Altus Insight: November, 2016

The Altus Insight

Market news, commentary and relevant topics for today’s alternative asset investor

Date: November 30, 2016
FR: Forrest Jinks
RE: Post Election Observations

As the author of a monthly distribution that some people sometimes read, I have a soap box of sorts. Before I get into the nuts and bolts of the immediate economic impact of the election I hope you will allow me a couple sentences of decidedly uneconomic opinions. I will try my best to not offend anyone in doing so. The Wednesday morning after the US population woke up in one of three camps. On one side were the ardent Trump supporters, celebrating a victory that most outside of themselves considered impossible. On the other side was a group of people that were bitterly disappointed in the results of the election. As we know from the lead up to the election and the fallout from the election, neither of these groups of people is especially fond of the other. In between these two, and who I think are the largest of the three groups, are the people that woke up Wednesday morning disappointed with who won the election, regardless of who they voted for. And even if the result had been a Clinton win, they still would have been disappointed. I am squarely in this third group.

Last December’s Insight discussed the growing divide among Americans (click here ). This election, regardless who won, turned a bright light on those divisions. I may have somewhat of a unique perspective on the divide due to living on one of the coasts but having spent a considerable amount of time over the past couple years in the fly over states, and with that perspective I would like to make an observation and voice a hope for all of us.

My observation is that people that voted against Trump feel those that voted for Trump are racist, bigots, ignorant, etc.. On the flip side those that voted against Clinton feel those that voted for Clinton are elitist, judgmental, hypocritical, feel they are above the law, and are trying to tell them how they should live their lives. Both sides basically think the other side is a “basket of deplorables” or whatever negative term might be associated with them.

The outcome of the election itself (regardless who won) wasn’t nearly as concerning to me as this growing divide. It started during the George W. Bush administration, accelerated during the Obama administration, and exploded during the recent presidential campaign. What happens to this divide under a Trump administration is still to be determined, but so far doesn’t look promising.

Unless we as a country are able to come together and acknowledge the legitimacy of the thoughts and opinions of others, the wall being built by the Trump supporters will grow taller and the chasm being dug by the Clinton supporters will grow deeper.

From my travels and experiences, those that voted for Trump, and especially the masses of those that voted for him that make up the middle group described above, are not bad people. Most are not racist. Most are not filled with hate. Most aren’t even anti-immigration. What they do want is it to be okay to disagree with political correctness. They want a government from the top to the bottom that respects and enforces the laws of the land, understanding those laws might be changed, but need to be enforced until then, not at the whim of an elite, but because it is the law. They want the government, and more than even the government, the PC society, out of their daily lives and businesses. The people I know that supported Trump span the full range of economic, race, religion, and geographic spectrum. Most are good people. And I believe the majority of the people that live in this country are good people, far better than the so called “elites” give them credit for.

On the flip side, those that voted for Trump need to understand that most of the “elites” are not evil people. Most truly have good hearts and hold their beliefs because they believe those beliefs are the better way. Yes, there is hypocrisy inherent in their opinions and platforms, but without a doubt there is also hypocrisy in the Trump platform. And in fact there is hypocrisy across the political spectrum and in each one of us. We are, after all, human.

And that is really the key of it all. We are all human. Most of us are good people at heart. We hold our beliefs not out of evil intent but because we believe our beliefs to be the best way forward. Elite or not, the truth is that none of us truly know what the future holds or how the past may have been different had different decisions been made. We are human and most of us are doing the best that we can. If we can recognize that in others, even if we disagree with their opinions, maybe we can at least respect their right to that opinion. Maybe, going a step farther, we can even acknowledge we may not be 100% correct in our opinions, and the opinions of others could hold some validity. Let’s call it compassion. With compassion we can come back together. Kudos to Trump for his acceptance speech. It was a step in that direction. Kudos to Clinton in how she handled the loss, it was a step in that direction. And kudos to President Obama in how he handled the election outcome. It was a step in the right direction.

