by Bryan Perry
May 23, 2023
Debt ceiling talks are ongoing and both sides have promised that there will be no default, yet the Parties are miles apart on terms. There is little time for brinksmanship, yet once again, it looks like the midnight oil is going to burn when procrastinators are pushed to the point of partial shutdowns to buy more time.
Turning to the markets, some beaten down sectors (energy, banks) are getting a bounce, but the focus of the bulls remains on big-cap tech, home building, and various special situations in the healthcare space, where there is some merger & acquisition action. A resolution to the debt ceiling, a Fed pause, some further proposed backstopping by the FDIC for regional banks, and a continuation of inflation trending lower opens the way for the market to maintain its recent range or even break higher as these clouds lift.
The jury is out on what, if any, kind of “landing” the U.S. economy will endure, but it’s safe to say there is both anecdotal and empirical evidence that the consumer is more watchful of their spending habits. There is no sugar-coating the numbers on how the consumer is spending. The numbers are trending lower.
As reported on May 12, the University of Michigan’s gauge of consumer sentiment fell to a preliminary May reading of 57.7, down from an April reading of 63.5. That is the lowest level since November 2022. Economists polled by The Wall Street Journal had expected a May reading of 63, a fairly substantial miss.
Inflation expectations are only down slightly in May. Americans now expect the inflation rate in the next year to average about 4.5%, down from a sharp surge to 4.6% in April from 3.6% in March. The more personal “Current Economic Conditions Index,” a gauge that measures what consumers think about their own financial situation in light of the current health of the economy, fell from 68.2 in April to 64.5 in May, and the Index of Consumer Expectations, another measure that asks about expectations for the next six months, moved down to 53.4 in May from 60.5 in the prior month. (Data from Marketwatch)
With the consumer caution flag now out, there is good reason for investors to check their stock and ETF holdings carefully, heading into what could be a period of extended uncertainty for the broad market.
In my view, the market has already priced in some form of a debt ceiling deal, as well as a Fed pause on a further rate hike at the upcoming June 14 FOMC meeting. I think it remains unclear as to whether the recent good news on inflation trending lower is anywhere near being considered “mission accomplished,” by all the previous Fed tightening moves. I also think the waters ahead for the regional banks will remain very choppy and worrisome if short-term rates remain at the 5.0%+ level for too long.
The current betting is almost 5-to-1 that the Fed will stand pat on rates in June (source: CMEgroup Fed Watch tool)
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
To get a handle on the numbers impacting regional and community banks regarding their commercial real estate exposure, you don’t have to look far to get the latest data. The most recent Financial Stability Report issued by the Fed clearly states that commercial real estate poses a clear and present danger, especially to smaller regional lenders exposed to the sector. Among the 60% of all commercial real estate (CRE) loans held by banks, more than two thirds are held by lenders with less than $100 billion in assets, as defined by the Fed. Collectively, they have nonfarm, nonresidential CRE loan portfolios totaling $1.55 trillion, of which $500 billion is invested in office and downtown commercial real estate.
Losses on CRE loans will depend on the borrower’s degree of leverage, as property owners with high equity cushions are less likely to default, according to the report. Also, banks that issue loans with higher loan-to-value (LTV) ratios are more likely to experience financial difficulty as these loans are harder to refinance or modify. When real estate prices fall, as they have in recent months, LTV ratios rise.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Navellier & Associates does not PacWest Bancorp, KeyCorp, Zion Bancorp, Western Alliance, Comerica, East West Bancorp, or M&T Bank, in managed accounts. Bryan Perry does not own PacWest Bancorp, KeyCorp, Zion Bancorp, Western Alliance, Comerica, East West Bancorp, M&T Bank, personally.
While many economists have warned about commercial real estate as a broad sector, most of the worst distress has been confined to office properties, which make up 24.2% of the $10+ trillion CRE market. Estimates vary widely on the total value. One estimate puts the CRE market over $20 trillion as of 2021.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Mack Wilkowski of Investopedia (in “Fed Report Highlights Risk of Bank Exposure to Commercial Real Estate, May 10, 2023) reported on the concentration of bad loans in parts of this sector:
‘Among the categories of CRE, only offices—particularly those in big cities—are struggling right now due to the rise of remote work, along with certain retail properties like restaurants that depend on office workers,’ said Joseph Wang, CIO at MonetaryMacro.com. Loans on office properties are disproportionately issued by the smallest lenders, which have greater exposure to the sector than big banks and mid-sized regional lenders. ‘The smallest banks—those which few people have heard of—tend to be the most exposed to commercial real estate and are most at risk,’ Wang said. ‘I don’t believe this crisis is systemic, as big banks and even most regional lenders have little exposure,’ Wang added.”
This last statement about big banks and regional lenders having little exposure should be somewhat gratifying to markets in the short-term, but unless rates come down significantly from current levels, refinancing office properties with high vacancy rates and low occupancy levels could trigger a wave of defaults. In the wake of the Great Recession of 2008-09, 140 banks failed in 2009, 157 in 2010, 92 in 2011, 51 in 2012, 24 in 2013, 18 in 2014, and about 5 per year thereafter average. Recently, 2021 and 2022 saw zero failures before this year’s three beached whales, SVB, Signature Bank, and First Republic.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Source: Forbes (https://www.forbes.com/advisor/banking/list-of-failed-banks/)
Trepp, the leading research firm analyzing commercial real estate debt, has a front-row seat to the reckoning. Trepp says that about $270 billion in commercial real estate debt is coming due this year, which means that landlords will need to refinance their properties at today’s higher interest rates — and face significantly higher monthly payments. Roughly $80 billion, about 30%, are on office properties.
Rich Hill, head of real estate strategy at Cohen & Steers pointed out, “You have fundamentals under pressure from work from home at a time when lending is less available than over the last decade. Those two factors will lead to a pretty significant decline in valuations.
So, while some of the strife related to deposit outflows seems to have calmed, investors should brace for a wave of headlines regarding troubled or failed office property refinancing when properties are valued well below where they were when first financed years ago, against an environment of considerably higher rates and tighter loan terms. It is not an overnight problem – like a run on bank deposits – but it is one that looms exponentially larger in scope, scale, and potential risk to the banking system.
All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.
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Bryan Perry
SENIOR DIRECTOR
Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.
Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry
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