Publications

- December 1, 2019: Vol. 6, Number 11

Forecast 2020: The economic caution flag is out

by Sheila Hopkins

If you liked 2019, then settle back and enjoy 2020.

Despite being hit by volatility from all sides — politics, stock prices, trade wars, weather patterns, energy supplies, the price of avocados — the 2019 economic climate was relatively calm, especially for real assets. Gross domestic product (GDP) continued to grow, albeit at a snail’s pace. Consumer confidence remained strong. Unemployment was at its lowest in the past 50 years. Jobs were added at a good clip. And numbers released in early November show these trends are continuing, though possibly at a bit slower pace. There is, therefore, no obvious reason to believe we won’t continue to see a slowly expanding economy, happy consumers and employed workers in the new year.

Why, then, does it seem everyone is talking about recession? Part of the angst is simply due to people believing in their gut that all good things must end sometime, and it is probably time for the record-setting expansion to end. No one wants to be caught unaware, like Wile E. Coyote, when that anvil finally falls from the sky.

This uneasiness and uncertainty are not completely unwarranted. Afterall, the economic indicators are throwing off mixed signals. Some are in the “let’s keep the party rolling” range, while others are waving red flags. Whether you believe the economy is solid or you believe it is being held together with bubble gum and duct tape depends on which economic indicators you put your faith in.

Those who see a repeat of 2019, with very little chance of a recession in the near future, tend to look at the GDP, consumer confidence index and the unemployment numbers. Those who feel we are on the verge of a recession point to business-related indicators, such as corporate profits, the ISM Purchasing Managers Index and corporate spending. In addition, the uncertainty around political decisions weighs heavily on many analysts.

A survey conducted during the summer by Zillow Research, for example, found that half of the 100 real estate and economic experts who responded said they expect the next recession to begin in 2020, with another seeing a recession in 2021. Trade policy, a geopolitical crisis and/or a stock market correction were the factors identified by panelists as most likely to trigger the next downturn.

INDICATORS FLASHING GREEN, YELLOW AND RED

A quick look at the primary economic indicators will show why most economists and pundits feel we will get through 2020 recession free, but why there is also a significant minority of experts who see darker days ahead.

On the positive side, the economy seems to be chugging along quite nicely, despite being in the longest expansion in U.S. history.

  • GDP has been the primary tool for measuring the strength of economies for more than 80 years. Critics point out that the world has changed since the GDP measurement was introduced but, when looking at trend lines, it is hard to beat something that goes back eight decades. The majority of major research houses are predicting slowing GDP growth in 2020 of just below 2 percent.
  • Consumer spending drives about 70 percent of the national economy, so knowing how confident consumers are in the economy — and thus how likely they are to keep spending — helps predict where the economy is headed. As of October, consumer confidence and optimism were still strong, with respondents anticipating larger income gains and lower inflation during the year ahead, according to the University of Michigan Survey of Consumers.
  • The U.S. unemployment rate is at a 50-year low, falling to 3.5 percent in September. The October U.S. employment report, however, indicated that hiring is slowing, and wage growth has been limited.

Not all is rosy, however. While the economy looks to be on solid footing, corporate health is a bit dicier.

  • Earnings growth estimates have come down drastically this year. Last December, analysts estimated S&P 500 earnings growth for the year would be around 7.6 percent, according to FactSet. That number is now around 2.3 percent. According to MarketWatch, Stephen Gallagher, chief U.S. economist for Societe Generale, predicts a 2020 recession based on the fact that corporate profit margins have been falling since 2015. When this happens, firms reduce inventory, cut back on purchasing and often cut costs by cutting personnel.
  • The Manufacturing Purchasing Managers Index tracks factory activity. If the index falls below 50, it indicates the manufacturing sector may be contracting. In August, the index fell to 49.1, and continued its downward trajectory in September, when it came in at 47.8, its lowest since June 2009. It rose a smidgen in October but remained well below 50. Tariffs, a trade war with China, a global trade slowdown and a strong dollar were the most often cited reasons for the manufacturing slowdown. However, a few analysts blame the decline on the GM strike, and predict the manufacturing index will bounce back when auto workers return to work.
  • Gross private domestic investment fell 5.5 percent during the second quarter, the worst since the fourth quarter of 2015, according to the Commerce Department. Businesses are hesitant to invest in future initiatives due to the same uncertainties listed by the purchasing managers cited above.

In addition to these conventional indicators, investors look at other activity that historically has signaled a coming recession.

  • The Federal Reserve Board has raised rates, lowered rates, sold bonds, purchased bonds, and generally acted during the past year like it was not sure what it should be doing. In addition, during the past few months, it has found itself pumping capital into the system when the bank repo rate (the interest rate banks pay when they borrow to cover a very short — often just overnight — cashflow crunch) jumped from its typical 2 percent level to 10 percent. This was the type of increase that occurred before the 2008 recession and, thus, many forecasters see it as a sign of bad things to come. Others point out that although the cash crunch is similar, the causes are different and, therefore, there is nothing to see here.
  • The inverted yield curve has historically been a major indicator that a recession is afoot. The U.S. Treasury yield curve has been inverted since May — meaning that the three-month Treasury bill has a higher yield than the 10-year Treasury note. This phenomenon preceded the past seven recessions, although it is often more than a year between the events.
  • The Cass Shipments Index, which measures North American freight activity, has fallen for 10 consecutive months, as of September. Based on the significant slowdown of global freight, the Index sponsors state that the index is “signaling an economic contraction.”
  • Commodity prices have also been signaling uncertainty. Copper, which is known as a barometer of economic health because of its use in homebuilding and commercial construction, was down over 13 percent in the last half of 2019. Conversely, gold, which is used as a safe haven in times of uncertainty, saw its prices climb more than 20 percent since May when the U.S. and China escalated their tariff fight.
  • The U.S. budget deficit stands at nearly $1 trillion, with no plan to bring it under control. In addition, the national debt has risen to $22.5 trillion, 106 percent of GDP. The fear is not so much that the debt and deficit will cause a recession, but that the government will be unable to soften its impacts when one occurs.