Attached (see links below this article) are multiple articles discussing the election from different viewpoints. Ben Hunt used social media heat mapping, anticipated the outcome, and took advantage of it as an institutional investor. Another of the articles looks at the election (and Brexit) from a geopolitical analysis standpoint. Two others have a dad and son economic consulting team taking different viewpoints on the future. We may agree or disagree with the thoughts and opinions of analysis such as these but what this election has shown us (again) is if we don’t take the time to learn and understand the viewpoints of others we can put ourselves in line for some sizeable shocks.
Economic Observations

  1. The Asian stock markets got killed when it became apparent Trump would win with the Nikkei down over 5%. The US future markets were down so far they were shut down (over 900 points). The ten year treasury, upon which a large percentage of real estate and business interest rates are based, skyrocketed, driving yields substantially lower. This is what was expected in the case of a Trump win. And then something else happened…Everything turned around, reversing course. By mid-morning on the day following the election the S&P was up over ½% and yields on ten year treasury had exploded over 20% from their Tuesday evening lows. We were scheduled to close on a Fannie Mae apartment refinance Monday and the rate on the loan increases our cost of borrowing $120,000 over the life of the loan. Now, nearly a month later the stock markets have continued to climb, hitting new highs almost daily, while bond prices have continued their freefall, with 10 year treasury yields increasing almost 60% from their post election (temporary) lows. SIXTY PERCENT!! This is a huge increase and caused sizeable pain for bond holders and adjustable rate borrowers.
  2. Despite the mainstream opinion being that Trump is a volatile, the “safe haven” US dollar has appreciated drastically against other currencies. It is up almost 6.5% versus the Euro, 11.5% versus the Japanese Yen, even 2.4% against the Chinese Yuan, which is supposedly soft pegged to the dollar.  All are big moves in the normally boring currency markets. And the stronger the dollar grows the harder it will be for Trump to push against the tides of foreign imports. Coming out of the Great Recession the weaker dollar was credited for many small manufacturers “on shoring” portions of their operations. The strong dollar could well cause the opposite. The benefit of a strong currency is cheaper consumerism (which can help the struggling retailers) and less expensive foreign travel. My upcoming trip to Japan basically became 11% cheaper since the election.
  3. We don’t know how big of a gap there will be between what Trump said and what he does. Unfortunately for his most ardent supporters, but probably fortunately for most of the rest of the country, a large part of his campaign platform was more rhetoric than substance.  Will there be changes to international trade? Yes. Is trade with Mexico and China going to stop? No. This is reinforced with currencies moving the way they have been (see #2). Currency moves alone may temper Trump’s ability to swing the trade needle as much as he claimed he wanted to.
  4. We may actually see inflation. The two levers that most affect inflation are amount of money in circulation and the velocity of that money within the economy. For the past 8 years the Federal Reserve has been trying to increase inflation, both by printing money/expanding their balance sheet (yes, I know it is much more nuanced than that) and lowering interest rates to entice people and business to borrow money (to increase velocity). It hasn’t worked. Basically overnight on the night of the election the opinion of the coming inflation changed on Wall Street, soon followed by Main Street. Because of how velocity of money impacts inflation, belief in inflation is something of a self-fulfilling prophecy. People think they thing are going to cost more in the future so they buy them now versus saving the money to buy later. That money spent money is then re-spent by the receiver of the money because they believe the item they want to buy will be more expensive in the future, and so on. The higher the degree of confidence that prices are going up, the more they will go up. The Federal Reserve tried for years to get people to believe inflation was coming with no luck. A Trump election, almost certainly without forethought by the President-Elect himself, created the phenomena overnight. I will give him credit for the second part of the equation, some of which I think is great and the other part of which is not. The good part is his ideas around bringing back cash held outside the US by multi nationals. A report by Fortune magazine estimates there is $2.4 Trillion dollars held outside the US by Fortune 500 companies. Assuming that money isn’t spent on stock buybacks, getting that cash back into the US would drive investment, increase currency in calculation, and increase velocity. That should help both real (investment leads to increased productivity) and nominal growth (cash * velocity). The part of this plan to which I am opposed is the planned increase in Federal Government spending. I am a big believer that our infrastructure needs investment but spending without making sure it is as investment just leads to an increased government debt load. Study after study have shown that increased government debt loads lead to slower growth. Though the studies vary in where the debt load becomes problematic, most agree that as the total debt moves past 100% of GDP economic growth declines. With debt currently at ~$19 Trillion and with GDP a little over $18 Trillion we have crossed the line. Extra spending may have short term benefits (although even that is arguable) but almost certainly with long term costs.
  5. Industries that benefited under Obama’s presidency will likely underperform the market and those that struggled will likely outperform the market. The pork belly doesn’t go away, it just has changed beneficiaries. Separately, if Trump really does make improvements in regulatory burdens (I am doubtful that a president can do much to change the living organisms of bureaucracy) this will benefit small and medium size companies on whom the regulatory burden was the most onerous Larger companies may also see a short term benefit, but will likely see an increased vigor in competition. This could be especially true in agriculture (it is interesting to see the lobbyists behind most ag. regulation) and banking (assuming Dodd Frank is eliminated).

