seen market predictions of a deep series of swift rate cuts slip to acknowledgements of 3 or maybe 4 cuts this year. Maybe that’s still an overestimate. Although inflation numbers are falling – how sticky may they yet prove? When economies are not sliding into recession and wage pressure remain high – why expect banks to risk easing rates? Rates will remain real – higher than inflation. Rates are not going below 3.5% any time soon.

And don’t forget Government bond yields remain a factor of demand. That’s particularly important for the US Treasury market, where the US treasury anticipates some $1 trillion of new borrowing in the first half of the year (and that includes the lower than expected Q1 estimate of $760mm.) The US may dither with debt ceilings, but a US default is very unlikely (unless Trump tries very hard indeed). Normally I would be quite bullish on the US bonds shrugging off concerns about how the market will absorb US supply. But the bond environment is changing.

• In the pre-Covid world Asian powerhouse economies bought and sold in dollars, and needed to invest in dollars. Now China and much of the non-aligned block is experimenting and forging new non-dollar markets in commodities and energy.
• The power of the dollar is waning – not just because interest rates are expected to fall, but also on the same geopolitical and cold conflict factors.
• Dollar investments from China are no longer a given, and Japan (the other large buyer) is internally focused. Europe is keen to establish the Euro as a dollar counter.
• The more the US isolates and retrenches the less critical the global dollar becomes.. Pieces of Eight anyone?

With about 30% of the Treasury market focused on Sovereign buyers in Asia, assume these investors will need to be replaced with new natural dollar buyers. In a normal environment that might dictate a modest rise in Treasury yields to keep the buyers of the globe’s most liquid asset market happy.

However, there is a third factor at play – the US’ Virtuous Sovereign Trinity. That requires the three legs of a stable currency, a sustainable bond market and political competency working together to maintain investor confidence.

• As noted above the dollar remains for now the premier global currency and defacto means of global exchange pricing – but is under pressure from changing geopolitics.
• The Treasury market is deep and liquid – but not unchallenged. If demand declines in line with a less influential dollar, how much does that become a problem.
• In view of the increasing polarisation of the US political process and in the event of a Trump election – bearing in mind his comments about revenge, breaking NATO and general bumptiousness – what is going to restore confidence in US political competency?

It would be rare for all three legs of a nation’s virtuous sovereign trinity to crash together, but the risk on US political competency looks high. Worth thinking about and pinning to the threat board.

Out of time, and off to walk the puppy!

Bill Blain

Strategist – Author of the Morning Porridge

https://windshift.capital