With all of this conflicting data, it is hard for investors to develop strategies to ride out the uncertainty.

WHAT IT ALL MEANS FOR REAL ASSETS

Despite some indicators flashing red, the economic trends we saw in 2019 are most likely to continue through 2020.

“The anvil is unlikely to drop in 2020,” says Adam Hooper, CEO at RealCrowd. “People have been calling for the end of the cycle for three or four years, but there is nothing apparent to cause a severe pull back at the moment. Investors, however, should be more conservative and look for strategies that will compensate for a correction when it comes — possibly in 18 to 24 months. That means taking on lower-leveraged deals that are structured with a long enough horizon to ride out any correction.”

Investors appear to be taking this advice and investing sensibly — or pulling out of the market all together.

“We saw a slowdown in capital raising in 2019, especially in real estate,” says Peter Hobbs, managing director and head of private markets at bfinance. “On the infrastructure side, 2019 is set to be a record capital-raising year, although we saw a drop off in the third quarter. In 2020, the asset classes should be resilient due to diversification and the contractual nature of their cashflows, as well as relatively low leverage. Investors are hunkering down through more resilient strategies, including real estate debt, investing in assets with long and durable cashflows, and taking on exposure to international markets, as well as positioning themselves to exploit opportunities associated with a correction.”

This move to hunker down has given rise to several real assets trends that should make an impact in 2020.

Affordable and workforce housing funds, for example, are picking up steam, both from U.S. investors and those looking to invest in the United States.

“We’ve seen tremendous flow of capital into affordable housing funds from Europe and Asia,” says John Williams, president and CIO of Avanath Capital Management. “Affordable housing is seen as a defensive strategy with a sustainable cash flow that is not going away. Most mainstream multifamily funds target luxury apartment development, which is appropriate for only the top 10 percent of renters. Affordable housing targets a much larger and durable renter pool.”

In addition to a durable cash flow, affordable housing plays into another trend affecting real assets, the growth of ESG and impact funds. Investments that have a positive social or environmental impact are gaining widespread acceptance. Fidelity and Vanguard, for example, have funds that meet the needs of investors looking at impact investing, with a growing cohort of investors requiring their investments meet ESG standards. According to Vanguard, at the end of 2018 there were more than 350 ESG funds available to retail investors in the United States, representing $89 billion in assets under management. More than $20 billion of that amount was added during 2017 and 2018 alone.

Tax-advantaged strategies are also expected to benefit from investors’ move to defense. Despite their slow start, opportunity zone funds should see a surge of support in 2020 as regulations are finalized and investors feel more comfortable with all their nuances.

“Given how impactful and how advantaged the opportunity zone program could be, we were surprised it was not more popular in 2019,” says Hooper. “Funds had announced they intended to raise billions of dollars for their programs, and we didn’t see that pan out.”

The reasons for the slow start for opportunity zones are varied, but it seems to come down to the uncertainty factor.

“It took the Treasury awhile to nail down regulations and nuances,” explains Williams. “Investors were wary to go into a new vehicle if they couldn’t be sure how the real estate would be taxed. It all comes down to surety. We expect to see an upsurge in interest and commitment in 2020.”

In line with looking at targeted investments such as affordable housing and opportunity zones, investors are also looking to move out of the big, mainstream markets and find smaller, easier digestible markets to invest in.

“We see continued opportunity in tenant and investor flight to secondary markets with growth potential,” says Rodney Richerson, regional president, western region at KBS. “These markets include Raleigh, Nashville, Portland, Austin, Denver and Salt Lake City, which have a well-educated workforce, robust employment, strong transportation infrastructure, major universities and a high quality of life.”

One final trend that could change how retail investors access opportunities in 2020 is the growth of fintech platforms. These platforms, which grant investors access to the same quality private equity funds that institutional investors have long used, appear to be reaching a tipping point as investors are demanding the ability to access alternatives from their RIAs, and institutional funds are eyeing a new market of retail investors.

BOTTOM LINE

Looking ahead to 2020 is a lot like driving a familiar but winding road in a snowstorm. You know you have navigated the twists and turns many times before, but the snow provides an added dimension. It obscures your vision, so you have trouble seeing if something is blocking the road, plus it threatens to send you into a ditch at any moment. Just like the driver of the car slows down, takes the familiar turns with more caution and is hyper-aware of danger ahead, investors in 2020 will find the investment climate to be very familiar, but surrounded by hazy uncertainty. Thus, they will continue to invest and move forward, but will exhibit extra caution. They never know when that Road Runner — or black swan — might just run across the road again.

 

Sheila Hopkins is a freelance writer in Auburn, Ala.

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