How does the election change what Altus is doing?
At the most basic level nothing changes at Altus. We are still value investors who focus on cash flow producing properties, preferably in markets with good long term economic growth prospects. We will still be looking for the needle in the haystack, still depending on our deep relationships to find those needles, and still looking to our organization’s strengths to capitalize on the opportunities attached to the needles we do find.
At a higher level we are viewing the world very differently since the election. Not specifically because of who was elected or what he himself plans on doing, but because of the market’s response to that election. We are in a business directly impacted by borrowing costs. Increasing inflation means increasing interest rates. Increasing interest rates mean rising cap rates. Rising cap rates mean each dollar of income is priced lower by the general market than it was previously. Below are our currently strategies for how to deal with these changes, but with one major caveat. The current inflation expectations are based purely on investors’ assumptions of Trump’s impact on the economy, and more precisely, on other investors’ assumptions of Trump’s impact on the economy. The underlying economic data, and especially given the risk of foreign market shock, don’t yet support the inflation trend belief. That means the belief itself is fickle. Fickle means things can reverse again, and quickly. The so called “Taper tantrum” in 2013 is a perfect example. Maybe we have truly turned the corner and we are on our way to normalizing interest rates, economic growth, and the economy. Or maybe we aren’t. Our focus:

  1.  Increases in interest rates will create substantial headaches for those using adjustable rate debt to create yield. The yield spread premium can absorb some rate increases at the expense of cash flow, but if rates continue to rise eventually the increased borrowing costs create negative cash flow. Even while the current increases probably haven’t pushed many properties into the red, the higher rates are still a big problem when the loan period has expired and properties need to be refinanced. I have heard of cap rates moving as much as a full percentage point in some markets over the past couple months (specific to retail). A 1% increase in cap rate on a previously 5 cap property is a 17% decrease in market value. With debt loads at 80% and often even 90% of previous values, the property becomes impossible to refinance. In short, the increase in interest rates, if sustained, is going to create problems in the real estate markets. Problems in leveraged real assets mean opportunity for the person on the other side of the table. Even as we were more conservative in 2016 than 2015, we will likely be that much more conservative again in 2017, focusing on fewer properties but making sure those buys are big winners.
  2. We still believe repositioning projects are a great way to go. As market prices decrease (or not), the repositioning project is still creating relative value. This benefits the investor who ends the project with more absolute value than at the beginning of the project (Additional reading about relative value can be found here ). The one change to our repositioning strategy is to make sure we structure our financing to protect ourselves against any large upward movements in rates.
  3. As cash flow investors, the cash flow an investment creates is of far more value to us than an increase in market price. Price only matters when it comes time to sell or refinance, and then, absolute price only matters when the sales proceeds are being moved out of an asset class to a non-correlated asset class. Cash flow is not technically created by the cap rate unless a property is being purchased without debt. If debt is involved the spread between the cost of borrowing and the cap rate is more important than the cap rate itself. This means strong cash producing opportunities can be secured even in a market with declining prices.
  4. Stay long term focused. Fear of inflation is driving the interest rates. Inflation should also result in higher market rents, but at a delay compared to the change in market prices. A long term focus can take advantage of those increases to rents, maybe even to the point in offsetting any cap rate driven declines in market price.

First there was the surprise of the election itself (for some more than others). Then there was the surprise at the way the financial markets reacted (maybe for me more than others). The markets are acting in such a way that we are now in a period of relative calm. But there will always be surprises and there will always be changes. We will be keeping our eyes on areas of possible surprises (French and Italian elections for instance) while doing our best to hedge against events that are impossible to foretell, the true black swan events. And of course, we will paying special attention to changes in the interest rate environment and how cap rates are affected. This almost assuredly will not be the last time this topic is discussed.
Happy Investing,
Forrest Jinks
Altus Equity Group, LP